“Real Estate Sales and Leasebacks”		«BACK
	by Krass Monroe
	from Krass Monroe, P.A

In recent years, due to low interest rates and the supply of real estate debt financing, there has been an emphasis away from the sale/leaseback transaction as an affordable method for the restaurant operator to proceed with development and financing transactions or access equity and capital. Sale and leaseback transactions have, however, been used in commercial real estate for many years, and, due to the underlying real property asset represent a traditional means of financing. Notwithstanding the cyclical nature of real estate and occasional over influence on the market by outside factors (e.g., the real estate tax shelters of the early 1980's), lenders and investors have enjoyed appropriate returns on real estate using sale/leaseback transactions. As the current interest rate market stabilizes and debt financing in the restaurant industry returns to more traditional levels, it is likely that the rates offered on sale/leaseback transactions will again appear attractive.

The actual sale/leaseback transaction has been streamlined by a number of financing sources in the restaurant industry. Financing through the use of a sale/leaseback can be used for existing properties in connection with takeout of construction loans, refinancing or accessing equity in real estate. Sale/leaseback transactions can also be structured for development of new restaurants.

Sale/leaseback transactions can be broken down into two general structures. The first would be the sale/leaseback of improved land and the second would be the sale/leaseback of unimproved land. With regard to the first, sale/leaseback of improved land, these transactions are typically structured as one of two types, indirect or direct purchase of the land by buyer/lessee.

Indirect Purchase. This type of structure involves a structure whereby the seller/lessee enters into a purchase agreement to acquire certain improved property from a third party seller. Then, simultaneously with the closing between the seller/lessee and the third party seller, the seller/lessee assigns its rights under the purchase agreement to buyer/lessor who actually takes title to the property from the third party seller. This assignment is usually handled by way of assignment of the purchase agreement. The assignability aspect of this structure is usually negotiated when the purchase agreement is executed.

Direct Purchase. This type of structure involves an arrangement whereby the seller/lessee actually closes on the purchase of the property and takes title in its name. Then subsequent to this closing the buyer/lessor will enter into a purchase agreement to purchase the property from the seller/lessee. Depending on the transaction, the period of time between the two closing can be short or long periods of time. The longer time periods are typical of transactions that entail development and construction on the site.

Construction Sale/Leaseback. The other typical type of sale/leaseback transaction, which is somewhat more complicated, is the sale/leaseback transaction with construction financing. This type of transaction involves the acquisition of raw land by the seller/lessee and the development and construction of the property. This type of transaction usually includes a structure similar to the direct purchase, however, on occasion the indirect purchase structure is used.

As mentioned above, this type of structure involves additional risk to the buyer/lessor. The additional risk arises out of the construction aspect of the deal. In particular, the increased risk arises from the fact that there will be lienable improvements to the land and draws to pay for such improvements. These types of issues could give rise to mechanic’s liens or contractor’s liens that may attach to the property if not paid and lien releases obtained. Additionally, in a recent Eighth Circuit Court of Appeals decision, the Court held that the Franchisor who designs and constructs premises may have ADA (American's with Disabilities Act) liability if the design and construction does not comply with ADA. United States v. Days Inn of America, Inc., 151 F.3rd 822 (8^th Cir. 1998). Sale/leaseback transactions with construction financing present a higher level of risk to the buyer/lessee in that it has to exercise additional caution to insure that all lienable work is paid for, that lien waivers are obtained, that the improvements are built in accordance with the various laws, rules and regulations and, as a result of the Eighth Circuit decision on ADA liability, that the design and construction of the premises conform with all federal, state and local laws and ordinances regarding building construction.

Lease Terms. While the third party seller and the seller/lessee are negotiating the initial purchase of the property, the seller/lessee and the buyer/lessor are simultaneously negotiating the sale/leaseback terms. The sale/leaseback terms generally focus on the buyer/lessor being able to realize an adequate rate of return on the transaction and will also include the normal rent provisions of rent escalations through the term of the lease. The lease is generally structured as a triple net lease. Also, these sale/leaseback transactions may include an option for the seller/lessee to purchase the property, but as discussed below, caution needs to be taken when drafting such purchase options.

Sale/leaseback transactions are not without complications. In addition to the issues discussed above, as well as real estate title, environmental and construction related issues and requirements noted above, sale/leaseback transactions may generate unique accounting and tax issues.

Accounting Issues. There are numerous rules and regulations devoted to the accounting treatment for sale/leaseback transactions. A real estate sale/leaseback transaction that covers the remaining economic life of a property may be treated as a financing transaction or a capital lease. There are a number of technical factors accountants look to in determining whether a sale/leaseback transaction will result in capital lease treatment or operating lease treatment. In general, an operating lease characterization will result in the removal of the property (and the related financing) from the balance sheet of the seller/lessee. On the other hand, capital lease characterization will, from financial statement standpoint, continue to reflect the real estate as an asset and the accompanying liability. These considerations can be very important in connection with negotiating financial covenants or maintaining loan agreement requirements (particularly for those operators that have financing from multiple sources). In determining if a sale/leaseback transaction is an operating lease or a financing (capital) lease, accountants will look at the following factors:

• transfer of ownership of the property to the lessee at the end of the lease term;
• a bargain purchase option;
• whether the lease term equals 75% or more of the estimated economic life of the property; and
• whether the present value of lease payments equals or exceeds 90% of the fair market value.

Tax Issues. There may also be numerous tax issues associated with a sale/leaseback transaction. While a number of factors used to determine the tax treatment are similar to those analyzed for accounting purposes, these factors are not always consistent. From a tax standpoint, the primary issue is whether the sale/leaseback transaction will be treated as a true sale or a financing transaction. In a true sale situation, the seller/lessee will be required to recognize gain (or loss) on the transaction and will be treated as entering into an operating lease (providing for deductible rental payments over the life of the lease). In the financing (capital) lease scenario, the buyer/lessor is treated as providing financing against the real property asset and the seller/lessee continues ownership of the asset. In this situation, rental payments will be characterized for tax purposes as interest and principal payments. In addition to those factors cited above, the typical factors that define a capital lease for tax purposes include:

• lease payments substantially exceed fair rental value of the property;
• little or no investment risk by the lessor;
• burdens and benefits of ownership of the property rests with seller/lessee; and
• economic viability of the leasing transaction.

Krass Monroe, P.A. has a number of attorneys actively involved in the restaurant financing transaction. The attorneys have participated in numerous sale/leaseback transactions and are well versed in the various issues associated with that transaction. In addition, Krass Monroe, P.A. has long been a leader in providing tax-related legal services and are well suited to address tax and accounting issues associated with sale/leaseback transactions. Please contact Krass Monroe, P.A. if you are interested in learning more about these types of transactions at (612) 885-5999.