A ‘sale-and-leaseback’ transaction or a ‘leaseback’ transaction is an alternative source of financing which could be explored by companies which own real estate assets and require the continued use of these assets for operating their businesses. It is also attractive on the buyside for long term investors. With the rise of real estate investment trusts (REITs) and other institutional real estate investors in the region, we have seen a growing interest in sale and leaseback transactions by institutional investors seeking yielding assets to add on to their portfolios.
In a leaseback transaction, a company, the Seller, sells their property to a third-party, the Purchaser, and immediately thereafter the Seller leases the property back from the Purchaser. The sale agreement and the lease agreement are usually executed simultaneously. The tenure of the lease and the rental amount payable under the lease is generally determined based on the amount paid by the Purchaser for the property and the Purchaser’s expected return from the transaction.
Considerations for the Seller
The key commercial considerations for a company when deciding whether to use a leaseback transaction to raise capital or to use one of the traditional methods (for example, obtaining bank financing, raising debt capital by mortgaging property or raising equity capital by selling shares) include:
- the Seller can raise capital without increasing its indebtedness, giving security, or without the shareholders of the Seller having to dilute their shareholding as the Seller is simply releasing the its capital which was ‘trapped’ in the real estate asset. This is especially attractive where investment yields are below the interest rates for conventional financing. The freed-up capital could then be deployed towards business expansion or other investments with a better rate of return.
- the Seller will not have to bear the risks associated with property ownership (for example, reduction in the value of the property and structural repair and maintenance). However, if the leaseback transaction is structured as a triple-net lease (that is, a lease arrangement whereby the tenant is responsible for the taxes, insurance and maintenance of the property), the Seller must bear the risks in relation to insurance for the property and repair and maintenance of the property without having the benefit of any increase in the value of the property over the lease term.
- the Seller may negotiate and have buy-back or right of first refusal provisions in the transaction documents which can provide comfort to the Seller (if they only wished to raise the capital short-term) that, once it has sufficient capital, it can re- purchase the property.
- if the lease does not contain automatic renewal provisions or if the Seller cannot negotiate a renewal of the lease on commercially viable terms, then the Seller would need to seek alternate premises from which to operate its business. Such a scenario, besides bringing uncertainty to the Seller’s operations, can also lead to the Seller incurring additional costs and expenses in moving their operations to new premises.
- the Purchaser may place restrictions on the Seller’s rights in dealing with the property. These restrictions could be in relation to: (a) undertaking certain business activities (for example, it is not unusual in this region for a purchaser to restrict the leaseback tenant from undertaking business relating to alcohol, gambling or pork products; (b) sub-letting or joint occupancy of the property; (c) structural changes or fit-out changes that may be made to the property. As the Purchaser/landlord is reliant on the strength of covenant of the Seller/tenant, it is also not unusual for these leases to include provisions for ongoing disclosure of the tenant’s financial information to the landlord. The Seller must be prepared for these enhanced reporting obligations.
- Depending on the jurisdiction in which the transaction is taking place, there may be several important tax considerations to be borne in mind by the Seller. For example, where capital gains tax applies, the Seller must factor this in to the analysis of the yield vs. interest/ weighted cost of capital when contemplating a sale and leaseback. Transactional costs such as stamp duties should also be taken into account. In addition, where there have been investment incentives or allowances relating to the development or use of the property, consideration should be given on whether these incentives could be lost or curtailed upon the transfer of the property. It is also important to remember the accounting treatment of the eventual lease. Depending on how the leaseback is structured, this could result in a financial lease or operating lease and the accounting and tax treatment of each structure could differ. Where the transaction occurs between related parties, depending on the jurisdictions, tax anti-avoidance rules should be considered and the sale price should reflect market value and the leaseback rent should be an arm’s length rent. Proposed changes to lease accounting under the account standard IFRS 16 will take effect from 1st January, 2019 and this will affect the accounting treatment of leases.
- A leaseback transaction could be structured to be Shari’a compliant and as such can be utilised by companies which only wish to obtain Islamic Financing.
Considerations for the Purchaser
The key commercial considerations for the Purchaser of the property are:
- Strength of covenant – The Purchaser is investing based on, amongst other things, the creditworthiness of the tenant and the stability of its business. The Purchaser, at the time of buying the property, would have the comfort of knowing the state of the property and the ability of the tenant to meet the rental and other obligations. The Purchaser can lock in its return through fixed rents and upward rent review clauses.
- The Purchaser will not have to bear any development risks as the property is normally already developed at the time the leaseback transaction is entered into.
- The Purchaser’s primary risk is that the Seller defaults under the lease agreement. The risk of the Seller defaulting under the lease agreement is mitigated to a considerable extent by the fact that the Purchaser, besides having the right to terminate the lease agreement and claim damages from the Seller, continues to enjoy its ownership interest in the property and would have the benefit of any capital gain in the property. The Purchaser can also find a third-party to lease the property. However, the Purchaser’s ability to lease out the property will depend on several factors including: (a) market conditions at the time; (b) condition of the property; and (c) whether the property is built to suit a specific business.
- Due Diligence is key – besides the creditworthiness of the Seller (and leaseback tenant) it is advisable for the Purchaser to carry out exhaustive due diligence on such matters as:
- potential environmental liabilities - where these lie with the land owner, these liabilities could be ‘inherited’ on a purchase of the affected land; and
- contracts with contractors – the Purchaser may need to assume the Seller’s position under the contracts with contractors and consultants, for instance, for any defects liability protection available under such contracts, collateral warranties can be useful to the Purchaser in this context.
UAE specific considerations
There are several jurisdiction specific legal considerations before deciding if a leaseback transaction is suitable for a company. We have highlighted below some of the key practical considerations which a company undertaking a leaseback arrangement in the UAE would need to evaluate.
- VAT – The introduction of VAT in the UAE from 1st January, 2018 will lead to VAT at 5% being payable on both phases of the sale and leaseback transaction. 5% VAT will be payable on the sale of the commercial property and a 5% VAT will also be payable on the rental payments made under the lease. Therefore, VAT will directly affect the cost associated with a leaseback transaction and may cause leaseback transactions to be less financially attractive than before VAT. This is especially true where the tenant cannot offset such input VAT on rent and other property costs against output VAT it charges on its own goods and services (for example a VAT exempt business). For such a tenant, VAT on rent and property maintenance costs becomes a net cost to the business and not just a cash flow issue.
- Ownership – The commercial property ownership laws in all the Emirates of the UAE contain restrictions (the restrictions may differ from Emirate to Emirate) on non-GCC nationals owning property unless there has been a relaxation of the restriction, for example in ‘freehold’ areas in the Emirate of Dubai. Generally, non-GCC nationals would usually enjoy possession and control of a commercial property under a long-term lease from the owner/landlord. Therefore, if a leaseback transaction is undertaken, then the Purchaser would become the new tenant and holder of the long-term lease from the owner/landlord and the Seller would become a sub-tenant.
This arrangement creates several legal and commercial issues to be considered before signing a leaseback arrangement. Some of the key issues are: (a) the head lessor’s ability to terminate the lease and its impact on the Purchaser’s rights to the property; and (b) head lessor’s consent may be required prior to the Purchaser (as the new tenant) subleasing the property to the Seller and the head lessor’s may also charge a subleasing fee (which in certain free zones can be as high as twenty percent of the rent payable under the sub-lease).
In conclusion, while leaseback arrangements are an attractive alternative to traditional methods of raising capital, companies should carefully consider the risks and benefits arising from leaseback arrangements in the jurisdiction where the transaction is proposed to be undertaken. Parties undertaking these transactions should also ensure they obtain suitable professional advice in structuring and implementing the sale and leaseback.