Sale-leasebacks accommodate buyer and seller in today’s healthcare real estate market: 7 reasons why they work, 5 pitfalls to note

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For many years, low interest rates allowed companies with strong credit ratings to obtain access to cheap capital through traditional financing methods – meaning there was little enthusiasm for sale-leaseback transactions.

But the recent spike in real estate values is once again shining the spotlight on another useful financing tool: the sale-leaseback. Corporate and institutional clients are especially finding sale-leaseback transactions useful when they seek to cash in on the equity from their real estate assets in order to grow their business and reduce some of the debt from their balance sheets; investors seeking more stable and predictable returns are also finding sale-leasebacks to be an attractive choice.

Hospital sale-leaseback transactions

The hospital and healthcare segment has become especially active in the sale-leaseback market in recent years. Hospitals have proven to be particularly inviting to investors because they are generally financially sound, have long-term growth prospects, utilize an established management system and own attractive real estate. Additionally, many hospitals are contemplating mergers, which is the ideal time to consider the sale of real estate and assets to avoid unnecessary duplication and waste of resources.

The following are some recent hospital sale-leaseback transactions that have received public attention:

  • In January 2012, Blue Cross Blue Shield of Minnesota sold eight buildings totaling 1.1 million square feet, including its suburban Minneapolis headquarters, to New York-based investment firm W.P. Carey for an undisclosed amount.
  • In January 2014, Reliant Hospital Partners, LLC, along with a joint venture of The Sanders Trust of Birmingham, Alabama and Harrison Street Real Estate Capital of Chicago, entered into a sale-leaseback transaction in connection with two hospitals from Senior Housing Properties Trust of Newton, Massachusetts for $90 million.
  • In May 2014, Hackensack (N.J.), a joint venture of University Medical Center and LHP Hospital Group (of Plano, Texas), sold its hospital in Montclair, New Jersey, to Medical Properties Trust for $115 million in a sale-leaseback transaction.
  • In January 2013, it was reported that Spire, the UK’s largest private hospital group, sold a £700 million property portfolio to two hedge funds and a Malaysian investor in a sale-leaseback transaction.

What a sale-leaseback transaction looks like and how it is typically structured

Essentially, a sale-leaseback is an agreement designed to strengthen the balance sheet. A company sells its property to a third party and enters into a long-term lease to continue its occupancy of the subject property. Where the company realizes a capital gain on the sale, the sale proceeds may be used to reinvest in the business or pay off debt. This sale then works to free the seller of the burdens of, and risks arising from, owning, managing, and financing real estate.

A sale-leaseback can be structured in many ways. In its most traditional form, a sale-leaseback provides that a purchaser-landlord will obtain legal title to the land and improvements at closing and will simultaneously lease the asset back to the seller-tenant. An alternative form is preferable if the seller-tenant desires to retain income tax benefits at the property. A seller can retain tax benefits by conveying the land, retaining ownership of the improvements, and entering into a ground lease for the land with the purchaser-landlord. In a ground lease scenario, the purchaser-landlord must negotiate terms to protect its right to obtain the improvements to the property upon the expiration or termination of the lease.

What makes these deals advantageous to both buyers and sellers? 7 things to know

Sale-leaseback transactions are a compelling investment vehicle for both buyers and sellers of commercial real estate, for the following reasons:

  1. A sale-leaseback enables a business to leverage its real estate as a source of capital funds to reinvest, expand its business or to satisfy debt obligations.
  2. The new rent payments may be less than the current mortgage payments.
  3. An owner frees itself of potential liabilities that come with property ownership, such as building depreciation, debt service payments, maintenance, insurance, and tax liabilities.
  4. The purchaser will take the subject property subject to a long-term lease with the property’s existing occupant.
  5. The gain realized from a sale-leaseback transaction can often be amortized on the corporation’s income statement, increasing reported earnings and potentially improving the company’s financial ratios and margins.
  6. Rental payments are typically 100 percent deductible against the company’s taxable income, whereas only the interest portion of a mortgage payment is deductible.
  7. Although the rent is ordinary income to the landlord, it is spread over the lease term with the landlord having a depreciation deduction to offset the rental income.

5 pitfalls to avoid in a sale-leaseback transaction

A sale-leaseback may not be the right answer for everyone. There are certain risks and considerations that should be taken into account when negotiating the contract and the lease. In particular, the purchaser will need to carefully evaluate the financial conditions and business prospects of the seller to ensure its ability to make rental payments throughout the lease term.

Judicial interpretation of tax laws and accounting rules may impact how the sale-leaseback transaction affects a company’s financial statements. In some instances, courts have held that a sale-leaseback transaction will be considered a financing device rather than a sale or a lease, if the tenant retains sufficient characteristics of ownership over the property. Moreover, the IRS will review a sale-leaseback transaction to ensure that there is a legitimate business purpose for the transaction, other than tax consequences.

Factors considered by courts and regulatory agencies may include the following:
  1. whether the tenant is obligated to pay all of the carrying charges on the property’s mortgage
  2. whether the tenant may repurchase the property at a predetermined price
  3. whether the rental payments were calculated to amortize the purchase price of the property at an agreed annual rate of return over the term of the lease
  4. whether the rental payments materially exceed the current fair market rental value and
  5. whether the tenant has an option to reacquire the property at a nominal price.

One final thought

Before entering into a sale-leaseback arrangement, a seller must consider whether the “leaseback” portion of the deal is as desirable as originally contemplated. A subsequent change in the seller’s business plan may occur, or the seller may determine that it would have been more advantageous to hold on to the real estate asset, given the limitations and lack of flexibility that are inherent in a long-term lease. As a result, the seller may want to consider incorporating a repurchase option into the lease, which allows the seller-tenant to either repurchase the property or terminate the lease at a later time.

DLA Piper’s Healthcare team offers experience in issues relating to sale-leaseback transactions for healthcare industry participants. Please contact us if you would like to more information about how the sale-leaseback model might benefit your business.