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I’ve advised a number of my clients recently to consider selling their commercial real estate and striking a three to ten year lease with the investor that buys it. A few have listened.
This structure, in our parlance, is known as a sale leaseback. Different than a straight lease and not a short term lease that accommodates a purchase, a sale leaseback allows an owner occupant the chance to sell at today’s high prices and remain in the building – albeit as a tenant – and avoid a move.
It’s a slick arrangement when the correct motivations are involved. I wrote about those reasons in a past post. You can read about it here.
Today, I want to spend a moment and discuss the downside of a sale leaseback.
The message it sends to the market. When a sale leaseback is listed and marketed for sale, the questions from buyers range from – “why is he selling?” to “is his company leaking at the gills and needs cash to survive? Generally, there is a story. Its critical to understand the story, why a seller is selling, and how the current financials present.
I will just pay more rent. Value is determined by taking the rent your company is willing to pay and packaging the rent as a return on investment. Simply, if your company can afford to pay $10,000 per month or $120,000 per year and the return is 5% – your building is worth $2,400,000. Easy, yes? Now the fun begins. Where is $10,000 per month in relation to what other comparable buildings achieve in rent? It’s either above, below, or at par. Par or below – you’re golden. Above and you’re scrambling. You see, an investor looks at the worse case scenario – you spit the hook after a year, can’t pay the rent – or worse file bankruptcy – and he’s stuck with a building he can’t rent for the same amount you were paying.
You strap your operating company. If you own your building and times get tough, you can adjust the rent your company pays you – after all, you are the owner AND the tenant. Once you inject an arm’s length investor into the mix – that flexibility evaporates. You are now bound to a lease. If you don’t pay, you may get evicted.
There are tax consequences. As we’ve discussed, selling appreciated commercial real estate comes with a heavy tax consequence – unless you employ a tax deferred exchange. Yes, you free your equity, but at a significant cost – in some cases up to 35%.