As credit gets tighter and traditional financing sources dry up, both large and small businesses must become more crative in looking at alternatives for capital funding. Converting real estate assets to cash is a time-honored technique used by major corporations holding large parcels of raw land or buildings not essential to their core operations. But what type of creative financing can work for a small business when the only real estate asset is the business facility?

Sale/leaseback is certainly one avenue that should be considered: selling the real estate to an outside purchaser who will then lease it back to the business. This transaction has obvious, and subtle, implications for business owners.

First, of course, is the freeing up of capital for expansion and other purposes. Expanding a business is especially difficult when credit becomes tight. Proceeds from a sale/leaseback can provide the funds for a much-needed expansion. Other uses for the proceeds that enhance the bottom line include retiring outstanding debt and repurchasing corporate stock. Operations improvements that aid efficiency are another way such proceeds can be used to improve the business.

Converting non-earning assets into investment capital helps enhance a company's financial position as well as its profitability. A sale/leaseback transaction, if properly structured, can improve a company's debt-to-equity ratio and reduce interest and depreciation expense.

Finally, the sale/leaseback transaction allows the owner to concentrate on operating the business. Most business owners aren't interested in being in the real estate business. Particularly in times of tight credit, it may make far greater sense to use corporate funds for the company's core business activity rather than having these funds tied up in a non-liquid asset. Entering into a sale/leaseback allows business owners to focus their resources on what they know and do best.

How the Sale is Structured

A deep-pocket investor, such as a fund sponsor who is pooling the dollars of individuals, will be the most likely buyer of a property in a sale/leaseback transaction. This purchaser will often be buying with cash, which has advantages for the seller. All-cash purchases mean that the sale can be conducted quickly without waiting for approval or closing from a lender. In times of tight real estate lending, like today's market, this is increasingly desirable.

Two important financial considerations are the sale price of the property and the rental rate and term of the lease. These considerations are the key negotiating factors to a sale/leaseback transaction. The typical guide to sale price is the market value of the property. Usually the seller will have the property valued by an independent professional appraiser, such as a member of the Appraisal Institute. The professional appraiser will consider recent sales of similar properties within a market area as a guide to market value. Market value is a matter of opinion and not scientific fact; so this will most likely be a point of negotiation between buyer and seller.

The lease rate, which represents the amount of rent the seller/tenant will pay, is largely dependent on the financial strength or credit of the tenant, the type of business the tenant is involved in, where the property is located, and the general financial markets. Other factors affecting this rate are the buyer/lessor's cost of funds, estimated residual value of the property at the end of the lease, and the tax benefits that the lessor receives. The risk/reward ratio is the key factor the buyer/lessor weighs in determining the acceptable lease rate. All of these factors will affect the lease rate.

How the Lease is Structured

A typical lease under a sale/leaseback agreement is long term, at least 15 to 20 years with renewal options. This allows the business owner to occupy and maintain use of the property over the long term. The terms will include a base rent computed as a percentage of the purchase price. Typically, periodic rent escalators will be included in the lease; these may be pegged to some indicator such as the Consumer Price Index, the tenant's business revenues, or both.

A triple net lease will often be used in the sale/leaseback agreement. This makes the tenant responsible for all costs connected with the property: taxes, maintenance, insurance and so forth. By not including these costs in the base rent, the triple net lease gives the tenant more control over these variable costs.

The Bottom Line: How Sale/Leaseback Enhances the Balance Sheet

As the following example illustrates, a sale/leaseback transaction can significantly reduce liabilities and eliminate restrictive debt covenants; it may also increase net income and improve financial ratios. Exhibit 1 shows the balance sheet for a business that owns land and a building with a fair market value of $1.5 million, a net book value of $1.3 million, and an existing mortgage balance of $1 million.

By entering into a sale/leaseback transaction, both the net book value of the building and the debt are removed from the balance sheet. Under sale/leaseback accounting, the gain on this sale cannot be recognized currently, but is reflected on the balance sheet as a deferred gain that is amortized into income (as an offset to rent expense) over the life of the lease. The end result is the balance sheet reflected in Exhibit 2. Because these transactions typically are sales for tax purposes, a tax may have to be paid that could result in deferred debits in the deferred tax balance. In this case, we have assumed the book and the tax basis of the property are the same, and that deferred tax debits are fully utilizable. Also, we've assumed the lease should be classified under FASB 13 as an operating rather than a capital lease.

The impact on the income statement is more dramatic, as shown by Exhibit 3. Exhibit 3 shows the income statement for the year prior to the sale/leaseback as well as the year subsequent to the transaction (assuming no other changes). To illustrate, we've assumed the $320,000 of cash proceeds from the sale (sales price of $1.5 million less debt repayment, accrued interest, and a $60,000 tax on the gain on the sale) are invested at 10%. Annual rental expense of $165,000 has been reduced by $10,000 to reflect the amortization of the deferred gain over the 20- year life of the lease. The net effect is to increase net income by 53%.

The cash flow from operations drops by $23,000 under the sale/leaseback scenario. Prior to sale/leaseback, cash flow is $112,000; after the transaction, cash flow is $88,000 calculated as follows:

NetIncome$95,000

Amortizationofdeferredgain(10,000)

Deferredtaxesrelativetothegain3,000

$88,000

However, there is an additional $350,000 to meet this demand. There are two primary reasons for the reduction in cash flow. First, the seller/lessee would lose $50,000 of depreciation deduction annually, which would save approximately $15,000 of income tax. However, in determining cash flow before a sale/leaseback, our example did not reduce cash flows for amortization of the principal amount of the mortgage. If the mortgage was a fully amortizing mortgage with a 20-year term, debt service would increase (and cash flow decrease) by $13,000. Second, in our example we have assumed that the lease payments have been established at 11% of the fair market value at the building, but the proceeds were invested to earn 10%. This is a very conservative example. If the return on assets was at least 13%, the cash flow this aspect of the transaction becomes positive as opposed to negative. Thus, the relationship between a company's ROA and the effective cost of the lease is a key motivating factor in doing a sale/leaseback transaction.

One word of caution: under FASB 98, sale/leaseback transactions must be strictly structured to accomplish these financial goals. This accounting can be used only if the transaction includes all of the following: 1. A normal leaseback; 2. Payment terms that comply with the initial and continuing investment criteria established by FASB 66, "Accounting far Sale of Real Estate;" and 3. Payment terms and provisions that transfer all of the risks and rewards of ownership to the buyer/lessor.

The statement gives examples of situations that do not meet these requirements: 1. The buyer/lessor can put the property back to the seller/lessee; 2. The seller/lessee provides non-recourse financing to the buyer/lessor; 3. The seller/lessee owns an interest in the buyer/lessor; or 4. The seller/lessee has an obligation or an option to repurchase the property.

It should be noted that the FASB does not consider a right of first refusal to be an obligation or an option to purchase. With a first right of refusal clause contained in the lease, the lessee will have the opportunity before any other party to repurchase the property when the lessor decides to sell. The right of first refusal works best when the buyer/lessor has a pre-established holding period (for example, a fund sponsor who plans to terminate the investment in seven to 10 years). Knowing that the property is scheduled to be sold at a predetermined future date, the seller/lessee can better plan for repurchasing. Furthermore, the lessee in a sale/leaseback is usually the most likely purchaser of the property when it is resold.

If these criteria are not met, the appropriate accounting method is either the financing or deposit method. Under these methods, the proceeds are reported as either a deposit or, more likely, a borrowing on the balance sheet. Rental payments are reported as debt service. The end result is an increase in debt-to-equity ratio and a possible decline in the entity's net income if the incremental borrowing rate of these proceeds exceeds the interest rate on the retired debt (if any) or the reinvestment rate. While this method still allows the company to obtain capital through real estate assets, the financial statement implications can be negative rather than positive.

Thinking It Over

The sale/leaseback has many advantages for the business owner. Structuring a sale/leaseback allows the owner to obtain additional capital while regaining the use of the business and its real estate assets. When credit is tight, it is wise to deal with all-cash buyers who are not affected by the lack of available financing. If structured properly, a sale/leaseback transaction can greatly enhance a company's financial position.

National franchise and chain businesses have led the way in using sale/leaseback to benefit business owners, but the system can work for almost any business--small or large. As the credit markets continue to tighten, particularly for real estate, more and more businesses will use sale/leaseback as a financing tool. Business owners who want to commit financial resources to their core businesses may well find the sale/leaseback of property to be an ideal source of capital needed to expand the business, improve operations, or reduce debt.