Your Roadmap to Financial Freedom
Sales and Leaseback as an Option
Sale and Leaseback is the sale of an interest in a property and the subsequent leasing back of that same property. It is one of the best tools to use in generating capital from Real Estate. This form of financing starts as a sale and the seller then agrees to lease back the property being sold. Sometimes this leaseback can merely be a move to entice the buyer into the transaction. In its more effective use, the sale and leaseback is a technique that allows the seller to maintain the use of the property.
On the Corporate front, real estate sale and leaseback is when a business sells its commercial property for its fair market value and then immediately leases it back. It is also used by developers to build a corporate building, serviced apartment or hotel as “financed” by the purchasers, but most importantly, the Corporate retains control of the property.
Here are some of the resulting benefits of a Sale and Leaseback for a Corporation:
- Free-up capital for re-investment.
- Improve the balance sheet.
- Receive 100% of Open market value.
- Low payments with long terms (up to 25 yrs.).
This has become an increasingly popular means of generating capital for immediate use. A sale-leaseback vehicle unlocks the value in your real estate assets and provides you with immediate working capital.
How do you start?
- Firstly determine the Open Market Value of the property
- Then you will need to ensure the existing or potential cash flow/opportunity cost in the said property.
- Then you determine the Yield that you will be providing and the basis of the yield i.e. Net, Double Net or Triple Net. Based on this yields and cash flows,
- You will then need to structure the “deal” i.e. Vendor’s Obligations, Purchaser’s Obligations and in some cases, a third party “Lessee’s Obligations”.
- The next is of course to package the whole thing together and commence the marketing of the product.
For personal needs in this scheme, it is always advisable to be the Buyer i.e. the Landlord of the property and the subsequent leasing of the property to the seller or their nominees. What do you buy in a scheme like this? We advise to only participate in Sale and Leaseback schemes where the seller or their nominee uses and maintains the use of the property i.e. as a hotel or a serviced apartment or for other commercial business usage. This kind of scheme would ensure that the seller is still involved and committed in the success of the Scheme for a long term.
Issues to look out for in a Sale and Leaseback scheme include:
- Term of Tenancy.The longer the better, but the norm is usually 3+3
- Date of Commencement of Tenancy, especially if you have bought an off the plan development. Ensure that the date is fixed
- Rental Amount.It will usually be a percentage of the Purchase Price or in some cases will also include a profit sharing ratio. Acceptable percentage levels include 6%-8% on both gross and Net levels and acceptable profit sharing levels will be 65% to the owner and 35% to the Seller/Nominee. It is important to ensure what the percentage level is and also the terms of the returns, i.e. whether it is Gross or Net. Do look out for what are the costs that you will have to bear, including Quit Rent, Assessment, Service Charges etc and whether the payment to you is net of all this amounts
- When the Rentals are Paid.For cash flow reasons, please check this clause carefully. Payment mode will differ from Quarterly, Half Yearly or even Yearly in advance
- Furnishing (if applicable).In most serviced apartments or hotel, furnishing is a requirement. Ensure if it is part of the purchase price or is separate and also ensure that the furnishing is the same for the whole development. This would make sure that there are no preference units.
- Sinking Fund.Look out for the establishment of the sinking fund for the Building. Very important especially is sale on Strata. In event the sale includes the Furniture, ensure the Seller/Operator also provides a sinking fund for your furniture.
There a lot of advantages in a Sale and Leaseback scheme, for both the Seller and the Buyer. However, the Sale and Leaseback is actually more complicated than it appears on surface. It requires good, sound structuring, packaging, marketing and possible legal and tax considerations. One should never enter into a sale and leaseback unless there is absolute confidence that the transaction is beneficial to both parties.
Real Estate is an essential part in business operations of corporations, not just as usage of the facility, but as a major investment vehicle. There is a strong believe that due to general scarcity of land the real estate values can be maintained, if not appreciated, in the medium to long term. Notwithstanding this notion, the values can oscillate beyond reason, as we have seen in the last Eight – Ten years since the 2008 Economic Crisis, and also due to external factors such as slowing global economies or unexpected events like the 9-11 incident. As a result, Companies need to deliberate the question of whether to buy or lease real estate, especially if real estate is not the core business of these companies.
We are going to explore on when buying or leasing makes more economical sense.
When Leasing is a Preferred Option
The following factors may lead a company to conclude that it should lease, rather than purchase, its business facility.
- The current cash flow is of vital importance– particularly in these hard times, a lease may be better than a purchase from a cash flow perspective. This is because up-front outlays associated with a lease are usually less than those required with a property purchase. With a lease, your main initial cash expense may well be limited to your security deposits, utilities deposits, plus first rent payment. With a purchase, you have to have the lump-sum purchase price, or at least a down payment on a loan.
- The Company does not want involvement in property management and maintenance.
- The Company wants to retain its mobility.Maybe the company is not sure that the facility selected now will serve its needs several years in the future. The company may need more or less space, the target market may have moved elsewhere, or better-suited properties may later be built.
- The Company’s credit rating may not support a loan/financial facility– if the business is rather new, or has experienced some financial difficulties, lenders may not be willing to extend it sufficient credit for a loan on the facility. With the same financial situation, however, a property owner may well be willing to rent a property to the company.
- The Company has not found a suitable property to buy– It may want to buy, but have found that all properties that would be suitable for it needs have been offered only on a lease basis.
- The facility may be in an area of declining real estate values– The Company may find a facility that meets its needs, but are concerned that the real estate values in the area are stagnate, or may actually drop in value. In this case, leasing makes sense: let the landlord suffer the effect of the declining values, not you!
When Purchasing is Preferred Option
The following factors may lead a company to conclude that it should purchase, rather than lease, its business facility.
- The Company wants control of the property.The Company intends to make substantial additions or renovations to the property. Or it decides to change the business hours or change something else about the way it is doing business. If the company rents the facility, it may have to get your landlord’s permission to make these changes. If, however, the Company owns the property, there will be no one question your moves and answer to.
- The Company is in strong cash flow positions and can seriously consider the long-term cost.A lease of course beats out a purchase in terms of cash flow, particularly in the early years. But over the long haul, a purchase is usually cheaper because a landlord, in addition to paying all of the costs associated with purchasing and maintaining the property, will attempt to build in a profit for himself. The Company avoids paying this profit premium by buying, rather than renting, the property, with the ‘rental’ payment going towards the payment of the mortgage, if applicable.Moreover, whether the property is purchased for occupation or investment, there is potential for an upside in capital values. In addition, there could be annual yields earned from the properties held for rental income. Leasing, on the other hand, does not give any returns at all as rental expenditure is essentially an expense.
- The Company wants to stay at the same location– for some businesses, the location is of utmost importance. If the Company has established a winning business location, it will not want to lose it because of increase in rentals or because the owners wants the property for another use. If the Company owns the facility, it won’t have these worries.
- The Company is in an area of appreciating real estate values– In event the Company locates itself in an area where the real estate values will continue to increase, it would be better to own the property (and thereby get the benefit of this appreciation) rather than to lease it.
- The Company wants to Enjoy the Tax/Depreciation Shelter.Owners of real estate actually enjoy tax and depreciation shelter besides the other benefits of ownership. Interest paid on a loan for a property is considered an expense, and thus can reduce the taxable income. Depreciation is also used to reduce income that is taxable. Therefore, both the interest expense and depreciation can reduce the taxable income, thus providing a tax and depreciation shelter for Company whilst such a shelter is not available for leases.
If a company is considering whether to acquire a facility (office, factory, warehouse etc) by purchase or by lease, it may have a tendency to concentrate on the short-term, such as the forthcoming years’ cash flow projections that would result for each of the alternatives. This is natural, and probably altogether necessary: If things don’t go well enough in the next few years of the business’s operation, it may not be around to see how a particular decision would have benefited it 10 years down the road. But having said this, it’s still worthwhile to consider how a lease or rental could affect a corporations business in the future. Will it be important for the business to be able to stay at the location for as long as you want? Do you foresee the need to modify the facility in a way that a landlord may not agree to?
Let’s say you look at the short-term and long-term implications of the rent-or-buy decision, and conclude that it’s in the long-term best interests of your business to buy the property. If your rent-or-buy question is otherwise a close call, this long-term consideration may lead you in one direction. If, however, buying the facility is out of the question, at least you’ll know that you should be thinking about how you can accomplish these long-term goals by other means.
This major decision on whether to buy or lease should finally be based on financial foresight, as you would not want to be caught in a situation of a credit crunch. Factors such as the interest rates, cash flow projections, values & affordability level and the cash available for deposits have to be carefully weighed before making the commitment.
There are several compelling reasons on why owners should refurbish their buildings. The economic crisis amplified the vacancies of office space, and buildings that do not offer all the amenities for image, comfort and flexibility are difficult to rent. Newer buildings are offering better facilities and environment at similar if not higher rental rates and have taken over the market space once competed in by the older buildings.
Moreover, user’s requirements have considerably changed in the last decade in terms of office equipment, communications, automation, quality of use and comfort. This dynamism in the user’s needs will be continuously and constantly changing.
Another driving force to refurbish is the owners’ cost to operate and maintain the office building at is present state is too expensive as compared to the rentals. The Mechanical and Electrical systems are not as efficient as compared to what it was and to the existing systems in the market. Management and energy costs do not commensurate with the rentals receivable.
It is also estimated that retrofitting a building costs much less than demolition and reconstruction (about half to one third of the cost).
What is refurbishment? Technically, refurbishment is the process of making as good as new, including essential modernization and renovations. It is the restoration of a building in order to give it a new ‘lease’ of life, in particular to restore its intended usefulness and style. It does not aim to alter the essential fabric and design of a building but to modernise and repair in order to preserve the building while replacing worn or obsolete components. Refurbishment, however, does not extend to reconstruction.
So now that the decision to refurbish has been made, what’s next? It is strongly recommend to use a holistic marketing approach to the next step. Refurbishments should only be based on a detailed market study and a gap analysis on where to position the property after refurbishment. This will strongly determine the strategy required to market the property after the refurbishment and also what is critical for the refurbishment. Based on the detailed market study, a gap analysis is conducted for market positioning purposes. We can do sample Gap Analysis for our clients who are proceeding with refurbishments for their office building are as follows:
AVAILABLE GAP IN THE MARKET
Based on the available gap, one then will know what needs to be done to position the building in the market. A Building Diagnosis is also conducted concurrently to evaluate the general state of the office building with respect to deterioration, functional obsolesces and indoor environment quality to users.
The Gap Analysis provides the marketing approach whilst the Building Diagnosis provides ample information on the existing condition of the building. Marrying both these analysis will provide equilibrium of what needs to be done i.e. a market driven building that is not functionally obsolescent.
As a guide, there are five main issues to consider when deciding what needs to refurbish. Firstly, the User needs i.e. compliance with the user’s anticipated professional activities and requirements in office space. A good office refurbishment exercise is one that can anticipate the requirements of the user and fulfil it.
Secondly is that the refurbished building must have the capacity to easily modify the interior space partitioning and general office layout without any major intervention on the buildings installations and structure. This Flexibility is important as the requirements of each tenant and user will differ.
Divisibility is third issue to consider. The refurbished building must have the capacity to divide each floor plate into separate and independent zones with autonomous energy metering in order to rent part of the floor plate.
Maintainability is very important for “after the fact”. All works done must have the capacity to facilitate easy maintenance of the premises, such as equipment layout in the plant room, and type of equipment.
The last issue is of course Compliance with regulations, both national and the local authorities. The will be a variety of regulations to consider, ranging from the Street and Drainage Act and Uniform Building Bye Laws to the Town and Country Planning Act.
Based on our observation and feedback from tenants and owners alike, the following items are the most crucial items in the refurbishment of office space:
Lobbies, including the Porte Cochere, the main lobby and all lift lobbies. These cosmetic and functional upgrading provide an immediate impact to the building. These improvements are not only for the tenants, but also to impress the tenants’ clients.
Lifts are the most crucial of all Mechanical and Electrical Systems in enhancing the value of the building. For the tenant, an upgrade in the lifts reduces waiting time for the lifts and enhances the travel time in the lifts. In the corporate world these days, every second counts.
Lavatories completes the last of the Three Main ‘L”s in refurbishment. Again, this has to do with the environment and quality of lifestyle that is provided to the tenants
Mechanical and Electrical. This would include the air conditioning systems, building automation systems, functional and ambience lighting levels and telecommunication systems. This factors are the hidden factors, i.e. not visible to the eye but only felt. The M&E systems are crucial in ensuring compliance with the users professional needs and activities within the premises.
Security Systems. We have seen an increase in request for security systems in new office buildings that now most systems are already a norm. These items are also to be seriously considered, especially the need to attract multi-national companies that place a heavy consideration on security. Items will include CCTV systems, Access card systems, Intrusion Detection Systems and the normal smoke and fire detection systems.
Facade. This is the most obvious of all upgrading, but we would not put too much emphasis on a total refurbishment of the facade as the translation to increment in rental value is minimal. It is important but simple and elegant efforts are more appreciative than extensive retrofitting of the facade. Improvement to the facade is only recommended for buildings with real functional obsolete facades i.e. does not play its part as an outer shell and protect the interiors.
The danger of refurbishment is refurbishing for the sake of refurbishing and overdoing it i.e. spending X Millions of Pounds but the eventual rental returns do not commensurate with the expenditure.
Refurbishments generally take between 12 – 18 months and up to 24 months for bigger buildings. Owners are also caught in a quandary on how to manage tenants during this period. Three alternatives are available. Firstly, reduction in rental rate and providing rent free periods during the refurbishment. If the works are major, then vacating the building would be the best option, though it would result in loss of income in the short term. The last alternative is to structure a rental scheme for “during” and “after” the refurbishment period.
The last and the most crucial part of the refurbishment exercise is the Sales and Marketing of the refurbished building. This specialized sub sector of the refurbishment would entail a Pre-Launching Exercise 3 to 6 months prior to completion of the refurbishment, Launching Exercise and the After Launch Sales. It has to be focused in its effort, mainly communicating the existence of the refurbished office building, as one can spend any amount of money on refurbishing but it is to no avail if the tenants, end users and consumers do not know about it.