A guide to sale leaseback transactions There are many ways for companies to raise capital: recruiting investors, reinvesting profits, borrowing funds, and selling stock are among some of the most common methods. Each of these methods has its own advantages and disadvantages, and many times, these traditional methods of raising capital come with downsides that can restrict companies from achieving their financial goals. In these cases, companies may begin looking for more creative ways to fund their initiatives. One capital-raising tool that has become more common in recent years is the sale leaseback. “What is a sale leaseback?” you might ask. In real estate, a sale leaseback is where a company sells all, or a portion of, the real estate that it owns and occupies, while it simultaneously signs a long-term lease to continue to occupy and use the property from the subsequent buyer. It is also common to see sale leasebacks with owned property other than real estate, such as commercial aircraft, cargo barges, solar plants as well as large scale machines and equipment. Sale leaseback transactions allow the owner/user of a property to extract their equity from an asset while still maintaining their ability to use it. For the seller, a sale leaseback transaction gives them access to the capital they need without incurring debt or impacting their balance sheet. For the buyer, the purchase of a sale leaseback provides a stable, long-term investment with an occupant already in place. Additionally, in some cases, the owner and the future buyer can negotiate the lease to help satisfy their goals. How do sale leaseback transactions work? There are typically two agreements involved in a sale leaseback transaction: one that states that the current owner/user will sell the property to an investor at a fixed price that both parties agree upon, with the second stating that the new owner agrees to lease the property to the previous owner with lease terms that both parties agree upon immediately following the sale. While the conditions of each sale leaseback vary, these two agreements form the basis of every sale leaseback transaction. Structuring the transaction this way provides advantages to both the buyer and the seller. By completing a sale leaseback, the original owner/user of the property ensures that they can continue to use it after the sale with little to no interruption. The buyer also benefits by receiving an immediately cash-flowing asset with no immediate risk of vacancy.

What are the Different Types of Net Lease? Among net lease investment properties, there are sub-types of leases with different expense structures. Depending on an investor’s needs, different expense structures and levels of landlord responsibility can be leveraged. Below, we have outlined the various types of net leases, ranging from absolutely no landlord responsibilities or requirements to expense structures that require a higher level of responsibility from the investor. Absolute Net Lease | Abs NNN Sometimes abbreviated to Abs NNN leases, absolute net leases are defined by their highly passive structure. Absolute net leases require absolutely no landlord responsibility for expenses whatsoever, making them highly attractive to investors who desire a truly passive income stream. While other expense structures require the landlord to pay for some or all the building expenses, absolute net leases require the tenant to pay these expenses directly. Triple Net Lease | NNN Triple net leases, or NNN leases for short, are similar to Abs NNN leases in that they require no landlord responsibilities. The tenant pays for property taxes, insurance, and maintenance of the roof, structure, and common areas of the NNN property. The difference between a triple net lease and an absolute net lease is that in a triple net lease, the tenant may not pay for expenses directly. In some situations, the landlord may pay for expenses up-front on behalf of the tenant, but by calendar or fiscal year-end, the tenant provides full reimbursement for those expenses to the landlord. Double Net Lease | NN or NN (R&S) In most situations with NN or NN (R&S) leases, the tenant is responsible for paying property taxes and insurance, whereas the landlord is only responsible for maintaining the roof, structure, parking lot, and/or common areas – hence the R&S abbreviation for roof and structure. If the landlord is responsible for paying any expense that is not ultimately reimbursed by the tenant, the lease should not be considered a true triple net lease. Single Net Lease | N or Net Lease Single net leases, or net leases, are similar to NN leases in that the landlord is responsible for paying for property maintenance in addition to another expense, like property taxes or insurance. However, single net leases require the tenant to pay for remaining expenses. Single net leases are rare.

For investors, there are numerous opportunities for creative real estate financing, each with its own unique advantages. Zero cash flow properties offer many benefits to investors with low equity, high tax burdens, or investors who want to extract equity without diminishing their portfolio. What is a zero cash flow property? A zero cash flow property, or a “zero,” is a highly leveraged asset with in-place, assumable, fixed-rate, long-term financing (typically 15 - 25 years) backed by a bond-style, absolute net lease guaranteed by an investment-grade credit. The high leverage nature is such that all net operating income goes directly to servicing the debt. Appropriately coined, zeros are commercial properties that produce no cash flow to the investor. Who buys zero cash flow properties? Zero cash flow properties can be attractive to several investor types, though the largest pool of zero buyers are those with a 1031 exchange need. Zero cash flow properties are attractive to 1031 exchange buyers who have little or no equity and are seeking to fulfill their trade need by replacing a significant amount of debt with as little equity as possible. A 1031 exchange buyer with a larger amount of equity may seek a zero cash flow property in order to take advantage of the paydown readvance feature provided in the loan, allowing the buyer to right-size the debt and equity requirements of the trade and extract a significant amount of tax-free equity once the 1031 exchange is completed. A non-exchange buyer may be looking to purchase an asset that will produce net tax losses, off-setting income elsewhere in the owner’s portfolio. How are zero cash flow properties priced? The most common method of pricing net lease investments is by using a cap rate, which is a one year cash rate of return on the purchase price, ignoring leverage. Given the high-leverage structure resulting in no cash flow, cap rates are typically ignored on zeros. These assets are priced instead based on the equity investment over the existing debt, expressed as a percentage of equity over the debt. Pricing of zeros will vary due to factors including the loan structure (fully amortizing vs. balloon), maturity of the loan/lease, perceived residual value, and availability of paydown readvance, among others. While many other structures are declining in value, zeros remain near their all-time high pricing at a range of 12 to 24 percent equity over the debt. How does the paydown readvance feature work? Paydown/readvance is a revolving credit feature in the existing loan. The loan provides the borrower the right to exercise an option to pay the balance of the loan down in full (i.e., the “paydown”) at any time during the term. The borrower has a subsequent right to exercise an option to instruct the lender to refinance the loan back to the balance it was prior to it being paid down (i.e., the “readvance”). Both the paydown and readvance options are rights provided the borrower in the loan agreement, and all terms and conditions of the loan remain constant during and after the process. There is no additional loan documentation required as part of the process. Certain requirements must be met in the exercising of both options, and to the extent those requirements are met the lender is obligated to perform. The paydown option may be exercised in order to allow a 1031 exchange buyer to purchase the property while matching the equity requirements of the exchange. Post-acquisition, the buyer may exercise the readvance option to extract equity from the asset. Illustration of zero cash flow transaction As noted above, in addition to the tax loss and relatively low initial equity investment, the most significant benefit for most investors is the paydown readvance feature which provides for the tax-free extraction of equity dollars through either the standard paydown readvance or Substitute Collateral Right language in the existing mortgage documents. In practice, here is how the feature works. An owner of a traditional investment property is preparing to sell the asset for $20 million and exchange into a zero cash flow property. She has held the property for a substantial period of time resulting in a debt obligation of $5 million with $15 million of equity. The owner has identified a zero cash flow property she can purchase for $20 million with $2 million as equity (approximately 11 percent above the debt) and assuming $18 million of debt. The owner applies the full $15 million in cash to purchase the zero cash flow replacement property, thus meeting the equity obligations of the 1031 exchange. The debt obligation is also covered as the $18 million of debt clearly covers the $5 million of outstanding debt on the original property. Prior to closing, the owner notifies the lender of her intent to exercise the paydown readvance feature in the loan documents after closing. The owner closes on the sale of the zero cash flow property, and her 1031 exchange is complete. The next day, or whenever she wants to within the timing restrictions in the debt instrument for the zero cash flow property, the owner engages the lender and provides notice of her intent to exercise the paydown readvance or the substitute collateral feature within the debt instrument. The owner had applied the full $15 million in equity to the purchase price, and of that $15 million, $13 million is available as excess from the $2 million of equity required to purchase the property. At this point, the debt is readvanced from $5 million to the original $18 million, with the proceeds of $13 million going to the zero cash flow owner. As a result, the income deferment protections under the 1031 have been successful, and the owner has pulled out $13 million in nontaxable proceeds from the transaction.

A 1031 exchange allows an investor to sell one or more appreciated assets and defer the payment of capital gain taxes by acquiring one or more replacement properties. 1031 tax-deferred exchanges allow investors to keep 100 percent of their money instead of losing about one-third of their equity to taxes, and allows investors to purchase substantially more replacement property. The 1031 “like-kind” exchange should be considered by every taxpayer who is planning to reinvest the proceeds from a sale of investment property into another similar type of investment property. The IRS Code Section 1031 describes the “like-kind” exchange: No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade of business or for investment. What Qualifies as a Like-Kind Property? “Like-kind” property can be any property used in a trade or business or as an investment. All of the following real estate can be exchanged as “like-kind” property: Condominiums Industrial Properties Apartment Buildings Duplexes Raw Land Commercial Properties Single-Family Retail What is a Qualified Intermediary? The use of a Qualified Intermediary (QI) or Accommodator is mandatory for a successful 1031 exchange. An independent third-party is typically hired by the investor to receive the funds at the time of sale for the investor’s relinquished property. This third-party holds those funds until the investor is ready to acquire the replacement property. The primary role of the QI is to ensure that the investor does not receive any monetary benefit from the sale of the relinquished property which would trigger a taxable event. 1031 Exchange Timeline Timelines are important in a 1031 exchange and missing specific deadlines could also trigger a taxable event for the investor. At its most basic, the investor must identify a replacement property within 45 days of the original property’s sale. Furthermore, the investor must then close on the sale of the replacement property within 180 days of the first sale. 1031 Exchange Identification Rules In order to meet the first timeline requirement of identifying a replacement property within 45 days, investors can choose from several options: Three Property Rule | One of the more common options, this rule allows investors to identify up to three replacement properties without taking into account the fair market value of those properties. This strategy is useful in case the first or second choice properties fall through, or if the investor is looking to acquire multiple properties in the “up leg” of his or her exchange. The 200% Rule | This rule allows investors to identify an unlimited number of properties as long as the cumulative fair market value of those properties does not exceed 200 percent of the value of the relinquished property. This strategy is more often used in exchanges with larger dollar amounts, while we see the “three property” rule used more frequently in smaller exchange transactions. The 95% Rule | While not commonly used, investors also have the option of identifying more than three replacement properties with unlimited value. However, the investor must acquire at least 95 percent of the fair market value of the properties he or she has identified, which can be challenging to achieve. Specific Description of the Replacement Property When identifying the replacement property or properties, investors must be specific in their description. Ambiguous language or descriptions that aren’t clear will not satisfy the guidelines of a 1031 exchange. Details such as the property address, a legal description of the asset’s location, or a distinguishable property name are acceptable and must be submitted to the QI no later than 45 days after the sale of the relinquished property. A 1031 exchange can be an extremely valuable tool for investors when utilized properly. Again, all rules and guidelines must be followed explicitly, or investors risk triggering a tax event. Proper consultation with tax advisors and legal counsel who are experienced in 1031 exchanges is strongly recommended for investors looking to receive the greatest tax deferral benefits. Likewise, qualified real estate investment brokers can help investors navigate the 1031 exchange process and determine the right strategy for an individual’s exact needs.

A net lease is a lease structure that places the responsibility of building expenses on the tenant, in addition to the rent paid. Those operations costs include property taxes, insurance, and maintenance; creating a passive income stream for the landlord. Who Uses Net Lease? Retailers, corporate offices, industrial users, healthcare providers, and government facilities utilize net leases for various reasons. Whether they use absolute triple net leases, double net leases or other net lease expense structures, net leases provide a wide range of benefits. What are the Benefits of Net Lease? Developers want to build the property, lease the property, sell the property to an investor, and then reinvest the capital into their next development project. Tenants want to focus their time and capital on running their operations, improving their supply chains, and growing their core business – for occupiers that currently own their real estate, the sale of their property to an investor provides capital to reinvest into their core business. Investors want a return on their capital, hassle-free property ownership, tax advantages, and reliable cash flow. What is a Cap Rate? Most net lease investments are traded based on their capitalization rate, or cap rate. A higher cap rate usually means more risk for the buyer, which justifies a higher return, while a lower cap rate typically means less risk for the buyer, but they’ll pay a premium for the “safer” investment. Cap Rate = Net Operating Income ÷ Current Market Value (or Sales Price) Example: A property that generates $60,000 per year and is valued at $1,000,000 would be a 6.0% cap rate ($60,000 / $1,000,000 = 0.06 or 6.0%) Factors to Consider When Investing in Net Lease Location Is this a location with demographics to sustain the business of the current tenant? What type of tenant could take its place if the current tenant vacates? Tenant Credit How likely is the tenant to pay their rent and fulfill the terms of the lease? Lease Terms How long is the lease? What type of rent escalations are included? What is the expense structure? Types of Net Lease Among net lease investment properties, there are sub-types of net leases with different expense structures. Depending on an investor’s needs, different expense structures and levels of landlord responsibility can be leveraged. Lease sub-types include: absolute net lease, triple net lease, double net lease, and single net lease expense structures. Advantages of Net Lease (always consult your tax advisor or financial professional) Passive Cash Flow As described above, an absolute triple net lease structure is a true hands-off ownership structure for the landlord. This is sometimes referred to as “mailbox money” or an “armchair investment.” Depreciation Tangible assets, like a property, can be depreciated over time allowing investors to lower their tax burdens. 1031 Exchange Reinvesting the earnings of an investment property sale into like-kind real estate allows investors to defer capital gains taxes on the proceeds.   Common Net Lease Investment Strategies Not all investors share the same strategy. Some are motivated to buy net lease investments for the passive cash flow and hands-off ownership structure, while others are looking to buy, sell, and reinvest the proceeds. Some of the more common strategies for private investors and developers include: Buy & Hold – Purchase an asset with no immediate intent to sell it. Investors can depreciate the real estate over time and collect the passive income stream for the length of the lease term. Some investors may choose to purchase an asset in a market or sector with anticipated growth as they seek long-term appreciation for that property. Reinvest & Build – Buy a property with the intent to sell it in a 1031 exchange, leveraging those proceeds to purchase a larger asset or multiple properties while reducing taxes. Developers who build net lease assets intend to sell those properties in order to reinvest the earnings into their next construction project.