As retail chains push for growth, sale-leasebacks remain an attractive way to keep the capital moving.

The sale-leaseback transaction has been praised for 50 years in the real estate community, and the chorus of voices exclaiming its economic advantages shows no sign of quieting. As a financing vehicle, it is growing in popularity, driven by the aggressive expansion plans of the nation's retailers.

In a sale-leaseback, a property owner agrees to sell property to an investor, who in turn agrees to lease the property to the seller, usually with a long-term lease ranging from 15 to 50 years. The leases are usually triple-net, requiring the lessee to pay all of the operating expenses on the property, including taxes, insurance and maintenance. In a few instances, some leases have provisions assigning the owner responsibility for roof and exterior wall maintenance.

Doing 'the most good' Although sale-leaseback transactions are undertaken with various types of real estate, the current wave of chain store expansion has given them much play in the retail arena. Seeking rapid growth, chain store owners are snatching up property and using the sale-leaseback to recoup their expansion costs.

Additionally, the growing attraction to freestanding store locations is boosting sale-leaseback numbers, says Gary Ralston, president of Orlando, Fla.-based Commercial Net Lease Realty. "Freestanding stores are the fastest growing portion of retail development," he notes.

"The retailer that 15 years ago may have gone into a strip shopping center, today wants a freestanding site," adds Linwood Thompson, senior vice president and divisional manager for New York-based Marcus & Millichap Real Estate Investment Brokerage Co.

The primary advantage of any sale-leaseback is that it removes capital from real estate and frees it up for investment in operations. "Getting the money out of the real estate is our main goal," says Patrick Totman, consultant/counsel for Albuquerque, N.M.-based Furr's Supermarkets.

"Typically, the return on equity for a public company is around 25 percent before tax," explains Gerald J. Levin, senior managing director of realty sale-leasebacks for Chicago-based Mesirow Financial. "The pre-tax return on equity for real estate is only in the 10 percent range. Companies need their money invested where it will do the most good, and that is not in real estate."

"We don't own real estate; our expertise is in retailing," notes Rick Blackwelder, vice president of real estate and development for Fort Worth, Texas-based Pier 1 Imports. "We want our money invested in the business."

For many chains, "the business" does not invest funds in real estate departments equipped to manage nationwide portfolios. "Retail chains operate out of numerous locations but don't want the costs associated with the large real estate departments needed to handle large property portfolios," says Jim Nolan, executive vice president and chief financial officer for United Trust Fund, a Miami-based subsidiary of Metropolitan Life Insurance Co.

Finally, sale-leasebacks give public companies the ability to grow without selling stock (and thereby diluting earnings). In fact, by using sale-leasebacks, retailers are able to increase the value of their shares, explains Chris Marabella, a partner with Laguna Niguel, Calif.-based Marabella Commercial Finance. For example, some public retail chains are selling the older stores in their portfolios, leasing them back, then using the capital to buy back stock.

Clearing the balance sheet In addition to the traditional advantages of sale-leasebacks, brokers are reporting a twist to the transaction. "We are seeing a different motivation behind sale-leasebacks," reports Thompson. "Today, corporations want to get 100 percent of their capital out of a deal and get real estate off their balance sheet."

"If companies can maintain a low debt-to-equity ratio, they look better to investors," explains Marabella. However, Totman warns that removing property from a company's financials is not necessarily going to yield favorable results on Wall Street.

"Anyone -- be it a ratings agency or an individual -- with even a little business knowledge, is going to place that real estate right back on the books when they are considering [the company's] financial status," he notes. "You can't hide debt from the ratings agencies," agrees David R. Piasecki, a senior managing director of realty sale-leasebacks for Mesirow Financial.

However, Nolan emphasizes that some tangible savings can be gained from the transaction. The sale-leaseback removes tax obligations and depreciation from the seller's financials, he explains, adding, "If the transaction is properly structured, the corporation ends up with all of the economic benefits of ownership without actually owning the property."

Site and cost control Sale-leasebacks can be structured several ways, depending upon ownership of the land underneath the property and whether the investor develops the building or purchases an existing property. Ideally, the retailer finances the acquisition of a parcel of land and the construction of the store; the investor steps in following completion and purchases the project.

In addition to giving the retailer control over site selection and construction, the sale-leaseback prevents the retailer from tying up capital in the equity requirements of a traditional lender. For example, if the retailer borrows money from a traditional source to finance a new store, the lender requires (at least) 15 percent equity in the project. If the property is sold, the retailer recovers only 85 percent of the cost of the loan.

"In a sale-leaseback, the investor will come up with the additional equity amount in the sale price to the retailer, and the deal will still look the same to the bank," explains Thompson. In that case, the retailer gets "100 cents on the dollar back, rather than 85 cents through a traditional financing arrangement," says Nolan.

Furthermore, large, public retailers are likely to be considered better credit risks than many developers, thereby giving them the clout to drive better bargains on purchase and construction. "Our rent is based on the investor getting a certain return on their investment, which is a combination of the cost of the land and building," says Blackwelder. "So the better deals we are able to negotiate, the less cost to us in the long run."

"We can cut the cost -- not because we negotiate better than the developer, but because we can avoid some of the fees and costs developers build into a deal," adds Totman.

Retailers can cut costs, too, by packaging their deals and standardizing construction requirements. "Doing one store at a time is very cumbersome and inefficient with regard to price and time," says Piasecki. As a result, package deals, called "forward commitments," have become the rule rather than the exception.

"Packaging" extends to leases as well, explains Marabella. "Public companies want to create 'cookie cutter' programs with a standard lease that cuts down on the cost and the transaction time," he says.

The tradeoff Sale-leaseback advantages are not limited to the retailer. For example, the most immediate payoff for the investor is the triple-net lease, which allows the property owner to collect rent without incurring the cost of maintenance. "One of the beautiful tradeoffs in a sale-leaseback is that the lessee is responsible for everything," says Piasecki.

Marabella notes that REITs are entering the market, seeking to close triple-net deals. "The Wall Street firms like the triple-net transactions because that makes the deal closer to a strictly financial transaction," he says.

With triple-net leases and fewer maintenance obligations, sale-leaseback investors are free to diversify their real estate holdings geographically while engaging minimal management services, says Thompson.

"We work with several major institutional investors that historically have been involved in very management-intensive property types," adds Levin. "But recently they have switched to investing in triple-net transactions to reduce their management responsibility."

In addition, sale-leasebacks offer the investor stable cash flow from a strong credit tenant over a lengthy period. "It provides a continuity of cash flow on which the owner can base future decisions about the property," says Marabella.

Primarily, the investors' decisions will be based upon potential return, which Nolan reports is currently at 9 percent. Finally, of course, there is the appreciation of the property itself.

Preparing for long-term occupancy Despite its many advantages, the sale-leaseback is not risk-free. For example, if a store does not succeed, the retailer retains the financial obligation (rent, maintenance, etc.) for a non-performing store or, in some cases, a shell.

Lease language is typically constructed to address some of the risks, says Nolan. For example, Walgreen's typically signs a 50-year lease on its sale-leaseback deals, and their leases generally include a clause giving them the right to cancel the lease after year 20, he says.

Renovation rights also can prove to be a drawback in sale-leasebacks. The property owner can deny or curtail the retailer's request to make changes.

However, notes Nolan, the issue is commonly resolved within the lease. "Most of the leases permit the lessee to do anything to the building as long as it doesn't diminish its value," he says.

"We give them the right to upgrade the building; we just want to be informed about the work," adds Piasecki. "For instance, if the retailer is going to expand the store by 20 percent and modernize it, that is increasing the value of our property. Why would we say 'No'?"

Demand holds firm Like retail, sale-leasebacks have emerged cyclically throughout their history, says Marabella. In the 1970s, for example, the transactions were commonplace until skyrocketing interest rates and changes to the tax code pushed them out of favor. "But interest rates came down in the late 1980s, and this started to stimulate things again," Marabella notes.

The recovery of the sale-leaseback appears to be complete as interest in the transaction continues to grow. Retailer expansion is holding steady at a blazing pace, and demand for space is not dwindling.

"As long as there is a demand for good retail space, there should be a need for sale-leaseback transactions," says Thompson.

"Sale-leasebacks will definitely become more of a tool for companies," says Levin. "There will be a tremendous off-loading of real estate from corporate portfolios through these type deals. Because firms will eventually realize there is often no advantage to holding a property if they can sell it and just pay rent."

Because they provide a readily available source of capital, sale-leaseback transactions have become an appealing alternative to holding corporate real estate. However, when analyzing the potential benefits of this acquisition structure, careful consideration must be given to determining the fair market value of the property for ad valorem tax purposes.

Under the laws of most states, the best indicator of a property's full fair cash value is generally considered to be a recent purchase between an unrelated buyer and seller. This does not hold true in sale-leaseback transactions, however, because they are financing arrangements rather than pure real estate transactions.

For example, in a sale-leaseback transaction on a property that was assessed based upon a fair market value of approximately $3 million but sold for $5 million, assessing authorities will most likely propose that the amount of the sale price be used to determine the valuation for property tax purposes. Without any indication of market value other than the $5 million sale price, there are no grounds for an appeal. If, on the other hand, an appropriately filed appeal seeks to have the transaction treated strictly as a financial arrangement, it is possible to obtain a reduction in the tax assessment valuation of the property.

Even though the seller now technically lacks legal title (as the lessee), it maintains interests consistent with ownership. Factors that would indicate substantial control over the property's use and disposition include:

1. The terms of the transaction provide for annual rental rates that exactly equal the payments that would be needed to amortize a loan at a current market rate of interest;

2. The lease is triple net, whereby the seller/lessee is liable for all expenses, including real estate taxes, insurance and maintenance costs;

3. The seller/lessee was given absolute options to purchase the property at various times throughout the lease term (i.e., the lessor would not benefit if the property were to appreciate in value); and

4. The seller/lessee had the ability to make alterations and lease the property without the consent of the lessor.

This type of evidence focuses the fact that the seller/lessee retains substantially all of the benefits and burdens of ownership. Furthermore, in many sale-leaseback transactions, it is possible to demonstrate that the purpose of the lease/financing plan was to generate additional cash to pay down short- to medium-term debt, or that the effect of the transaction was to provide the retailer with additional capital flexibility.

Under these circumstances, the transaction must be viewed as a financing agreement -- not as a sale transaction. A more appropriate determination of the property's value for tax purposes, therefore, is derived from an appraisal based on recent true sales of comparable properties.

Martin S. Katz is a partner in the Chicago-based law firm of Fisk Kart and Katz Ltd., specializing in property tax law for 56 years.