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FEATURE ARTICLE, NOVEMBER 2004
THE SALE-LEASEBACK FACTOR
Various real estate players use tactic to boost cash flow
and reduce debt especially with tax-deferred and TIC incentives.
Jeff Young
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Young
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The “sale-leaseback,” already a popular method
for companies to increase cash flow and reduce indebtedness,
may be set for an even better year in 2005 due to a confluence
of factors, not the least of which is the real estate investors’
healthy appetite for 1031 tax-deferred exchanges into tenant-in-common
(TIC) properties.
In a traditional sale-leaseback, a company structures the
sale of the investment property they own to the buyer, while
simultaneously leasing back the property, typically for terms
of 15 to 25 years with several 5-year options under a triple
net lease. By doing so, it can reap 100 percent of its equity,
while traditional financing would net the seller only 60 percent
to 80 percent. Other advantages include:
• A cleaner balance sheet, since that debt is no longer
a liability to the owner. Furthermore, if the seller uses
the proceeds of the sale to pay off debt secured by the property,
that too is removed from the seller’s financial statement.
• By monetizing its real estate, a company can free itself
of property management, which presumably is not its core business.
The company can then can free up assets to finance other business
strategies.
• Tax incentives.
• Retaining control of the property.
Added benefits to the subsequent tenant-lessee include receiving
both favorable rental rates, especially if it is a credit-worthy
company, and a premium price for quality property in this
seller’s market.
One other motivating factor favoring the sale-leaseback is
the reluctance of many companies to participate in synthetic
leases, which came under fire during the accounting scandals
of the past several years. This year has shown a decline in
this business approach, which is a hybrid form of financing
that uses an off-balance sheet, special purpose entity (SPE).
If all this were not enough to spur the growth of creative
financing through the leasebacks, the TIC market has provided
an even greater source of capital from 1031 exchanges. Many
real estate investors who formerly were restricted in their
choices of “like-kind” property, have, since 2002,
had the advantage of participating in these tenant-in-common
deals with the issuance of IRS Revenue Procedure 2002-22.
Many national sponsor companies — Tax Strategies Group,
W.P. Carey & Co. and Macfarlan — to name a few, are
seeking quality sale-leaseback properties for their investors.
These investors are individuals seeking to defer capital gains
and related taxation (depreciation recapture and state taxes)
and participate in real estate deals they would not have otherwise
been able to. In addition, they are looking to become more
“passive” investors while receiving a more steady
income stream backed by a hard asset. While most TIC deals
utilize mortgage financing, lenders are more willing to lend
and offer favorable rates if a long-term lease with a quality
credit-rated tenant is in place.
For the seller-lessee in these transactions, there are many
creative and flexible strategies that can be employed to support
its long-term goals and objectives. For instance, it could
decide to lease back just a portion of the property that was
sold if that were to fit the company’s model better.
Also, if the company had plans to relocate say in 7 or 8 years,
the lease could be tailored specifically for that event.
An even modest increase in interest rates within the coming
year could accelerate the trend toward sales-leasebacks even
greater. A market fueled by demand and lower rates has led
to over-building and higher vacancies in many major areas
of the country. As the curve flattens, these factors could
favor sellers wanting to maximize their real estate value,
opting to sell and become a tenant. Concurrently, the demand
for TIC properties continues, and the availability of properties
leased to credit worthy tenants will make the properties more
attractive to these investors.
These arrangements do not come without risks, however minimal
they may be. A close analysis should be completed to insure
that the company understands all of the tax ramifications
involved. Also, the rent will probably exceed debt service
on the old mortgage, and financial officers would be well
advised to consider all alternatives to drawing capital from
their properties, including refinancing.
There are many advantages for corporations converting to tenancy
from ownership. Real estate is a non-performing asset and,
by liquidating it, the cash can be invested in performing
assets, such as stocks. Risks on the side of the buyer-lessor
are purchasing a property that does not appreciate as anticipated
and assuming responsibility for the management of that property.
All in all, the sale-leaseback remains an attractive alternative
for owners seeking to put assets toward their core business,
pay off debt and move out of the property management business.
And should they decide to pursue this course of action, there
are plenty of TIC buyers on the sidelines waiting to participate.
Jeff Young is a senior vice president and investment
advisor for First Financial Equity Corp.in Scottsdale, Arizona.
| CORPORATE AMERICA
PUTS BIGGER STAKE IN 1031 EXCHANGES
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Ross
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People will do almost anything to avoid paying taxes.
Tax accountants and financial advisors are constantly
urged by private and institutional real estate investors
to find “safe harbors” so they can continue
to play their real-life game of Monopoly, trading less
desirable properties for more attractive ones without
writing big checks to Uncle Sam.
And for more than 80 years, these experts have been able
to reach into their tax toolkits and recommend the benefits
of the Internal Revenue Code Section 1031 tax-deferred
exchanges. However, only in the last 4 years, when property
values have soared to record levels, has the IRS tax deferral
law been so popular among large corporations.
Using the 1031 exchange, individuals who purchased a piece
of property 20 years ago for $1 million can now sell it
for $5 million and roll the profits into a new $20 million
transaction as a 25 percent down payment on the new property
– without paying capital gains. The sellers not only
improve their tax situation on the property sold, they
also now own a $20 million property, having geometrically
increased the value of their real estate portfolio.
By adding a zero or two behind those numbers, that proposition
becomes even more important on the institutional side.
Large corporations, especially life insurance companies
with growing portfolios of real estate, stocks and bonds,
are increasingly turning to the 1031 exchange as a means
of avoiding giant federal tax bites resulting from the
sale of their properties. Whereas a typical 1031 exchange
transaction has been in the $1 to 5 million range, today
high net worth individuals and corporations are trading
properties worth $10 to 75 million. This is a trend that
will continue.
In one of the dozens of 1031 exchange transactions I have
completed in the last 2 years, Northwestern Mutual Life
Insurance acquired an industrial warehouse building in
Santa Fe Springs, California, where the tenant was Liz
Claiborne. Because Northwestern was in the midst of a
1031 exchange — the property it sold had to be replaced
with what the IRS calls a “like-kind” property
— the life insurance company’s bid for the industrial
site was more aggressive and it was able to win the acquisition.
In another deal, a Toys “R” Us store was sold
for $3.6 million to two private investors who, because
of the 1031 exchange, were willing to pay more than the
minimum required so they could avoid paying higher taxes
on the transaction. This created a win-win for both parties.
In addition to the obvious benefit of deferring capital
gains taxes, the 1031 exchange is allowing companies to
maximize their real estate portfolios by acquiring larger,
more valuable properties, which they can hold for longer-term
appreciation.
A third benefit, and one of the reasons why property owners
ultimately sell, is that the depreciation schedules on
their real estate holdings have expired. However, by selling
their property and buying another of equal or greater
value under the 1031 exchange rules, they start a new
tax depreciation schedule, as well as avoid paying taxes
on the sale.
The downside? If property values go down (unlikely) and/or
interest rates go up (more likely), a 1031 exchange could
result in a break-even or losing return. However, most
investors are in it for the long term and, with good tax
advice, can minimize any liabilities.
Overall, the result of the long-standing but newly popularized
IRS code is positive. As long as property values continue
to increase, and investors — both corporate and private
individuals — continue to build wealth, the tax base
also rises. It has stimulated the real estate market by
attracting more commercial real estate buyers and sellers,
and by offering large corporations the opportunity to
convert their tax-deferred dollars into other economy-building
ventures.
Michael Ross is a senior vice president and manager
of the Investment Services Group of Colliers Seeley
International in Los Angeles.
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