Sale and leaseback — the saviour or pitfall in raising capital?
The sale and leaseback is an old favourite when it comes to raising finance.
What is a sale and leaseback?
At its simplest, a sale and leaseback is the sale of a property to a third party who then leases the asset back to the seller. The seller will still use the property to operate its business and will benefit from an initial cash injection from the sale but will now be subject to rent payments and tenant responsibilities.
Such transactions can range from quite simple arrangements to complex structures involving large portfolios. A recent example of a mega-deal is the Sainsbury’s supermarket and British Lands’ joint venture sale to Realty Income Corp — a £429 million portfolio.
The sale and leaseback is an old favourite when it comes to raising finance amongst the retail sector and was used by Woolworths back in 2001 which questionably lead to its ultimate demise in 2008. More recently this year, Next Plc completed a sale and leaseback of its national headquarters and warehouses in a bid to raise £107 million following the lockdown during the coronavirus pandemic.
Institutional investors such as CBRE Global Investors, Legal & General and Aviva often have ground rent or income strip funds dedicated to sale and leaseback structures with occupational tenants, where the institutional investor will benefit from either a ground rent or an income strip lease interposed above the occupational lease and the original owner benefits from a cash injection in exchange for foregoing a slice of their income.
Why a sale and leaseback?
One of the main reasons for entering into a sale and leaseback arrangement is that it can be a quick and effective way of raising cash from existing real estate assets. It can provide an opportunity for growth and companies can reallocate capital back into the operational business. Logistic and last-mile businesses have been able to use the COVID-19 pandemic to thrive and this model has been one way to raise a much-needed cash boost.
It’s also especially useful in difficult markets where traditional funding may be scarce. Another recent example from the retail sector is Ted Baker’s sale and leaseback of its headquarters in London to British Airways Pension Trustees Limited raising £78.75 million. With the long-lasting impact of the coronavirus pandemic still coming to light and the announcement of a UK recession, we may begin to see a further increase in this mechanism of raising finance.
For the seller, a sale and leaseback can offer lower costs compared to standard borrowing and can transfer the risk of managing/maintaining property to a third party.
A buyer, however, can purchase the property by using a property company that can be used to finance the investment enabling favourable lending terms. They will also have guaranteed income for a term certain which is quite attractive. In the case of an institutional buyer, who might look at a hotel asset, the attraction is a ground rent income or an income strip that will usually provide for RPI uplifts and if the occupational tenant covenant is strong, this is an attractive structure, providing the original investor with a cash injection but with the option to retain rights to buy back at the end of the income strip period or the end of the ground lease.
A key point to consider will be the tenant’s covenant strength. In these uncertain times, one of the reasons companies are looking to sell is because they are struggling financially and, therefore, their commitment to pay rent in the future may be questionable.
The tax position will be an important consideration in any sale and leaseback deal. A number of key tax points are as follows:
- Direct tax (corporation tax/income tax/CGT) — the direct tax consequences will need to be reviewed and assessed. The sale will, in most cases, be treated as a (part) disposal of the property by the seller for capital gains tax (CGT) purposes with attendant CGT consequences and the rental payments under the leaseback will generally be a deductible expense in calculating the taxable profits of the business. Specific tax advice will however be required in each case.
- Stamp Duty Land Tax (SDLT)/Welsh Land Transaction Tax (LTT) and Land and Buildings Transaction Tax (LBTT) — a sale and leaseback comprises an exchange for SDLT/LTT/LBTT purposes meaning that both parts of the transaction (the sale and the leaseback) are chargeable based upon the greater of the market value of the interest transferred and the actual consideration. However, provided certain conditions are met (which will need to be reviewed and confirmed in each case) the leaseback element of the transaction can qualify for relief from SDLT/LTT/LBTT. Whilst the purchase of the property (sale leg of the transaction) will attract SDLT / LTT/LBTT, it will be based upon the market value of the encumbered interest (i.e. taking into account the leaseback) provided there was a written agreement, at the time of the sale, for the leaseback leg to be entered into.
- VAT — there are no special reliefs or VAT provisions in relation to sale and leaseback transactions. Accordingly, if the property is opted to tax by the seller (lessee), the buyer (lessor) will need to pay VAT on top of the purchase price (unless, in the particular circumstances, the transaction can qualify as a transfer of a going concern). If the seller occupies the whole of the property then it is unlikely that the sale will be able to qualify as a transfer of a going concern but it may be possible where part of the property is already sub-let by the seller and the buyer acquires the property subject to this (ongoing) sub-lease. If the buyer/lessor opts to tax the property (to recover the VAT payable on the acquisition of the property if not a transfer of a going concern and any ongoing costs incurred in relation to the property) then VAT will be payable by the seller/lessee on the rents. This VAT will be recoverable to the extent the property is used by the seller/lessee for the purposes of its taxable business.
- Capital allowances — the capital allowances implications will depend upon the precise circumstances and require specialist advice but generally speaking the seller will (subject to any relevant and applicable capital allowances elections entered into with the buyer on the sale) lose the benefit of capital allowances.
The lease is traditionally granted on a long term for around 20-30 years typically, being important for operational buildings such as supermarkets. However, more recently, we have seen a shift to shorter leases of non-core assets such as headquarters where the seller plans to vacate the space after seeing out the lease. Some key areas of concern for the seller will be:
- Repair — the seller will want to be careful about onerous liabilities such as a “put and keep” repairing obligation. If the property is older and not well maintained this could carry extra cost and liability bringing it up to standard. A qualified repair obligation linked to a schedule of condition may be required in such situations. If the property is new, the seller will want to ensure it alleviates issues of inherent defects.
- Break option/assignment — one of the main reasons for a sale and leaseback is because of financial concerns. Therefore, the seller will want the flexibility to break the lease or assign in certain situations as they were free to do so before.
- Rent — the seller will want to make sure that the rent is not excessively high and that there is certainty over future affordability. Any uplifts in rent should be fixed e.g. by way of index-linked or stepped increases. The ongoing costs associated with leases (nearly £300 million) was a major criticism of the restructure and subsequent poor performance of Debenhams Retail Group.
- Renewal rights — the seller may want the ability to renew the lease at the end of the term so they do not have to relocate their business when the lease comes to an end.
A purchaser will want to ensure that the lease terms are marketable and acceptable to any financial institution that may finance the transaction. They will also want to ensure the lease can easily be brought to an end should the tenant get into financial difficulty. If there are any doubts about the seller’s covenant strength, then additional security by way of a rent deposit or guarantor should be considered.
In some transactions, entities may be used to separate the property from its operational functions. Property Company (Propco) and Operational Company (Opco) structures.
The property is transferred to a Propco within the same group which is specifically for the purpose of holding property. The operative parts of the business stay with the Opco who takes on the lease. The Opco can then use the money from the Propco to inject back into the business.
The Propco can also use the property to raise finance as the Propco is more likely to get a favourable deal with a lender rather than a standard corporate loan. This is because the Propco will have a steady rental income from the Opco. The debt will be serviced by the rental income.
In the case of sale and leaseback to ground rent or income strip funds, the structure is achieved by interposing the ground lease above the occupational lease or income strip lease and the terms of this can be flexibly negotiated.
The main disadvantage of the sale and leaseback is that the seller may be giving up important assets. It also gives up flexibility on how the seller deals with and enjoys its property; any future changes are likely to be subject to having to obtain landlord consent (subject to the terms of the lease) and met with additional costs.
A seller should also consider their future affordability in keeping up with their new rent payments. A quick cash injection now could become a cumbersome burden in years to come. The seller should carefully consider how highly leveraged it wants to be.
In 2019 there was an accounting change — IFRS 16 — which made liabilities in leases form part of the balance sheet of a company. Previously they were in profit and loss accounts and not balance sheets so it was misleading for companies with multiple leasehold properties as those liabilities were not visible. With better visibility on leases now, this new accounting structure should be taken into account when considering sale and leaseback.