Many financial buyers prefer to acquire companies free-and-clear of real estate. After all, these buyers are focused on growing their businesses’ top and bottom lines, not on property management. However, there are times when there is little choice but to acquire a business’ real estate in tandem with the business.
The necessary purchase of real estate in M&A is a potential turn-off to some buyers, but in many cases it is actually an opportunity. Enter the sale-leaseback.
In a sale-leaseback transaction, the owner of an asset (“A”) will sell it to another party (“B”). The terms of the sale dictate that “A” will lease the asset from “B” for a specified lease term, among other terms and conditions negotiated by the parties.
As it relates to real estate, the former owner of the property (“A”) retains the use of the property while also receiving an up-front cash payment from the sale of the property.
As it relates to M&A, the acquiror of a business with real estate would enter a sale-leaseback with an unrelated party (who was not involved in the M&A transaction) contemporaneous with closing or soon thereafter.
There are quite a number of benefits to a sale-leaseback from the lessee’s perspective. We have listed a few below:
- Immediate cash inflow: The sale-leaseback provides an immediate injection of cash into the business. It can be used to invest in the business – whether for capital needs or working capital purposes, to reduce debt, or for an immediate return on the acquisition (i.e., through a dividend). Each of these uses enhances a buyer’s return on investment or the strength of the business’ balance sheet.
- Acquisition arbitrage: In certain cases, the sum of a business’ parts – especially when real estate is factored into the purchase price – is less than their standalone value. This holds true particularly for real estate. When the purchase of a business is predicated on its cash flows or earnings, there may be little implied value for the real estate as its value is essentially the present value of the after-tax rent expense the business would otherwise be paying. However, when sold to a third party, the real estate may be more valuable as its full appraisal value will likely exceed that implied by your purchase price. The chart below illustrates this concept. (Note that the figures provided are assumptions based on current market conditions.)
- In the chart above, we assume that a business and its owned real estate are acquired for $48 million, based on $8 million in annual EBITDA and a 6.0x EBITDA multiple. After the sale-leaseback, the business pays $2 million in rent expense, which decreases annual EBITDA by $2 million. Now, the business is worth $36 million, based on $6 million in annual EBITDA and a 6.0x EBITDA multiple. However, by selling the real estate, the seller generates $22 million in gross sales proceeds, based on $2 million in rental income and a 9.0% cap rate (11.0x cap rate multiple). In this example, the sale-leaseback has created $10 million of additional value.
- Tax savings: A lessee is typically able to reduce its taxable income by the amount of its lease payments as they are considered expenses for tax purposes. As the owner of the property, a business may only be able to take advantage of the depreciation and interest-related deductions. Thus, while cash outflows may be greater under a sale-leaseback (depending on the underlying capital structure), there are greater tax savings to be had when incurring operating lease payments.
Clearly, there are a number of potential benefits to a sale-leaseback transaction; your specific situation will dictate the availability and size of these benefits. Similar to many M&A issues, it would be prudent to engage your financial and legal advisors as well as your lender when contemplating a sale-leaseback transaction.
We believe, however, that this information may give you the opportunity to make a deal when you otherwise may have walked away.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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