Sale-leaseback transactions: an opportunity to unlock value for private equity investors

 
The mechanics of a sale-leaseback transaction are straightforward. The property owner sells its land and improvements to a buyer, who then simultaneously enters into a long-term lease with the former owner, allowing the seller to continue operating at the site. Typical lease terms range from 10 to 20 years, with extension options that may stretch the duration to 40 or 50 years. Parties calculate lease payments using a “cap rate”—which is the purchase price divided by net rental income, expressed as a percentage. Viewed as a form of financing, these cap rates function much like an interest rate.

A deep and diverse pool of specialized REITs and institutional investors stand ready to execute these transactions. As a result, sale leasebacks are attractive compared to acquisition financing or traditional real estate finance.

The lease documents for these transactions typically follow a "triple net" structure, requiring the seller/tenant to pay all property expenses, including insurance, maintenance and taxes. This arrangement leaves the buyer/landlord in a purely passive position—collecting the arbitrage between its cost of capital and its rental income, while capturing the asset’s residual value at the end of the lease term. Appropriately structured leases give the tenant broad latitude to perform alterations and improvements at the property, impose limited (if any) financial reporting requirements and place few restrictions on the tenant's business operations. A feature that is particularly attractive to PE owners is that these leases typically grant broad assignment and transfer rights, provided the resulting tenant maintains a net worth equal to or greater than the assignor.

Consider an example: the acquisition is a middle-market company in the industrial sector, with a purchase price of $60 million. The target owns a facility recently appraised at $20 million that serves as the primary location from which it operates. If the target enters into a sale-leaseback transaction at the time of acquisition, the real estate asset generates an immediate $20 million in proceeds, which the PE acquirer can use to reduce the equity required to close the deal and de-risk the transaction on the way in. Assuming a 7% cap rate, the target pays $1.4 million in rent in year one; by year five (at hypothetical exit, with 2% annual increases), that figure rises to approximately $1.54 million.

At exit, assuming an EBITDA multiple of 10x, the sale price decreases by $15.4 million—but during the five-year ownership period, the PE acquirer has (i) paid a potentially lower carrying cost than traditional acquisition financing, (ii) operated with fewer restrictions and (iii) insulated the business's financial performance from broader real property market fluctuations. The PE acquirer also avoids any requirement to repay the initial $20 million in proceeds at exit, unlike with traditional financing structures. Finally, this structure may offer tax advantages—although FIRPTA remains a concern for certain Canadian investors, since the IRS treats the leasehold interest as a FIRPTA-qualifying asset.

Private equity firms excel at driving operational efficiencies and performance improvements, but these skills yield far greater returns when applied to operating businesses than to parcels of real estate. The sale-leaseback transactions allow PE sponsors to focus their efforts where they will bear the most fruit. When circumstances warrant, a sale-leaseback transaction limits the capital deployed into assets that are less likely to appreciate dramatically (fixed real property), allowing capital to flow exclusively to the "pure play" operating asset that private equity can most effectively transform. These transactions can also create value on exit by offering a more attractive structure than traditional financing. Sometimes, you can have your cake and eat it too.