Sale/leasebacks can provide capital well below conventional rates, and can give a boost to your cash flow.
Orion Research Inc. said it sold its headquarters building to the Mutual Life Insurance Co. of New York for $10.75 million and will lease it back.
Orion, a marker of analytical instruments, said it has an option to repurchase the building in 1991 at a fixed price that it declined to disclose. The company said the sale will reduce existing bank debt, much of which is at floating rates. Orion Research news release, 5/19/81.
Orion (1980 sales: $19 million) is just one of an increasing number of small businesses that are turning to the real estate sale/leaseback as a creative source of new financing. With real estate prices pushing through the roof these days, most people -- including businessmen -- would rather own an appreciating asset than let some landlord reap the gains. But for a growing business, ownership of real estate, a noncurrent asset, often obscures potentially current liquid assets that can be put to work more effectively. Like Orion, many expanding business seeking to stabilize their balance sheets against the vagaries of loan rates, or entering the market for more money, might look first to their own fixed holdings. By selling property for cash and simultaneously renting it back from the buyer through a long-term net lease, a business may be spared the perils of borrowing and the headaches of a stock flotation -- and gain capital advantages, too.
Indeed, through tax benefits to the buyer and cash flow improvement to the seller, a well-executed sale/leaseback deal can turn out to be one of those rate arrangements in commerce that result in measurable profits for both parties. Here's how:
Suppose a business has owned its factory or headquarters for 20 years. The depreciated property is carried on the books at a residual value of 20% of the purchase price, even though its true market value may have risen dramatically. As such, it is clearly a wasted asset that does not even enhance the balance sheet. As one alternative, the building could be refinanced by entering into a new mortgage, usually for about 80% of the market value. But the Internal Revenue Service does not consider such refinancing a taxable event. Therefore the new value cannot be depreciated, and a major tax advantage is lost. Without it, mortgage payments will be higher than many small companies' cash flow can absorb.
If the building is sold outright, on the other hand, the company will have to pay capital gains taxes on the profit. If the original cost was, say, $120,000, the property would be carried at perhaps $20,000 for the land (which can't be depreciated) and $20,000 residual value for the structure. The company will have written down $80,000 in depreciation. Let's assume the property is sold for $400,000, generating a $360,000 capital gain. If the effective corporate tax rate is 30%, $108,000 is paid in taxes, leaving $292,000 to plow back into the business, in contrast with a bank refinancing that would generate $320,000.
In terms of working capital, the business is initially $28,000 better off via the mortgage route. But now the fun begins -- much of it subtle and some of it downright ingenious. Depending on the clauses that each party can dream up (and on strategies that the IRS hasn't ruled against), a sale/leaseback agreement can be a truly innovative financing instrument.
One of the cornerstones of the agreement is the fact that a buyer is often willing to accept an annual rent that will cost the company less than annual interest on a loan. The buyer can do so since total return -- profit on the continuing appreciation of the property and tax advantages that accrue to new ownership, as well as rental income -- will make the package attractice. As a result, the sale/leaseback can effectively provide capital at rates that are 1 1/2 to 2 1/2 points under conventional debt rates. To appreciate the distinction, note Princeton, N.J., corporate finance specialists Harry Brener and Michael Masanoff, it is important to understand that the last thing a bank wants is to end up owning a piece of real estate, whereas to the buyer in a sale/leaseback, ownership is paramount.
The buyer might accept a lease, therefore, at $40,000 a year for 10 years, where orthodox financing might cost $48,000. The lessee takes the rent off gross profit as a business expense. (If the business is operating at a net loss, the rent contributes to a tax loss carry-forward.) The buyer, often a limited partnership whose participants pay individual tax rates, gains tax advantages that include depreciation on the new, higher basis, interest deduction on the financing, possible accelerated depreciation on such installations as pollution devices, renovations to specifically qualified structures and other components, and deductions for management fees. Wrapping up his profit picture in one nicely sheltered bundle, the buyer likely will grant the seller a buy-back option on prearranged terms.
A carefully drafted sale/leaseback is not regarded as a financing vehicle by the IRS. Thus the terms of the deal can be quite far-ranging. (Examples: The lessee can expense payment for rent on the land, which as owner he couldn't do. Or through a sale/leaseback, a selling company could make a capital distribution to long-patient shareholders.) Further, as a corporate strategy, the item can be kept off the balance sheet and simply footnoted, so that it does not increase either current or long-term liabilities. Thus the seller's current debt/equity ratio, and hence its credit rating, is actually enhanced. And write-downs for 100% of the rent can be taken at a faster rate than depreciation schedules, which permit only 80% of purchase price, would allow an owner.
Another instance of sale/leaseback application involves a company that doesn't own real estate at all, but wants to acquire the use of a facility. Suppose there's one on the market for $400,000, but the company has only $100,000 to spend. The company doesn't want to go to a bank for several reasons -- a loan eats up credit, perhaps, or the terms may be poor, or the company may not be credit-worthy. So, through a broker, the company finds a sale/leaseback deal. The company may put up $50,000, buying the land (which the prospective buyer can't depreciate), while the investor puts up the remaining $350,000. It is leased back to the company for, say, $35,000 a year for 10 years, after which period the company commits to buying it back at a profit to the owner. Now the company can depreciate the building all over again at the new, higher basis, and the investor may end up, if Reaganomics endure, with more favorable capital gains treatment than current provisions allow. Because of the appeal of good shelter (it's possible that an investor may not have to pay taxes on the rental income at all) and a builtin long-term gain, investors are not hard to find.
Why, then, might a company elect not to enter into a sale/leaseback arrangement? Only if the business's rate of growth is expected to be slower than the appreciation rate of its property, advise Brener and Masanoff.
Experts agree that the sale/leaseback tactic, long popular in Europe where ownership is not the sanctified institution it is here, is becoming part of real estate's "new wave" of alternate financing. There is nothing mysterious about such arrangements, notes Richard H. Ader, vice-president of Integrated Resources, whose affiliated American Property Investors is among the country's largest sale/leaseback writers. "What it comes down to is a choice between having your money in real estate or in cash flow that can be put into the business."
Since the lessee of the leased-back premises enjoys the perquisites of ownership -- he can add to or otherwise alter the property as needed, retaining total control -- in a sense he still "owns" it. If you have the rights to use it, then it's really yours, point out Brener and Masanoff. And to clients who stubbornly insist that their company facilities are profitable assets, they retort, "Then sell your business and go into real estate.