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IntroductionWhen a client seeks assistance with the acquisition and/or

development of commercial real estate, there are a number of financing structures that may be utilized depending upon the client’s financial resources and objectives. This article seeks to highlight two of those financing structures, mortgage loans and sale-leasebacks, with emphasis on the unique aspects of sale-leaseback transactions relative to traditional borrowing. It should be emphasized that this article is not an exhaustive cata-logue of the financing structures available to a client, nor does it purport to be an exhaustive analysis of the circumstances under which a client may opt to utilize or avoid one of the financing structures discussed herein.

Mortgage Loans and Traditional Borrowing

A purchaser may seek financing from a traditional lender or, perhaps, a seller may agree to provide ‘seller financing,’ whereby the seller accepts a promissory note from the purchas-er at closing and the purchaser makes payments over a specified period of time until the purchase price and accrued interest have been paid in full. Under either scenario, a party other than the purchaser is providing financing for all or a portion of an acquisition in the form of a loan and will typically require that the purchaser’s obligations relative to the loan be secured by the real estate being acquired. The purchaser becomes both a property owner and a borrower at closing, and the party pro-viding financing for all or a portion of the acquisition becomes a secured lender by virtue of the security interest it obtains in the real estate acquired using the loan proceeds.

feature article

Sale-Leasebacks:An Often Overlooked Financing Option Available for Commercial Real Estate Transactions

by B. Hans Ipson and Dain J. Johnson

B. Hans IpsonB. Hans Ipson is a partner in the Omaha office of Kutak Rock LLP. He has experience representing a wide range of clients in complex commercial real estate transactions throughout the country, includ-ing the acquisition, development and disposition of commercial properties, leasing and financing transactions, and matters involving zoning and land use. Mr. Ipson

received his J.D. degree, summa cum laude, from Creighton University School of Law and he is admitted to practice in the State of Nebraska.

Dain J. JohnsonDain J. Johnson is an associate in the Omaha office of Kutak Rock LLP. He has experience repre-senting clients in a variety of real estate matters with emphasis in the areas of real estate development, commercial leasing and financing, and low-income housing trans-actions. Mr. Johnson received his J.D. degree, with distinction, from the University of Nebraska

College of Law and he is admitted to practice in the State of Nebraska.

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A basic mortgage loan financing includes a promissory note and, depending upon the law and customs of the state in which the real estate collateral is located, a mortgage, a deed of trust or a deed to secure debt. Whether a mortgage, a deed of trust or a deed to secure debt is used, the practical effect remains the same. The lender is making a loan evidenced by a promissory note and the loan is secured by an interest in real estate (which may be a fee simple or leasehold interest), providing the lender with the legal right to obtain title to the mortgaged property or sell the mortgaged property at auction, with the proceeds being applied to any amounts due the lender, in the event that the borrower fails to comply with his or her obligations relative to the loan. The terms of a particular mortgage loan may allow for the loan proceeds to be used for acquisition of the mort-gaged real estate, for renovation of the mortgaged real estate, or for other business purposes unrelated to the mortgaged real estate.

A variant of the simple acquisition mortgage loan financing structure is a construction mortgage, where the borrower seeks to use loan proceeds to construct new improvements or signifi-cantly rehabilitate existing improvements upon the mortgaged real estate. In the case of a construction loan, the loan proceeds are disbursed as construction of the improvements progresses to ensure that the loan proceeds are utilized for lien-free con-struction of the improvements that secure the outstanding loan amounts and that the value of the real estate collateral increases incrementally with each disbursement of loan proceeds.

The real estate collateral for a mortgage loan is subject to market conditions and the lender in a mortgage loan transac-tion will want to be sure that the loan terms adequately reflect and appropriately allocate the risks associated with the pro-posed loan. A lender underwriting a mortgage loan transac-tion will likely consider the value of the proposed real estate collateral, taking into account both the underlying value of the real estate and the cash flow derived from any existing or pro-posed leases, the borrower’s intended use of the real estate, and any unique attributes or use limitations that exist with respect to the real estate. In addition, a lender will typically assess the borrower’s history and experience with similar transactions and the assets of the borrower and any proposed guarantors. These factors will determine the terms of the proposed loan and, ultimately, whether the loan is recourse to the borrower, non-recourse to the borrower or non-recourse to the borrower with limited recourse carve-outs.

Mortgage loan financing may be a good fit for clients who lack the financial ability to acquire or develop real estate using solely their own funds (or those who desire to leverage equity funds they may have), if the proposed real estate collateral and the client are able to satisfy the underwriting conditions necessary to obtain a loan upon terms acceptable to the client. Mortgage loan financing is a popular means of financing real

estate acquisitions and developments because mortgage loans can be structured in nearly limitless ways to accommodate the objectives of borrowers relative to a wide variety of real estate transactions.

Sale-Leasebacks Although far less common, a sale-leaseback transac-

tion can provide another valuable financing option for a client who owns real estate and is unable, due to unfavorable credit conditions or other regulatory or contractual limitations, to pursue conventional borrowing, or a client who wants to fully convert its equity in a real estate asset that is already owned and constructed into a source of cash for other business purposes. A properly structured sale-leaseback transaction can provide the parties involved with desired tax benefits and accounting treatment largely unachievable through traditional mortgage loan financing.

A. The Sale-Leaseback Structure

A sale-leaseback transaction typically begins with a prop-erty owner who owns developed real estate and is seeking to simultaneously sell its fee simple interest in the real estate to a third party and take back a leasehold interest in the real estate, thereby obtaining the full market value of the real estate at closing and also retaining a possessory interest in the real estate sold. A basic sale-leaseback transaction includes a deed, by which fee simple title in the real estate is transferred, and a lease, by which the post-closing rights and obligations of the seller-lessee and the buyer-lessor are established. The lease is typically a long-term ‘absolute net’ lease, providing that the seller-lessee is responsible for all operating and maintenance expenses, capital improvements, property taxes and insurance premiums during the lease term. As further discussed below, the lease is generally an operating lease with the seller-lessee retaining no participation in future changes in the real estate’s market value. The seller-lessee and the buyer-lessor negotiate the terms of the lease as part of the overall transaction, so the actual lease terms can be tailored on a transaction-by-transac-tion basis to address any unique circumstances or client-driven considerations.

A variant of the basic sale-leaseback transaction is a situ-ation in which a property owner seeks to convey unimproved real estate and, as a condition to the post-closing lease, requires the buyer-lessor to finance and undertake construction of certain improvements on the real estate for occupancy by the seller-lessee during the term of the lease. The fact that the seller-lessee originally sells and conveys the unimproved real estate to the buyer-lessor differentiates this type of transaction from a traditional ‘build-to-suit’ leasing transaction; how-ever, the lease form utilized under either scenario is likely very similar. A sale-leaseback transaction can be effectuated with

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C. Considerations for Buyer-Lessor

Utilizing a sale-leaseback structure, a buyer-lessor is able to simultaneously acquire a fee simple interest in a real estate asset and secure long-term rental income upon desirable terms that the buyer-lessor negotiates prior to entering into the transac-tion with the seller-lessee. A sale-leaseback transaction can provide a fixed return on a buyer-lessor’s original investment, having negotiated the rental income from the transaction’s inception, with the added upside that the buyer-lessor enjoys from any long-term appreciation in the value of the acquired real estate asset. Taking advantage of depreciation rules, a buyer-lessor may also be able to offset some of the tax liability derived from the rental income. A buyer-lessor that is entering into a long-term “absolute net” lease with a credit-rated seller-lessee might actually be able to leverage the positive credit of the seller-lessee to negotiate better terms on a mortgage loan utilized by the buyer-lessor to acquire the real estate as part of a sale-leaseback transaction.

The primary risk to a buyer-lessor entering into a sale-leaseback transaction is that the seller-lessee will become insol-vent and default under the post-closing lease that it entered into with the buyer-lessor with respect to the real estate. Unlike a secured lender that must work through the often cumbersome foreclosure process in the event that a borrower fails to comply with its obligations relative to a mortgage loan, a buyer-lessor need only work through the eviction process if a seller-lessee fails to comply with its obligations relative to a sale-leaseback lease. The process for addressing a potential default by a seller-lessee might be easier to navigate, but a buyer-lessor must still reconcile the fact that the fixed rate of return that the buyer-lessor negotiated from the outset of its sale-leaseback transaction is subject to the risk that the buyer-lessor might not be able to find a suitable replacement tenant willing to enter into a long-term lease for the real estate upon comparable terms. A lender in a traditional mortgage loan transaction would enjoy the position of a secured lender fol-lowing the bankruptcy of a seller-lessee; however, the buyer-lessor in a sale-leaseback transaction would be considered only a general creditor. Of course, this distinction would only be significant in a soft market in which a buyer-lessor is unable to find a suitable replacement tenant for the real estate that is willing to pay a commensurate rent.

D. Tax Considerations

It is beyond the scope of this article to discuss the vari-ous tax implications and accounting rules applicable to sale-leaseback transactions. It should be noted, however, that a sale-leaseback transaction may fail to provide a seller-lessee and a buyer-lessor with the transaction’s anticipated tax ben-efits if it is determined that the sale-leaseback transaction lacks

improved real estate, unimproved real estate or just the building improvements on improved real estate. In sale-leaseback trans-actions involving only the building improvements on improved real estate, a separate lease of the underlying land may also be required to achieve desired tax benefits and accounting treat-ment.

B. Considerations for Seller-Lessee

Utilizing a sale-leaseback structure, a seller-lessee may be able to (i) eliminate a real estate asset from its books, together with any concomitant debt, and replace it with an operating lease; (ii) liquidate any equity that may exist with respect to the real estate asset while avoiding any regulations or contractual restrictions that would otherwise prohibit traditional borrowing or the incurrence of new debt; and (iii) retain possession of the real estate for a desired term and upon conditions that the sell-er-lessee negotiates prior to entering into the transaction with the buyer-lessor. A seller-lessee could extract existing equity from its real estate asset by obtaining a mortgage loan, but it is highly unlikely that the seller-lessee would be able to obtain a mortgage loan equal to 100% of the fair market value of the real estate asset and avoid the financial covenants (e.g., debt service coverage ratios, tangible net worth requirements, etc.) that are typically imposed in mortgage loan financings. The typical loan-to-value requirement for mortgage loan financings in the current commercial real estate market can range anywhere from 85% to 65% or higher. In contrast, a seller-lessee utilizing a sale-leaseback structure will typically receive 100% of the fair market value of the real estate asset at closing. The primary difference between the two financing options is that the seller-lessee will no longer own the real estate once the term of the leaseback portion of the transaction terminates, but there may also be significant tax and accounting benefits for a seller-lessee that is looking to utilize a sale-leaseback transaction to improve its balance sheet. A seller-lessee that is seeking to liquidate a real estate asset at a desired time, perhaps to coincide with optimal market conditions relative to the real estate’s market value, can do so utilizing a sale-leaseback transaction without having to simultaneously relocate existing business operations from the real estate.

On balance, a seller-lessee should understand that a sale-leaseback transaction will eliminate any future benefit the seller-lessee would have otherwise derived from a real estate asset’s long-term appreciation, and may, depending upon the terms of the post-closing lease, result in the seller-lessee having less flexibility in dealing with the real estate than it would have otherwise enjoyed as its fee owner. The initial sale of the real estate by a seller-lessee as part of a sale-leaseback transaction may also cause the seller-lessee to incur tax liability from the sale, while no such taxable event would occur in a mortgage loan transaction.

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tax purposes. Familiarization with applicable provisions of the Internal Revenue Code, Treasury Regulations and IRS guidance, relevant case law and treatises by tax experts and practitioners within the field is essential when assisting a client in the nuanced structuring of a sale-leaseback transac-tion. Consideration should also be given to the applicable accounting rules related to sale-leasebacks and any guidance by the Financial Accounting Standards Board (FASB) in order to structure a sale-leaseback transaction with the accounting treatment intended by a client. An accounting professional might also be a valuable resource when analyzing the consid-erations summarized above within the context of a proposed transaction.

OverviewFor a client looking to convert a fixed, non-liquid real estate

asset into cash while still retaining the long-term continued use of the asset, a sale-leaseback transaction may present benefits that are largely unachievable through traditional mortgage loan financing. Aside from assisting a client to understand and evaluate an alternative financing arrangement, a practitioner willing to learn how to structure a sale-leaseback transaction in a manner that will be honored for tax and accounting purposes could provide significant value to clients who routinely deal in commercial real estate transactions.

References Michael A. Yuhas & James A. Fellows, Sale-Leasebacks Revisited:

The Old and the New of Federal Tax Law, 31 Real Est. L.J. 9 (2002).

Stuart M. Saft, Commercial Real Estate Transactions Ch. 9 (3d ed. 2015).

Stuart M. Saft, Commercial Real Estate Transactions Ch. 11 (3d ed. 2015).

economic substance. A seller-lessee and a buyer-lessor can enjoy the tax benefits incident to both the sale and leasing of real estate, namely that a seller-lessee is allowed to remove a real estate asset from its books, together with any concomitant debt, and replace it as an operating lease (with fully deductible lease payments), so long as the sale-leaseback transaction is characterized as an actual real estate transaction (a “true lease”) as opposed to a mere financing device (a “financing lease”). If the Internal Revenue Service (IRS) determines that a particu-lar sale-leaseback transaction lacks economic substance and is merely a financing device, then the involved seller-lessee will be treated as the true owner of the real estate and the involved buyer-lessor will be treated as a lender-mortgagee for federal income tax purposes. Factors to be considered when structur-ing a sale-leaseback transaction and analyzing the appropriate tax and accounting treatment include (i) whether the purchase price of the real estate approximates current fair market value; (ii) whether the rent payable under the lease is competitive with current market rates; (iii) whether the term of the lease exceeds the useful life of the real estate; (iv) whether the seller-lessee maintains a continued involvement in the real estate or a right to purchase the real estate upon expiration of the lease term; (v) whether the seller-lessee will occupy the real estate for use in its trade or business and whether any subleasing of the real estate will occur; (vi) whether the proposed transaction has a business purpose other than the incidental tax treatment; and (vii) whether the lease will be considered an operating lease for accounting purposes.

The more characteristics of a genuine real estate trans-action that a proposed sale-leaseback transaction possesses aside from the tax treatment desired by the parties, the more likely the sale-leaseback transaction will be respected for