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A large number of business owners want to own their real estate, from office space to factories. Although this choice can help strengthen your balance sheet, and give you increased control; it’s not the only way to achieve these goals. Leasing, if structured correctly, can also provide this control and use without the risks associated with ownership.
For the most part, property owners tend to favour sale-leaseback transactions and enter into net lease arrangements. Sale-leaseback transactions allow the property seller to transform illiquid assets into cash while maintaining use of the property.
A net lease agreement is an agreement, on a property, where the tenant agrees to pay additional fees, over and above the normal fees which include rent and utilities. These additional fees can include, but are not limited to; real estate taxes, building insurance, and maintenance of the property. Because the typical duration of these lease agreements is long, the landlord generally receives a fixed rental payment, net of all property expenses. A net lease is the opposite of a gross lease, in which the lessee makes a single rental payment and the lessor pays all of the property’s operating expenses.
The two primary classifications of net leases are; bond leases and credit leases.
It does not seem intuitive that a creditworthy company would choose to lease. But there are many benefits to this strategy.
A net lease can allow a company to match a long-term real estate asset with a long-term liability. What this means is that a company gets long-term financing, by way of lease terms that typically range from 15 to 25 years, and also renewal options equal to the initial term. This is important for less mature companies or those that do not have an investment-grade credit score. Additionally, this lease structure could suit a company that is expanding rapidly and opening new stores. For example, if a fast food chain is opening 30 new stores, real estate costs of $5 million per store could require as much as $250 million in additional capital just to finance the real estate. Net leasing each location would satisfy that financing need with long-term capital.
A lessee can classify a lease as either a capital lease (reported on the balance sheet) or an operating lease (off-balance-sheet). A net lease is an off-balance-sheet financing transaction if it is structured as an operating lease in accordance with the Financial Accounting Standards Board’s (FASB) 13 rules for operating leases and capital leases. Off-balance-sheet items help with a company’s leverage, which can impact your credit rating. If a lease meets any one of the following criteria, however, you must classify it as a capital lease:
A lease that does not meet any of these criteria is an operating lease, and can, therefore, be an off-balance-sheet item. The main benefit of this classification is reducing your debt-to-equity ratio, which will ultimately impact your cost of debt and is core to your day to day operations (interest payments) and the valuation of your business (impacts the discount rate).
A net lease allows a company to deploy its capital for more profitable investments. Owning a property will not afford you immediate gains, even if you see a capital gain (unrealised). In general, a company should expect to pay rent equivalent to 10% of the cost of the property. The target for capital projects, in particular for growth companies, should be anywhere from 15-20%, if not more. Therefore, if you adjust these gains for the rent you pay (10%) you are netting a 5-10% gain by choosing to rent and deploy your cash elsewhere. In fact, owning real estate can be a long-term distraction from your core business activity. You are not a property investor, you are running a business. Sale-leaseback transactions can enhance the value of stockholders’ equity, reducing risk through more equity and less debt.
Lessors of net-leased properties benefit from having a stable, creditworthy, lasting tenant. Because the net lease provides for the lessee to pay all operating expenses, rental increases flow directly to the bottom line. Although other lease structures may afford a larger increase in rental rates, after adjusting for the corresponding increases in operating costs, often NOI growth is no greater than a net lease. Due to the increased risk, through exposure to vacancy and variable operating expenses, a net lease is generally the safer choice. In addition, the lessor can often obtain more favourable financing for the property than the lessee, because the lessor can pledge the lease income stream toward repayment of the debt.
A sale-leaseback coupled with a net lease can benefit both buyers and sellers. The lessee, the sale-leaseback’s seller, receives long-term control and property use without a balance sheet impact (off-balance-sheet transaction). The lessor, the sale-leaseback’s buyer, receives a stable income stream, no operating expense variation and reduced vacancy risk. These benefits can also appreciate the real estate asset.