Crafting Custom Real Estate Solutions for Your Unique Goals, Part 2
In Part 1, we considered holding long-term and refinancing. In Part 2, we are taking a closer look at a Sale Leaseback. How it works and whether it’s a good idea. Each of the strategies offers its own advantages and disadvantages depending on the unique circumstances of each investor. Understanding market trends and the mechanics of each strategy factors heavily into the development and execution of a real estate strategy that maximizes investor returns.
Ok, you decided years ago that being your own landlord was a good thing and bought a building for your company to call home. Well, you were about as right as right can get BUT all that equity you have built up over time remains trapped in your building and you just might have plans where it may come in handy!
If your company still functions efficiently in your building and you prefer not to move, a sale-leaseback could be your answer. In this scenario, the entity that owns your building (typically an LLC, trust or partnership) sells the building to an investor while your company signs a lease to become the tenant. You get your cash out of the property to do with as you please, the investor acquires a 100% leased property and your business gets to stay in a facility suited to its needs.
It’s a win-win for everyone, right? Not so fast. What seems too good to be true, generally is. So, let’s dig a bit deeper. Perhaps the biggest hurdle to overcome in a sale-leaseback transaction is establishing the rental rate. For the past decade, the availability of low-interest loans for the acquisition of owner/user buildings caused an unprecedented run-up in property values. And, while lease rates also moved higher during that time, the pace of rent growth lagged behind that of sales price growth. Why does this matter? Because when you apply a market capitalization rate (cap rate) to a net operating income (NOI) that reflects a market lease rate, the property turns out to be worth less to the investor than it would be to another owner/user.
The idea of selling the property for less than it is “worth” to the highest bidder doesn’t seem like such a good idea to most property owners, which is why the sale-leaseback model has not been in wide use during the current real estate upcycle. That may be changing though, as interest rates for owner/user loans have doubled in the past year and we are starting to see owner/user pricing soften to compensate for higher borrowing costs. Thus, that gap between sales pricing and lease rates may be narrowing again, which, in turn, would narrow the gap between investor and owner/user pricing.
Investors are still motivated to acquire quality assets in prime Southern California markets, and they are also willing to accept less of a return to do so. That combination has put the sale-leaseback front and center as an option for owner/users, particularly for those whose properties have been heavily improved or specialized (think manufacturing or medical) to meet the specific needs of the business. Having to start from scratch to improve a different space, incur moving expenses and downtime could come at a price far greater than the premium that would come from selling an empty building to another owner/user.
But Chris, what do I do with the proceeds from the sale? Whatever you want. Remember, if you sell outright, you’ll have to pay Uncle Sam his cut. If you exchange, Uncle Sam has to wait. You could even do seller financing on the deal, which means you pay your taxes over time (we will explore this in part 3). Most small private investors utilize loans to purchase properties anyway. You can earn a nice return on the note you carry back and your company pays a market rate to lease the property that still fits the use. What’s not to like?! The decision is yours and unique to your circumstances. My point is there is more than one way to structure the deal. And, if you are not done running your business, but you feel like it’s time to cash in on your equity, the sale-leaseback could be a great solution.