Most users of commercial or industrial real estate only care about the control and use of a property.
That said, owning the property isn’t always necessary to achieve those goals. With leasing, users can control and use properties without owning them.
To that end, many property owners choose to execute sale-leaseback transactions and enter into net lease arrangements on their properties. In a sale-leaseback, sellers can convert illiquid assets into cash while still retaining use of the properties. Essentially, the user sells the property to an unrelated third party and then enters into a lease for the property for a mutually agreeable term or time period.
Why would a creditworthy company choose to lease? First, a net lease can provide a company with the ability to match a long-term real estate asset with a long-term liability. In essence, the company gets long-term financing through lease terms that typically range from 15 to 25 years, plus renewal options equal to the initial term. This is important for less mature companies (those without an investment-grade credit rating) andcompanies that are expanding and rapidly opening new stores. For example, a retail company that is opening 50 new stores with real estate costs of $5 million per store could need 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.
Second, a net lease is treated as 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. A lessee classifies a lease as either a capital lease (reported on the balance sheet) or an operating lease. If a lease meets any one of the following criteria, it is a capital lease:
A lease that does not meet any of these criteria is an operating lease. The operating lease obligation is reported in the financial statement notes as a contingent liability, as opposed to being reflected on the balance sheet. The company thus achieves a lower debt-to-equity ratio, which may favorably affect its cost of debt and equity for its core business.
Third, and most important, a net lease allows a company to use its capital for more profitable investments. Typically, a company would expect to pay (net lease) rent equivalent to 10 percent to 12 percent of the cost of the property. Normal return on investment targets for growth companies range from 15 percent to 20 percent. Thus, a net lease should allow a company to net a 5 percent to 10 percent gain on the capital that is now available for more profitable investments, such as the company’s core business. In fact, a net lease encourages a company to concentrate on its core business by minimizing the potential long-term distraction that real estate ownership creates. Moreover, academic research has concluded that sale-leaseback transactions can enhance the value of stockholders’ equity, reducing risk through more equity and less debt.
Finally, a company considering a sale-leaseback also should perform a sensitivity analysis, using after-tax cash flows, for leasing versus owning. A residual value (the value of the property at the end of the lease term) should be assumed, and the company should use its weighted average cost of capital (also known as weighted average required return) as its discount rate.