International Society of Primerus Law Firms

Catching Up on the Use of Sale/Leaseback

Written By: Dennis L. Monroe, Esq.

Monroe Moxness Berg PA

Minneapolis, MN

Sale/leasebacks have been around for a long time.  At times, the franchise industry has used sale/leasebacks as a primary source of financing, particularly for real estate intensive concepts. There have been many groups that have been involved in the sale/leaseback market – major players, like GE, to niche players (who have basically served as real estate developers and then end up entering the sale/leaseback transaction as a culmination of the development work).

The primary reason to use a sale/leaseback is to protect the equity of the company, and the available cash for use in numerous operations; thus, tying dollars on the real estate side.  Real estate is a separate investment decision.  Real estate returns may not be the type of returns you would expect on the operating assets.

Sale/leaseback transactions have always provided a maximization of financing, being able to finance 100% of the real estate and in times past, more than 100% of the real estate cost.

One of the traps people have fallen into is not looking at this as a financing arrangement but looking at it simply as an operating arrangement.  Under the proposed GAAP rules for leases, there will be no doubt most sale/leasebacks will be treated as capital leases and will require that the asset and liability be put on the balance sheet.

One of the key mistakes people have made is to include the furniture, fixtures and equipment cost into the sale/leaseback transaction.  This may result in a payment for those assets for the life of the lease.

Consider the following when thinking about a sale/leaseback:

How does the sale/leaseback affect your fixed charge coverage (or, what we sometimes call “effective leverage”)?  You need to understand that this financial relationship will last for the life of the lease (and any extensions); thus, the lease transaction should be looked at as a long term financing arrangement.  It should also be clearly understood that in most cases, the sale/leaseback transaction cannot be undone or prepaid.  There are certain sale/leaseback groups that do offer buyout options; but in most cases, the lessor in the sale/leaseback transaction is interested in a long term return.

Most sale/leaseback transactions include step increases in rents.  This means that the base rent will be increasing, normally at the end of each five year period or every year. When it comes to GAAP reporting of your lease payments, this will have an affect on the current expense amount.  The current expense amount is equal to the average rent paid during the life of the lease, not the current cash payment.  So in the early years you will have additional expense with a deferred rent component; in later years you will actually pay more cash and have less of an expense than your cash payments.  In summary, you have to look at the overall leverage aspect of any sale/leaseback transaction and take that into account.

Also consider the flexibility of a sale/leaseback transaction.  Control of real estate has always been an important component for the franchisee.  It gives them options in the case of troubled situations.  If there is any doubt as to the site or the future of the site, please look at ownership.

Key Elements.  When you enter into a sale/leaseback transaction, it is all based on the valuation of the property using an agreed to CAP rate.  The CAP rates we are seeing today are between 7.5% and 11% on most franchise transactions (they do have a significant variation).  One key in looking at the valuation is that many times it is driven by the rent as a percentage of sales.  It is very important in a sale/leaseback transaction that the rent, as a percentage of sales, be kept to a reasonable level for the type of concept.  If your system can support 6% of sales for rent, then that is the amount of rent that should be used. In order to determine the appropriate rent as a percentage of sales for any transaction there are a variety of metrics pertaining to both the seller and the specific location that must be considered. If rent is set strictly as a percentage of sales, then the tenant may pay rent which is too high and rent payments could stress future cash flow.  This will also put upward pressure on the CAP rate during the sales process which means lower net proceeds to the seller. The opposite can occur as well; by not recognizing underlying fundamentals, the seller may not be aware of when downward pressure can be put on the CAP rate (higher net proceeds to the seller) based on the identical rent.

In many cases, franchise business owners (in an attempt to leverage the transaction and possibly take out equity in the real estate) look at a much higher percentage (8.5% to 9%).  This is fairly short sighted because it not only results in additional cash on the transaction but becomes a long-term obligation which may impair the operations of the company.

Additionally, you need to understand the risk factors for your concept and company when negotiating the CAP rate.  The CAP rate will also be driven by both of those.  Try to keep the CAP rate as low as possible.

Because of the long nature of the sale/leaseback transaction, be sure you have certain rights:

  • The ability to substitute additional property of like kind and like value in case you want to dispose of the property.
  • Have certain buy out options which sometimes can be very difficult to obtain.
  • The lessor should understand the rights that the franchisor has and take those into account in the sale/leaseback transaction.
  • Avoid master (or combined) lease arrangements where the properties are tied together as this creates a significant limitation on future flexibility.  This is a common practice to avoid cherry picking in bankruptcy.  There are, however, good compromises in this area that should be looked at.

Legal Provisions. You should consider some of the following legal provisions when entering into a sale/leaseback transaction:

  • Make sure your lease allows for leasehold mortgages to be granted to lenders for financing of the operating assets (furniture, fixtures and equipment).
  • Make sure the lease does not take personal property on the premises as collateral and that the lien holder (or lease company on the sale/leaseback) has the right to remove that equipment in the case of a default.

It is important that the lessee has clear rights of assignment because the odds of the lessor holding that property until the end of the lease are fairly small.  Such rights should include:

  • the ability to assign to an operator of similar financial status as the original lessee;
  • in the case of a franchise system, the ability to assign to an approved franchisee with a certain number of units and period of time in operation in the system.

Financial Analysis. It is important that the prospective lessee do a detailed financial analysis of the cost of this lease.  This means the lessee needs to prepare a fixed charge coverage analysis, a cash flow with a sensitivity analysis as it related to sales levels (i.e., how low can sales levels go and still be able to have appropriate fixed charge coverage in light of the lease transaction).

Sale of Operations. In the sale of a business that includes ownership of the real estate, a tenant should strongly consider bifurcating the business and the real estate in order to maximize value. By selling the real estate and operations separately, the transaction can easily generate increased sales proceeds.

Sale/Leaseback Types. The two most popular sale/leaseback types in the market today are one-off and portfolio sales. Each execution method has its own benefits and drawbacks.  The first and most popular form of sale/leaseback involves a sale of a single location to an investor. The primary benefit under this scenario is that it generally yields substantially more sale proceeds and offers a rate that can be 15-25% lower than a portfolio sale which is far more advantageous to the seller. The drawback is a somewhat higher execution risk in the case of a portfolio, or simultaneous sales of multiple locations, and higher closing costs per transaction. This sale/leaseback type should be employed if you do not have a specific date by which the funds are needed and the seller would like to realize the highest net proceeds possible. The primary benefit of selling as a single portfolio is a lower execution risk (one transaction as opposed to multiple transactions) and lower closing costs. This method should be considered if you are planning on selling your operations and need a high degree of certainty of when net proceeds will be available. The primary drawback of a portfolio sale is a higher sale/leaseback rate and lower net proceeds for the real estate.

In general, a sale/leaseback transaction can be a very effective means of acquiring capital to your business but needs to be used in a judicious and prudent manner with the understanding that this is a long-term transaction that is very hard to undo.

Dennis L. Monroe is a shareholder and Chairman of Monroe Moxness Berg PA, a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation.  Monroe Moxness Berg PA is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999.  For previously published articles, and other Monroe Moxness Berg PA information, please refer to our web site at

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