On 1 January 2019, International Financial Reporting Standards 16 came into effect, which introduced a change in reporting requirements for operating leases (such as leaseback leases). But has this had the negative effect on the prevalence of sale and leaseback transactions that the real estate market initially predicted? Victoria Landsbert investigates…
In the real estate world, a sale and triple net leaseback transaction takes place when a Seller sells a (typically) freehold or valuable leasehold estate in land to a Purchaser, for the Purchaser to immediately grant a lease back to the Seller on a "triple net" basis. A triple net lease separates out the costs of ownership of the property from the costs of operating the property, meaning the Seller (i.e., the tenant) is liable for operational costs—including basic (or principal) rent, building insurance, real property taxes, and property servicing and maintenance costs (and the Purchaser takes no financial liability for these operational matters). The rent payable under the triple net leaseback may be an open market rack rent, an index-linked rent (or a combination of the two), or an amount calculated by reference to the purchase price of the asset.
A sale and triple net leaseback can enable a company to release cash tied up within real estate (whether that be a single asset or a pool of assets; for a single asset class or multiple asset classes). The company then continues to enjoy the benefit of occupation of the asset through the triple net leaseback arrangements.
On 1 January 2019, IFRS 16 became effective (a new lease accounting standard), which introduced the requirement for operating leases (such as a leaseback lease) to be recorded on a company's balance sheet as an asset or a liability (as applicable). Prior to the introduction of IFRS 16, operating leases did not need to be recorded on the balance sheet. Many commentators were concerned IFRS 16 would spell the end for sale and leaseback transactions, on the basis that all companies which lease real estate would see their balance sheet liabilities increase.
As a result of IFRS 16, there is now a consistent accounting approach for both finance and operating leases (although please note that generally speaking this accounting change should be ignored for tax purposes). However, the impact does need to be carefully considered for investors and lenders alike. For example, a hotel operator tenant looking to raise debt finance will want to ensure its newly-categorised operating lease is appropriately treated for the purposes of categorising "Financial Indebtedness" under a loan agreement, which could impact the covenant calculations in circumstances where "Financial Indebtedness" is used to determine the overall health of the hotel operator's business. Similarly, on the investor side (and of concern for lenders), if moving operating lease assets into the balance sheet results in an increase in a company's or group's gross assets, this may affect contractual mechanisms such as guarantor coverage tests that impose coverage thresholds by reference to gross assets. There will also be interest expenses and charges to depreciation in respect of "old" operating lease assets, which may impact defined EBITDA concepts.
As we approach the end of 2019, we see the market has not seen the downturn for sale and leaseback transactions that was expected, as property investors continue looking to extract capital from their real estate portfolio. Surprisingly in fact, sale and leaseback transactions have seen an upsurge in recent months. Sale and leasebacks still represent a "partial" off-balance sheet financing—unlike conventional debt finance, only the present value of the rental payments is counted as a liability, and usually the discount rate used will be significantly higher than property yield. The balance sheet impact could be as low as half the amount raised from the sale, so this still represents an attractive option against other forms of finance. In addition, the introduction of IFRS 16 has been long awaited, and lenders have had the opportunity to consider ways of structuring debt covenants to exclude the effect of the new regulations. Indeed, the LMA has now incorporated wording into its loan documents to specifically exclude the effect of IFRS 16.
In addition, sale and leaseback transactions can be tax efficient. Firstly, the rental payments under the leaseback may be tax deductible as an operating cost of the business. However, there can be other benefits—whilst stamp duty land tax (SDLT) is generally payable on the sale aspect of the sale and triple net leaseback transaction, relief from SDLT liability is often available on the grant of the triple net leaseback. In order to qualify, specific conditions generally all need to be met, and it will be necessary to ensure they are met on a case-by-case basis. VAT leakage must also be considered. If the company has opted to tax the property for VAT, then the purchaser will need to pay VAT on the sale consideration. In addition, the VAT element will generally attract SDLT, thereby increasing the overall SDLT cost to the Purchaser (unless SDLT relief is available). However, with some forward planning, the position can be mitigated, and advice should always be sought on a case-by-case basis. Balanced against this, a Seller will of course need to consider the capital gains position on the sale of the asset/portfolio of assets.
So, it would seem sale and triple net leaseback transactions are far from being consigned to the history books. In fact, according to data from Savills, sale and leasebacks have accounted for more than 11 per cent of this year's retail transactions in Europe to-date, and the volume of sale and leaseback transactions from Q1 – Q3 of 2019 across Europe amounted to €1.7bn, more than the total for the entire of 2018. For so long as valuable capital can be extracted from an asset, whilst the benefit of occupation remains available, these transactions seem set to continue.
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