Sale Leaseback Transactions: An Overview 

publication 

Spring 2007 - (Lang Michener Real Estate Brief)

Lang Michener Real Estate Brief
The Typical Sale-Leaseback Transaction 

Companies that carry on an operating business, whether it is manufacturing, retailing, or some other operation that is not in the business of investing in real estate, can often help maximize the use of their assets with a sale-leaseback transaction. An owner will sell its real property to investors and retain the benefits of its location through a tenancy, usually a long term lease with terms of 10 to 20 years. 

A typical example would be a company, which I will call Xco, which has over the years acquired a number of locations across Canada where it manufactures its products. It has acquired these sites over time and either constructed or retrofitted buildings to make them suitable for its manufacturing purposes. These locations were acquired to meet the needs of its operating business and to be close to its customers in locations where it can obtain the raw materials and skilled workers for its manufacturing process. Xco acquired these locations using a mixture of the profits from the business (shareholders' equity) and loans to the company. Being in those locations helped the successful business grow and Xco is now a strong company with assets, a strong business and good support from its customers. However, Xco is not a professional real property investor or land developer. Its expertise is in manufacturing, sales and client service and there may be a number of reasons why it wishes to consider a sale-leaseback transaction as a way to free up debt and equity capital for the use of Xco or to provide to its shareholders. 

Some of the possible benefits of a sale-leaseback transaction, where Xco sells its real properties and leases them back for 10 to 20 years, are as follows: 

1. Xco frees up equity either to distribute to shareholders or to use by the corporation in a more effective, advantageous way than to hold real estate. 

2. Xco ensures the continued use of those crucial sites for its operating business for the foreseeable future. 

3. Xco makes strong profits in its core business-manufacturing, sales and services and can obtain greater returns than it can from the ownership of real estate. 

4. Xco can eliminate debt and/or free up its ability to take on other debt to assist with the financing of its operational business. For example, Xco can use its borrowing capacity to acquire new manufacturing equipment as opposed to holding real estate. 

5. Xco can focus its personnel on its core business. For example, Xco's plant supervisors can now deal with manufacturing, sales and service and not focus as extensively on property ad­ministration issues. 

6. Xco can take advantage of existing market conditions by carrying out the sale and leaseback transaction at a time when market conditions are favourable. 

7. Xco can take advantage of purchasers that have real estate expertise to handle future property issues. Xco can, for example, nego­tiate expansion rights in its lease and set out terms where its purchaser, a professional real estate manager, would be res­ponsible for carrying out that expansion and charging back the cost in a reasonable rental to Xco. 

8. In addition, depending on the corporation, there may well be material tax or accounting advantages of the restructure. For example, Xco under an operational lease will be entitled to deduct its rental as an ongoing operating expense. As an owner of a building, Xco was limited to taking capital cost allowance at low rates prescribed by law. In addition, Xco can shift the burden of capital tax to its purchaser (perhaps a tax-free entity). 

Other Similar Transactions

What is described above is a typical sale and leaseback transaction but each transaction will have its own individual character­istics. Other Vendors/Tenants in sale and leaseback transactions may have different goals. For example, Xco may decide to consolidate its five locations into a single location serving all of Canada with a goal of freeing up capital and taking advantage of the existing market conditions. It could carry out a sale and leaseback transaction with much shorter leases with a goal of continuing to provide the operating company with the use of the real estate assets only until the longer term organizational goal was realized. With that variation, the negotiation on the sale side and lease side is much closer to a traditional property sale and short term lease negotiation. While that kind of transaction is also technically a sale-leaseback transaction, it is for different goals and does not fit as closely with the typical structure this memorandum deals with. 

Another approach is to use a sale-leaseback transaction more as a financing technique, much more akin to a build-to-suit arrangement. In this situ­ation, Xco has a site that it would like to develop, it arranges for a contractor/developer to buy the land from Xco, develop and construct the manu­facturing facility and lease it back over a long term lease that will provide the developer/contractor with sufficient funds to pay off its financing and to obtain a reasonable pro­fit from the construction of the building. In those circumstances, the lease is much more of a capital nature, not an operating nature and at the end of the term the tenant usually has the right to purchase on a nominal or reduced cost basis. Again, while technically a sale and leaseback, this financing is more a financing technique and is not the subject of this paper. 

Process

There are a variety of possible purchasers in a sale and leaseback transaction. Obviously one significant group is institutional investors, like pension funds, which do not face the same tax ramifications of holding income producing investments in real property that the operational owner faces. In addition, companies whose principal business is real estate may have the ability to offset the gains and incomes made on the site with losses on other real estate properties. Both groups have reasons to pay an enhanced value for the properties. One key factor in the traditional sale and leaseback transaction is the security that the investor gets from the long term lease and from the strength of the covenant of the Vendor. Clearly, a property that is sold with a strong tenant and a long term covenant to pay a fair rental is much more valuable to an investor than a vacant building in the same market. 

The process to carry out a sale and leaseback transaction requires expert assistance in both marketing and legal structure. There needs to be offering material put together to describe the property, to describe the strength of covenant of the Vendor and the Vendor's business, and to set out the basic lease terms required. There are a number of brokerage firms that are experienced in putting together such packages and in identifying in the market the potential investors to approach. It is important that the Vendor also have appropriate legal assistance to structure the sales contract and lease in terms that help maximize the sales opportunity and protect the Vendor's interests. As you will see in the discussion that follows, Lang Michener LLP often finds that the challenge is to strike a balance between the goal of the broker to have the most marketable product that it can and the goal of the Vendor to ensure that it has adequate protection for its business interests in the future. That balance is a fundamental aspect in the key long term document in the sale and leaseback transaction – the lease. 

A  typical sale-leaseback transaction involves the preparation of an offering memorandum of some kind, to which we contribute the purchase agreement and a package of essential lease terms. The broker will identify prospective purchasers and approach them to market the sale and leaseback pro­posal. Bids will be collected and, when the successful bidder is identified, it will be necessary for the broker and the lawyer to negotiate the final provisions of the agreement of purchase and sale in a prompt and efficient manner. Sometimes at this stage the lease is also negotiated. If it is not, it is negotiated and settled in a conditional period very shortly thereafter. The lease document is so fundamental to the nature and strength of the transaction that it is part of the inherent structure of the deal.

Lease Terms 

It is important that the essential lease terms be established and clearly identified before the information memorandum is sent out. It is an interesting process and when I recall the discussions that I have had with clients at this stage, I often smile be­cause it often felt that Lang Michener LLP was negotiating against itself on many of the terms. Since it is part of the marketing package, the goal in drafting the lease terms is to be as fair and neutral as reasonably possible. A lease that is overly tenant friendly could be seen by pros­pective purchasers as unreasonable and could affect the marketability of the property. So the constant focus on the general provisions of the lease is to be fair to both the Landlord and Tenant. The following is a brief commentary on a number of provisions in the typical sale and leaseback lease and a brief discussion as to how those provisions need to be dealt with in the sale transaction itself. 

Rent
 
Rent is clearly a key component. The Vendor/Tenant wishes to maintain its right to use the real estate asset at a fair and reasonable price and the Purchaser/Landlord will look at the rate of return that it expects to receive when it sets the purchase price paid. This pushes the rent to be a fair market rental and often marginally above anticipated rates to ensure that the purchase price is maximized. It is often possible for the Vendor/Tenant to achieve greater than usual certainty regarding increases in rent and renewal rents, as this gives the Purchaser/Landlord a more certain rate of return. This is often appreciated by institutional investors or lenders. 

Business Issues
 
It is important that the lawyer take some time and care with the Vendor/Tenant to understand and appreciate its business needs so that the lease can protect the essential elements of the business. The following are some of the provisions we have included to meet the needs of specific business operations: 

1. Alterations – Special rights to make alterations or additions to the premises to deal with the specific nature of the business operation or possible future changes to the business operation. 

2. Expansion Rights – One of the advantages of obtaining the real estate expertise of the Purchaser/ Landlord is that the terms and conditions of the expansion op­tions can be negotiated and put into place as part of the sales package. 

3. Signage – As these are single purpose properties and will continue to reflect the nature and character of the business, signage rights are often expanded. 

4. Extension and Renewal Rights – So long as the rate of return is specified or the Pur­chaser/Landlord has reasonable protection in accordance with the terms, the Vendor/Tenant often wants to ensure that the special purpose building can continue to be used by the Vendor/Tenant. 

5. Removal an Restoration Obli­gations at end of Term – Care needs to be taken. Consult with the Broker to structure the transaction so that the Vendor/Tenant gets to remove the equipment and other essential pro­perty that it requires for its operational business and the Purchaser/ Landlord obtains a facility in which it can convert to uses for other tenants in a cost-effective way. Again, while its important to protect the Vendor's interest, it is also important to have a structure that would seem fair and reasonable to a prospective Purchaser. 

6. Assignment and Subletting – As the transaction is usually part of a restructuring and the leaseback will run for a substantial period of time, it will need to accommodate potential changes to the business of the Vendor/Tenant, such as the use of parts of its premises by third party ser­vice providers and the proposed or potential future restructuring of the Vendor/Tenant and its business. 

7. Waiver of Distraint – Since this is an operating business with significant assets all distraint rights should be limited. 

8. Destruction – The Vendor/ Tenant needs to advise his lawyer clearly as to the business and operational needs in the event of damage or destruction to the property. While those must be tempered with the Purchaser/Land­lord's rights and its ability to obtain financing, the Vendor/Tenant needs to ensure that it can carry on its business operation in the premises or elsewhere.

Environmental 

A key issue effecting both the lease and the sale is the environmental condition of the properties. It really makes sense to do an initial environmental audit of the property before any sale. It is inevitable in these days that a Purchaser will require the same and a clean audit will both facilitate the sale transaction and provide an accurate baseline for the environmental provisions in the lease. As far as responsibility for environmental conditions after closing, both the Purchaser/ Landlord and the Vendor/Tenant should take the property and the premises, respectively, in an "as is" condition, both in respect of a physical condition and environmental matters. However, both parties need to cove­nant how they will be responsible for environmental matters just like they need to covenant how they will be responsible for repairs and maintenance during the term of the lease. The allocation of responsibilities needs to be fairly determined depending upon the extent of the Purchaser/Landlord's acti­vities and involvement with the site. The baseline environ­mental audit and arrangements for a termination audit are excellent ways to be able to allocate responsibility. 

Repair and Maintenance
 
The responsibility for repair and maintenance can vary according to the structure of the deal that the Vendor/Tenant wants. At one end of the spectrum the Ven­dor/Tenant can maintain effective control of the property, paying taxes and doing ongoing maintenance and repairs with the Pur­chaser/Landlord only being res­pon­sible for major structural or capital repairs. At the other end of the spectrum, the Vendor/Tenant wishing to limit its involvement in real pro­perty management may choose to allocate more of those responsibilities to the Purchaser/ Landlord. The circumstances need to be adjusted to the needs of the particular Vendor/Tenant with the Broker's advice as to the market implication of such elements. 

Financing
 
Obviously for the sale and leaseback to be marketable to as many prospective purchasers as possible, the lease needs to provide sufficient flexibility for the Purchaser/Landlord to obtain financing and set out the manner in which the security of the Vendor/Tenant's interest is protected in the event that the Purchaser/Landlord defaults. There must be appro­priate subordination non-disturbance, and attornment language to allow flexibility to the Pur­chaser/Landlord and yet protect the Vendor/Tenant is important. 

Lease Conclusion

In the end, the lease in a sale-leaseback transaction must be of a balanced nature and result in a marketable document that is reasonably neutral and fair to both the Vendor/Tenant and Purchaser/Landlord. 

Conclusion

The traditional sale and leaseback may be an excellent way for a company to use real estate that is important to its operations for the foreseeable future, while allowing the company to free up debt and equity capital and achieve some of the various advantages listed earlier. In order to complete such a trans­action there are significant marketing and legal issues to be dealt with and it is important for a company to obtain the right advisers so that the transaction is carried out, the value is maxi­mized and that the company's operational interests are adequately protected during the term of the lease. Lang Michener LLP has enjoyed having the opportunity to work on a number of these transactions and can bring significant expertise to the structuring and negotiation of these deals.

By Bruce McKenna