§ 20A.02 A Net Lease Sale-Leaseback as an Alternative to Mortgage Financing

• Jurisdiction: United States
• Publication year: 2022

§ 20A.02 A Net Lease Sale-Leaseback as an Alternative to Mortgage Financing

A net lease sale-leaseback enables the owner of real estate to monetize its equity in one or more sites while maintaining some significant level of use and control over the site or sites while allowing the buyer-landlord to generate a return on its capital investment in the real estate. These basic features of a net lease sale-leaseback resemble traditional mortgage financing, and a net lease sale-leaseback can be a viable alternative to mortgage financing. Whether a mortgage financing or a net lease sale-leaseback is preferable in any given situation depends on the relative advantages and disadvantages of each type of transaction.

There are many considerations for both property owners (i.e., potential seller-tenants or borrowers) and capital providers (i.e., potential buyer-landlords or mortgage lenders) when comparing net lease sale-leaseback transactions with mortgage transactions. Some of these considerations are as follows:

? Amount of Proceeds. An owner can fully monetize its equity in the real property in a net lease sale-leaseback transaction.¹ This means that the owner can get more (and a capital provider can fund more) proceeds than under a traditional mortgage loan, where such proceeds are usually limited by the lender's loan-to-value requirements.² Also, because rent payments in a net lease sale-leaseback transaction are sometimes determined as a fixed rate of return on the purchase price, in some cases the parties may agree on a purchase price that exceeds the fair market value of the site in a traditional sale. In such a case, there will be an even bigger difference between the amount of proceeds funded to a borrower under mortgage loan when compared to the amount of proceeds paid to a seller-tenant in a net lease sale-leaseback transaction.³

? Risk of Loss and Potential Appreciation. In a net lease sale-leaseback transaction, the seller-tenant shifts the risk of a loss in the value of the real estate to the buyer-landlord. However, the seller-tenant also relinquishes any potential appreciation in the value of the real property to the buyer-landlord.

? Periodic Payments. The implied "interest rate" in the rental payment can be higher than the interest rate for comparable mortgage financing, both because the buyer-landlord's invested capital is generally less liquid than a loan and because there is no "equity cushion" helping to ensure repayment of the seller-tenant's obligations upon default.⁴ However, the significantly longer term of a net lease sale-leaseback transaction can result in the implied interest rate being lower than comparative mortgage loan interest rates in the future, if such rates rise, and negotiated rental increases in the lease are not as great as the amount of the rise in rates.

? Taxes.⁵ While only the owner's depreciation of physical improvements on the land (but not the land itself) and the interest portion of a mortgage payment are deductible when calculating income taxes,⁶ the seller-tenant's entire rent payment (usually calculated on the entire value of the real estate, including land and improvements) generally is deductible.⁷ However, the sale of the real property in a net lease sale-leaseback transaction can result in material capital gain to the owner subject to taxation if the real property has appreciated since it was purchased or if the owner has taken significant depreciation on the improvements.⁸

Both mortgage payments to a lender and rental payments to a buyer-landlord are taxed as ordinary income to the recipient of those payments although lenders are only taxed on the interest component and not on repayment of mortgage principal.⁹ However, rental income may be offset with deduction for interest on mortgage debt, which is deductible subject to certain restrictions.¹⁰ As an owner of real property, the buyer-landlord may also claim depreciation and any available tax credits.¹¹ Also note that state and local transfer tax can be due both on the transfer of the real property to the buyer-landlord and also on the lease, depending on the jurisdiction and the length of the term of the lease.¹² However, certain jurisdictions impose a specific tax on mortgage transactions that would not be applicable to a net lease sale-leaseback transaction.¹³

? Financial and Operational Flexibility. In a net lease sale-leaseback transaction, the lease may hinder the seller-tenant's flexibility in financing additional improvements, and in selling its interest or keeping its interest at the end of the lease term.¹⁴ Even if the lease allows the pledging of the leasehold interest, the terms of such financing are generally not as favorable as mortgage financing on the fee interest.¹⁵ Also, any sublease or assignment is likely subject to the consent of the buyer-landlord, and even with such consent, the leasehold interest might not be as readily marketable as the fee interest would have been.¹⁶ So, if the site is no longer desirable from an operations standpoint, a net lease sale-leaseback transaction can make it more difficult (when compared with fee ownership subject to shorter-term mortgage financing) to move those operations to a different location or to liquidate the interest. If the site remains desirable from an operations standpoint at the end of the lease term (including any extension options), the seller-tenant risks losing use of the site if the buyer-landlord will not relet it to the seller-tenant. Of course, the transfer of fee ownership in a net lease sale-leaseback also means that the seller-tenant is free of the burdens of owning the real estate after the end of the term.

In a net lease sale-leaseback transaction, a buyer-landlord's fee interest in the real property is often highly liquid and is attractive to both potential buyers and mortgage lenders, although the overall quality of the real estate, the specific nature of the improvements, and the credit of the seller-tenant (and any related guarantor) are all factors that can greatly influence liquidity.¹⁷

? Specific Provisions in Documentation. The specific provisions in a sale-lease-back net lease might be more favorable overall to a seller-tenant than the alternative mortgage loan provisions, or vice-versa.^18. For example, a seller-tenant's use of the sale proceeds is usually unrestricted in a sale-leaseback net lease, whereas many mortgage lenders impose requirements for how loan proceeds must be used by borrowers. Conversely, a right of prepayment is relatively common in mortgage loan transactions, but analogous provisions in net lease sale-leaseback deals are relatively rare. However, generalizing about the documents utilized in each deal type is extremely difficult, as there are many factors that can influence terms, including when the deal is consummated (as "market" conditions change over time), the individual characteristics and preferences of the borrower or seller-tenant, the individual characteristics and preferences of the lender or buyer-landlord,¹⁹ and the particular facts of a deal.²⁰

? Term. The typical length of the initial term of a sale-leaseback net lease (often twenty years or longer) means that the parties have "locked in" the negotiated terms for a much longer period than the term of a typical mortgage loan (usually less than ten years and oftentimes five years or fewer).

A seller-tenant may see this as an advantage, especially if market terms are expected to become less tenant-favorable over time, or merely if the benefit of certainty of terms that allow profitable operations at the site outweigh any possible benefit of better terms in the future. If such a market shift occurs, the seller-tenant will benefit by simply continuing to lease the space at below-market rents. Further, if the seller-tenant negotiates the right to assign or sublease, it can potentially profit from such a market shift as well, assuming that it has not agreed to share the full amount of any positive difference between the sublease rental (or implied rental in valuing the price of an assignment) and the lease rental. While extensions of the repayment date are somewhat less common in mortgage loan deals, options to extend the term are relatively typical in net lease sale-leaseback transactions, which gives the seller-tenant added flexibility.

A seller-tenant also can see the very long initial term of a sale-leaseback net lease as a disadvantage, especially if market terms are expected to become more tenant-favorable over time.

Many buyer-landlords enter into net lease sale-leaseback transactions because of the secure, long-term income stream they provide.²¹ However, as with the analysis regarding the seller-tenant, if the market becomes more favorable to lenders over time, the income stream in a net lease sale-leaseback might be less than would be available to a lender whose loan is paid off and who can then redeploy its capital at a higher return.

? Remedies. Although highly dependent on the laws of the subject jurisdiction, a buyer-landlord's remedies upon a seller-tenant breach of a sale-leaseback

...