Setting the Sale Price and Rental Rate for a Sale-Leaseback
Assessing the purchase of a sale-leaseback is like evaluating the acquisition of any real estate asset with existing tenants. The difference is that with existing occupants the rental income is largely fixed due to the leases already in place with each renter. With a sale-leaseback, the rent (and other terms) can be negotiated by each party so the lease terms and the sale price are tailored to meet the needs of both the seller and the buyer.
LoopNet spoke with Larry Fitzgerald, a commercial real estate broker in Northern Virginia with Newmark Knight Frank and Mark Fornes, President of Mark Fornes Realty, Inc., in Dayton, Ohio and they both agree that one of the most important factors of any real estate valuation, be it a sale-leaseback or an outright sale, is the amount of rent paid by the tenant.
The Delicate Dance Between Rent and Sale Price
The higher the rent, the greater the value (or sale price) of the asset. Under one scenario, the current seller (and future tenant) might agree to a very high rent to elevate the sale price and achieve optimal value for the asset. The buyer in this scenario, however, is motivated to not overpay for the asset, and will need to assess the advantages and disadvantages of getting above-market rents in exchange for a higher purchase price.
On the surface, getting above-market rents seems like an advantage for the buyer; but are those rents sustainable? When this tenant leaves, will the owner be able to achieve similar rents in the future? Another consideration is the length of the lease. If the lease term is long, say for 10 years, and rents are above market, the total income might justify the greater upfront cost.
From the seller’s perspective, agreeing to a high rental rate will validate a greater sale price and generate more money up front, but the monthly lease payment going forward might be more than the company can reasonably afford, given other business expenses and strategic priorities.
On the other hand, if the seller (and future tenant) commits to a lower rent, the value of the asset (and sum received by the seller) will be less. Thus, the seller needs to weigh the benefits and detriments of generating more revenue from the sale versus higher monthly rental payments.
The Benefits of Market Knowledge
Fitzgerald referenced a sale-leaseback transaction in which the operating company (the seller and would-be tenant) set a below-market lease. “In that case, it translated to a less-than-market [sale] price,” making it very attractive to the purchaser; in part, because he “knew the submarket and saw the opportunity.”
The below-market lease was for five years, a relatively short time. The investor knew the leasing dynamics of the market very well, and he believed that when the lease expired, the space could be leased at market rates, significantly increasing returns. According to Fitzgerald, that is exactly what happened.
The takeaway from this example, said Fitzgerald, is that “the underlying lease is ultimately the single largest value consideration that determines what the selling price is going to be. There are sticks and bricks that play into it, but it's that cashflow, the length of term, and the underlying tenant credit that someone's really going to evaluate.”
Factors to consider beyond length of lease and creditworthiness of tenant, according to Fornes include flexibility and reusability of the real estate asset and a solid location. Fornes concluded, “this is more art than it is science.” For the purchaser, the process requires balancing the rent and price with long term ownership considerations, risks the seller will no longer need to bear.
