Not long ago the Rapid City Journal did an excellent two-part series on the 1986 sale/leaseback by the State of South Dakota of many of its government buildings. The proceeds of the sale/leaseback put a total of $29 million into infrastructure improvement over several years, with no cost to taxpayers. It was described by then-governor Bill Janklow as “making money out of nothing.”
While the transaction was viewed by many people as confusing, it really isn’t that difficult to understand. Sale/leasebacks have been a tool used by owners of real estate for decades, and the concept is not terribly complicated.
Basically a sale/leaseback is a transaction where the owner of a property sells it to a buyer, then immediately leases the property back from the buyer. The seller, rather than moving out, stays in the building and rents the premises from the new owner.
The seller ends up with cash and gets to stay in the building for the term of the lease. The tradeoff is that the seller now becomes a tenant. The buyer ends up with a building, a tenant (typically a long-term tenant), and income in the form of rent payments.
Why would a seller and a buyer want to do a sale leaseback? There are many potential advantages and disadvantages on both sides.
One reason is that the seller has a greater need for cash than for real estate. Perhaps they can use the cash in their business. Perhaps they can purchase a different asset at a significant discount, thus receiving a higher return that owning the real estate. Selling may also be a way to lock in high real estate values in anticipation of a real estate crash.
For the buyer, the purchase may serve as an investment opportunity that comes with a tenant already in place, eliminating the risk of letting a building set vacant for months while searching for a new tenant.
This is basically what the State of South Dakota did. It sold 118 buildings to investors, who then leased back the buildings to the state under an agreement where the state was obliged to buy the buildings back in 30 years. This is called a “lease/purchase,” where the buyer has either an option or obligation to purchase the property during the term of the lease. The state invested just enough cash from the sale to produce sufficient return to pay the rent on the buildings for 30 years and fund the repurchase. When that was said and done, the state had $12 million left over.
The main factor that made this work was that the state was able to invest the money at a higher return than the cost of leasing back the property. Had the cost of leasing back been greater than the return the state could get on the sale proceeds, this would not have worked as the state would have lost money.
Additional benefits a seller may realize from a sale/leaseback are tax advantages. For one thing, lease payments are 100% deductible. Or perhaps a seller may have large business losses that can be used to offset a large gain from selling their real estate. It’s a way to benefit from the unfortunate loss at the same time gaining money to put back into the business. The funds can be used for any purpose the business may have, including investing the proceeds to fund a lease/purchase as South Dakota did.
While the details of a particular sale/leaseback may be complex, the basic purpose is straightforward. It’s a way to use a real estate asset to provide business benefits to both parties.