The recent economic challenges related to the COVID-19 pandemic have caused businesses to look for ways to raise cash to weather the financial storm. A number of companies are looking into sale and lease-back transactions (SLB) of their own real estate as a way to raise capital.
The Rules have Changed
Companies that have transitioned to the new Lease Accounting standards (ASC 842 and IFRS 16), may find that the near term cash infusion may no longer outweigh the long term implications of an SLB. Under these new standards, the gain from an SLB is recognized in the then-current period instead of over the remaining term. Analysts will likely disregard these gains as a one-off transaction and see that the long-term expense is now significantly increased. The lease will also likely create a net negative impact on the balance sheet as the liability amortizes more slowly than the right of use asset. And with leasing, there is no chance at recovering some residual value at the end of use to help offset book and balance sheet impacts over the term.
And so has the Market
Fortunately, the investment demand for credit tenant leases has increased significantly since the Great Recession. Redemption of corporate debt, stock repurchases and reduced number of IPO’s have all created competition among capital sources for a smaller pool of investments. The significant investor demand for yield has driven billions of dollars into the business of investing in corporate properties, as evidenced by the growth of the asset class in Wall Street funds and the myriad of net lease REITs that have sprung up in the last decade. Most recently, a number of large footprint corporate entities have begun to look at ways to unlock the value that their properties and their occupancy create. The key element of the new strategies is to maintain ownership accounting treatment to avoid the increased expense and negative Balance Sheet impacts of the leaseback.
These Changes Intersect to Create Opportunities
The capital markets and commercial lenders underwrite asset investments based on a standing lease. For this reason, the first strategy to consider is forming a subsidiary real estate holding entity that consolidates into the parent company. This subsidiary can be created with a combination of common and preferred stock, or simply with the parent contributing the property as equity. The operating company then leases the property from the subsidiary to create the underwriting vehicle for funding. From an accounting standpoint, the lease disappears on consolidation, resulting in ownership treatment and thus more favorable book and balance sheet treatment. This structure can generate from 70% to 100% of the cash value of the properties included and allows for minority partners who can contribute to financing, management, and end of use development. While that structure provides the best results, it requires a learning curve for executives that have long been living in an operating lease environment. If the immediate need for cash requires an SLB, there are other structures that will offset some of the adverse impacts, such as an SLB with a purchase option and a non-consolidating joint venture. From an accounting standpoint, the repurchase option will result in a “failed sale” and thus be treated as financing instead of a lease. This eliminates the negative impact on equity described above, while still giving the company the ability to control the property indefinitely. The decision is then whether the option is at a bargain price or at a proscribed rate consistent with book value and useful life. A bargain option means higher rent through the term and a $1.00 purchase at the end, while the proscribed rate provides lower payments and a high purchase price.
The non-consolidating joint venture allows the company to offset occupancy costs through participation in net cash flow and also have an interest in long term appreciation. These ventures can also include buy/sell provisions for eventual control, but still result in lease treatment.
The Takeaway
There are five key considerations when evaluating the different options to monetize corporate real estate:
1. Understand the true market value created by the company’s credit and occupancy, and get market interest rate pricing.
2. Financed Ownership will yield both lower expenses and long-term costs than operating leases.
3. In the absence of a 100% ownership option, creating a subsidiary can allow for the selective sale of common or preferred stock to reduce the equity requirements.
4. A non-consolidated joint venture is still preferable to a traditional SLB in reducing ongoing costs and preserving residual value.
5. If an SLB is still chosen, unbundle the leases by the property to provide more operational flexibility and wherever possible, include a purchase option at some proscribed amount.
Jackson Cross Partners, LLC (JCP) has been actively modeling and advising these alternative finance structures since the inception of discussions on the new Lease Standards, and built the necessary partnerships to execute on these strategies. That effort, combined with its strong transactional history, uniquely qualifies JCP to advise leading companies on the most beneficial occupancy strategies to emerge from the pandemic, and operate successfully in the years to come.
For more information, contact the author of this White Paper:
LJB@jacksoncross.com
610-265-7700 Ext. 112