COVID-19 lockdowns across the world have created sudden and significant short-term cash flow problems for many previously solvent and profitable business enterprises.
In New Zealand, the first wave of disruption to the local supply chain came as Wuhan, and progressively wider parts of China, shut down manufacturing and export operations. This was overlapped by a second, more severe wave of economic pain, as New Zealand itself entered Alert Level 4 lockdown affecting multiple business sectors around the country.
Against this backdrop, and throughout lockdown, Bayleys national director real estate advisory sales Stephen Rendall says its sales and leasing teams have fielded a number of requests for proposals from business owners seeking to improve their balance sheets and fuel business growth by exiting property ownership.
Rendall says numerous businesses that own real estate are considering “sale and leaseback” transactions to free up capital, reduce debt and/or focus on their core activities which can include research and development, new product lines, acquisitions, customer retention and staff recruitment and training.
“Creative thinking is required for many businesses experiencing interim cash flow constraints due to restrictions on trade and the multiple handbrakes that are being applied throughout the economy due to the pandemic,” says Rendall.
“Selling core real estate assets to release equity which in turn can be channelled into the business’s day-to-day operations makes sound financial sense for a range of business sectors – and never more so than in today’s uncertain environment when it’s all hands to the pump to keep the dollars coming in.
“It’s certainly not to be viewed as a failure but rather, as an astute realignment of priorities and finances.”
Executing a real estate sale and leaseback transaction is a multi-layered process involving a range of professionals.
Rendall says having a team of trusted legal, accounting, valuation and tax advisers on hand to support the process, in addition to a real estate agency and advisory team, is invaluable and will help to make the process robust and with more chance of achieving an optimal outcome.
In a typical sale and leaseback, a business that owns real estate enters into a sale and purchase agreement with a purchaser. On settlement, the purchaser acquires ownership of the land, buildings and other improvements on that land, and simultaneously, the business leases some or all of the land, buildings and improvements back from the purchaser for an agreed period of time.
“So, the business owner converts capital that had previously been tied up in real estate into liquid form, for better use within the business, while retaining occupation and economic use of the real estate,” says Rendall.
“The purchaser becomes the owner of the real estate and is entitled to receive the rent and other payments that the business is now obliged to make under the terms of the lease.”
Rendall says as with all business operational and ownership structures, there are pros and cons, but it is hoped that in freeing themselves of property ownership, the business itself takes centre stage.
“To illustrate the benefit with a simple example, imagine that a business – that owns the real estate it occupies – determines that it expects a cash return on equity of 5-7% per annum from its property asset.
“However, in doing the numbers, the business expected a cash return on equity of 12-14% per annum across the same horizon from the business’s core area of expertise (for example, the manufacture and distribution of farm irrigation systems).
“All other things being equal (including the relative risk of the two ventures), the business could derive significant additional return for its investors by converting the equity held in the real estate into investment in the business’s core business, thereby generating higher returns for investors.”
Rendall says given the inherent uncertainties in the current market, a real estate sale and leaseback transaction could free up capital to be redeployed to deal with immediate, business-threatening circumstances.
“Examples include requirements imposed by banks to reduce debt exposure, or to avoid a breach of banking covenants in the short-term, or bank conditions that make further lending contingent on the sale,” he explains.
“Equally, businesses may need the cash to be sure of meeting payment obligations to suppliers or staff.
Although the real estate is now owned by a third-party investor, the lease back to the business will grant the business exclusive occupation and use of the real estate for the term of the lease, potentially on terms which are more favourable for that business by comparison with ownership.
“For example, a lease can – and often will – allocate certain maintenance and replacement obligations to the landlord,” says Rendall.
As to the potential downsides to a business, losing long-term control of the physical real estate is the main one.
“The business will not ordinarily take a lease back that is indefinite in term – although Guinness signed a lease for the St. James's Gate Brewery in Dublin for 9,000 years,” he says.
“Also, leases do not usually grant full rights of exploitation, meaning a tenant must use the premises as they are constructed, and for a specific use.
“While modifications with landlord consent can often be negotiated, in simple terms, the tenant can no longer treat the property as if it was the owner.”
The way leases are structured can also impose obligations, there are transactional costs and tax implications to be managed, and there’s an intrinsic loss of security for the business.
“Obtaining ongoing finance could also become more challenging without banks/lenders having capacity to lend against owned real estate put up as mortgage security,” outlines Rendall.
Bayleys has structured and executed sale and leaseback transactions for a wide range of businesses in recent years including ANZ, Fonterra, MediaWorks, Woolworths New Zealand, Foodstuffs, NZ Post and KiwiBank.