www. NYLJ.com Volume 253—NO. 31 Wednesday, February 18, 2015

Transactional Real Estate Sale-Leaseback

By And Transactions Peter E. Mitchell L. Fisch Berg

ale-leaseback transactions have sale-leaseback usually yields more proceeds ating lease treatment is often beneficial to a long been a means for operating than traditional mortgage financing. Lease lessee in meeting debt covenants under its businesses to monetize their real payments are typically calculated to provide corporate-level financing.2 estate holdings and reduce lever- for a stated return on the purchase price Disadvantages age. Sale-leaseback transactions over the term of the lease, plus agreed rent mayS be of particular value to companies that increases. The proceeds of the sale can, in The sale-leaseback does come with some are not in the business of owning real estate some cases, exceed the fair market value of disadvantages for the seller-lessee relative per se. The transaction allows the seller the real estate, provided that the buyer can to owning the real estate with debt financ- to convert equity in real property to cash underwrite the rental stream and residual ing. The company loses both the residual immediately available for debt reduction or value to support the price.1 For a private value of the property and the benefits of operations, while retaining possession and equity firm looking to finance the acquisition appreciation and, more importantly, runs continued use of the property during the of a company with significant owned real the risk that the property may not be avail- term of the lease. estate holdings, the sale-leaseback is a pre- able to it at the expiration of the lease term.3 Over the last several years, sale-leasebacks ferred financing tool, and may be particularly The company runs the risk of losing its core have been implemented with increasing fre- attractive for a business with poor credit operating assets if it cannot comply with the quency, perhaps driven in part by a prolifera- that may have difficulty finding attractive lease terms. Perhaps the greatest drawback is tion of real estate investment trusts (REITs) debt financing. the loss of operational flexibility that comes and other institutional buyers seeking the Many companies only pursue sale-lease- with the lease covenants designed to protect stable returns these transactions provide, backs if the lease will be classified as an the buyer’s investment. The lease may place and in part by private equity buyers seeking “operating lease” under applicable account- meaningful restrictions on use, alterations an alternate means to finance the acquisition ing standards rather than a capital lease (i.e., and transfers, and will impose obligations of the companies that occupy the real estate a financing). With operating lease treatment, enforceable by the lessor for many aspects or, as part of the acquisition, to delever the the seller’s fixed asset (i.e., the real estate) of the operations at the property. A corporate company. The sale-leaseback market has is replaced with a current asset (i.e., the secured loan (a likely alternative to a sale- grown robust, to the point that attractive cash proceeds from the sale), the rent pay- leaseback transaction) will impose covenants deals are now available to tenants with weak- ments will be treated as deductible operating of a similar nature, but such covenants will er credit quality; in addition, tenants are able expenses, and the property is not recorded typically be far less restrictive. to command favorable non-economic terms. as an asset on the books of the seller-lessee In particular, the lease may significantly Sale-leasebacks are attractive to operat- (and, consequently, the transaction is not compromise the ability of the company to ing companies for a number of reasons. A treated as debt for the seller-lessee). transition out of uneconomic locations, and If the lease is classified as a capital lease, may impose restrictions on corporate-level the property remains an asset on the lessee’s transactions. The seller-lessee will want to Peter E. Fisch and Mitchell L. Berg are partners at Paul, books and the lease obligations are treated as preserve, to the greatest extent possible, the Weiss, Rifkind, Wharton & Garrison. Vincent Asaro an associate of the firm, contributed to this article. debt on the company’s balance sheet. Oper- right to “go dark,” dispose of unprofitable or

In some jurisdictions, this reprint may be considered attorney advertising. Past representations are no guarantee of future outcomes. Wednesday, February 18, 2015 obsolete locations and enter into corporate the lessee has subleasing and/or substitu- ing owners or ground lessors (in particular level transactions—matters over which the tion rights (as discussed below), it may be in the retail context, where reciprocal ease- seller-lessee has unfettered discretion when important for the lessee to have the right to ment agreements for shopping centers may owning the property, but all of which are shut down its operations (i.e., “go dark”) if contain their own operating covenants). Con- generally viewed by buyers with concern. the economics of a particular location make tinuous operating covenants in third-party The lessee’s desire for flexibility is compli- it prudent to do so. While the lessee must agreements often provide for a reversion of cated by a lessor’s bankruptcy concerns in continue to pay rent even if permitted to “go title or a purchase option in the event the multi-property sale-leasebacks. Buyers will dark,” the location may be operating at a covenant is breached. insist on the characterization of the lease significant loss even without taking rent into Right to Sublease as a “unitary” agreement demising multiple account, and there may be a variety of other properties, as opposed to a lease severable business reasons dictating such closure. The most feasible means for a lessee to with respect to each property (or groups of free itself from an unwanted property is a properties). The risk of the latter character- broad right to sublease. Assignment is not a ization in a bankruptcy of the seller-lessee Over the last several years, useful right to deal with specific locations in a would allow “cherry picking” of locations sale-leasebacks have been sale-leaseback structured as a multi-property by the seller-lessee pursuant to the lease implemented with increas- lease. A sublease, however, allows the com- rejection right provided by 11 U.S.C. §365, pany to shed an uneconomic property while leaving the lessor with only the less desir- ing frequency, perhaps driven ameliorating the economic loss involved. able properties and a diminished income in part by a proliferation of Given that the lessee continues to remain stream. Lessors will generally prefer, even real estate investment trusts liable to the lessor for all rental and other in a large portfolio transaction, to have a and other institutional buy- obligations under the lease in the event of a single lease, or at most a limited number of sublease, logic would dictate that the lessor master leases involving multiple locations, ers seeking the stable returns should be flexible with sublet rights. How- in order to limit “cherry picking.” Even with these transactions provide. ever, lessors are often concerned about repu- a single master lease, lessees have been suc- tational issues that may accompany certain cessful in convincing a bankruptcy court to subtenants and also may be concerned that use its equitable powers to treat the lease as Lessors, on the other hand, generally take a “less substantial” subtenant is less likely to severable based on certain features of the the view that a continuous operation cov- maintain the property to the proper standard lease.4 Certain lease provisions on which the enant preserves the value of the building that and to otherwise comply with the lease. seller-lessee may insist in order to maintain serves as their collateral. Notwithstanding In addition, as in the case of “going dark” operational flexibility (such as the right to the covenant in the lease requiring mainte- provisions, if too many locations (or in a terminate the lease with respect to individual nance and repair, lessors will argue that a single-property transaction, significant por- properties in the event of a casualty or in lessee is more likely to maintain the property tions of the property) are no longer used in the event that such properties are no longer at the appropriate level if the lessee is operat- the lessee’s business, it may increase the useful in the conduct of the seller-lessee’s ing at the property. In addition, lessors tend risk of rejection by the lessee in a bank- business, or to renew the lease as to some to perceive the risk of the tenant rejecting ruptcy. Consequently, negotiations will often properties but not others) can be regarded the lease in bankruptcy as diminished if the center on limiting the number of locations as inconsistent with the unitary lease char- tenant is actually operating its business at or the portion of a single property that may acterization and present a recharacterization the property. be sublet, and in some cases subtenants risk to the lessor. The market has recently swung in the les- are required to satisfy certain financial and The Right to “Go Dark” see’s favor and the right to “go dark” has operational requirements. become more common. A middle ground is From the lessee’s perspective, it is impor- Particularly in the case of retail and res- often reached, allowing a right to cease opera- tant to negotiate a requirement that the taurant properties, sale-leaseback leases tions at a limited number of locations in a landlord provide subtenant non-distur- frequently require that the tenant continu- portfolio transaction and/or a right to cease bance so that subtenants will be recognized ously operate in the leased space, with the operations for a specified period of time (gen- as direct tenants by the landlord should specifics of such a requirement being subject erally to allow the lessee to cease operating the primary lease be terminated. Without to negotiation (and with portfolio transac- while seeking an appropriate sublet), but not non-disturbance protection, the universe of tions generally allowing more flexibility with indefinitely. Lessors will be unable to provide potential subtenants will be somewhat lim- respect to continuous operation covenants this flexibility for properties that are subject ited. Lessors understandably and strongly than single-property leases). Even where to covenants to operate in favor of adjoin- resist such a requirement, particularly if it Wednesday, February 18, 2015 is not limited to sublessees and subtenants leased properties, and thus take on the less lessors resist these provisions, it is usually meeting standards satisfactory to the les- desirable locations in order to maintain the over concerns that the transaction will result sor. The lessor may argue, for example, that better locations. Lessees frequently negotiate in a change in the capital structure of the les- a sublease at a rent below the ratable lease the right to renew the lease for fewer than see’s enterprise that reduces the credit qual- rent for the applicable property should not all of the properties in the lease portfolio. ity of the lessee. Lessors occasionally bargain be entitled to non-disturbance, although This allows the lessee to dispose of unde- for requirements that must be satisfied if the if a sublease is at market rent the lessor sired locations at the end of the initial term lessee is to undertake a corporate-level sale would be no better off were it to re-lease or any renewal term. Lessors are typically or merger, such as (a) a requirement that the the property after termination of the lease. flexible with renewals, given that they usually senior management team of the successor Even where a lessor will agree to subten- underwrite the transaction based on the ini- lessee have substantial experience in oper- ant non-disturbance, it will often limit the tial term. However, in many cases the lessee ating the business, and/or (b) net worth, number of subleases that are eligible for non- may be limited in the number of locations EBITDA or other financial tests. disturbance during the term, and also may that may be excluded with respect to each One risk that lessors must consider is provide non-disturbance only to subtenants renewal. The right to selectively renew is the lessee’s ability to enter into transac- of a certain credit quality. another feature that may be in conflict with tions to strip assets from the lessee that do Sublet rights may unwittingly be frustrated the unitary lease analysis. not involve transfer of the lease. An ongo- if the use clause of the lease is drafted too ing financial covenant from the lessee may narrowly. From a lessee’s standpoint, the use adequately protect the lessor against such a clause should allow any “legally permissible The transaction allows the risk. Absent any ongoing financial covenants use,” but lessors may seek to define permit- seller to convert equity in real of the lessee, though, the lessor may require ted uses with more specificity, especially if property to cash immediately that the lessee include the lease in any trans- the use figured prominently in the lessor’s action involving the sale of a substantial por- underwriting (in which case the use clause available for debt reduction tion of the lessee’s other assets. may take a more restrictive form, such as or operations, while retaining ••••••••••••••••••••••••••••• operation of a store under the company’s possession and continued use 1. A typical term structure for a lease is 20 years plus four (4) five-year extension terms, so the underwriting would be existing and/or future trade names). limited to the initial term rental stream. Note that the pro- of the property during the ceeds of the sale will likely trigger taxable gain (unlike a mort- Property Substitution Rights gage financing), though the company may have tax attributes term of the lease. that mitigate the impact. 2. The full accounting and tax implications of capital lease In a portfolio transaction, a lessee may versus operating lease treatment are complex and beyond the scope of this article. also eliminate a location that is no longer 3. Purchase options of any kind run afoul of operating lease Sale of the Company requirements, but many leases do contain “right of first of- economically viable by exercising a property fer” and/or “right of first refusal” provisions that are typically permissible under the applicable accounting standards. As a substitution right. Effectively, a substitution With sale-leasebacks frequently involving practical matter, especially for certain property types that are less adaptable to other users (such as industrial properties), right allows the lessee to “swap” one or more a substantial portion of a company’s operat- the buyer will likely be more than willing to renew the lease or sell the property back to the user at the end of the term. new properties for one or more of the proper- ing locations, it is imperative that a lessee 4. As a general matter, the issue in front of the bankrupt- cy court is whether the parties intended separate contracts ties in a lease portfolio. This right is usually negotiate the flexibility to enter into a sale, even though they are contained together in one purportedly unitary agreement. Whether a “master lease” is severable limited to no more than a specified number merger or other combination of the company is a fact-intensive inquiry in which provisions contained in the lease inform the intent of the parties. Among the factors of substitutions during the term of the lease. so that the lessor does not have the ability considered by the bankruptcy court are as follows: whether (a) rent for the individual properties is apportionable under Typically, the lessor has approval rights over to hold up a corporate-level transaction. The the lease; (b) the landlord has the right to sell the underlying the substitute property in accordance with lessor usually takes comfort so long as the property relating to any of the individual properties, resulting in severance of that property from the lease; (c) the tenant its underwriting standards, and the value of party who is the lessee under the lease at any has substitution rights; (d) there is separate consideration for each of the properties; and (e) an extension of the lease term the substitute property must be no less than given time has substantially all of the operat- results in different expiration dates for different properties. the value of the existing property. The lessor ing assets of the lessee that it underwrote. will condition the substitution on approval The permitted transfer provision should from the fee lender, if applicable. Once the address (a) sale of all or substantially all of substitution is completed, the lessee can the lessee’s assets, (b) sale of all or substan- freely sell the substituted property. tially all of the direct or indirect equity in Partial Renewal the company, or (c) merger (of either the lessee or a direct or indirect parent) with a If the lease has an “all or nothing” renewal third-party entity. Reprinted with permission from the February 18, 2015 edition of the NEW YORK provision, the lessee would be forced to exer- The ability to consummate corporate-level LAW JOURNAL © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 cise the renewal rights with respect to all transactions is fairly market-standard; where or [email protected]. # 070-02-15-22