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By Fredric Carsley Sale-leaseback investment and liquidity win-win D espite the credit crunch that has seen the once-frantic pace of commercial real es- tate slow, sale-leaseback con- tinues to be an attractive vehicle, both for owners seeking liquidity from their real estate at attractive cap rates, and for in- vestors seeking long-term, stable returns on investment. Sale-leaseback is a term for a transaction where a property owner sells an asset and then leases it back. Real estate investment trusts which, due to current tax rules, must now main- tain passive income from the properties to qualify for the REIT tax status, find sale-leaseback arrangements a good port- folio fit, where the tenant and the lease qualify for what is known in the trade as the "credit tenant lease." The credit tenant lease A credit tenant lease is, above all else, a method of financing real estate. The land- lord borrows money, in more normal eco- nomic climates on a non-recourse basis — subject to typical carve outs for what are known as the "bad-boy acts" — on the se- curity of the real estate, focused principally on the lease and the credit worthiness of the tenant. The more onerous the obligations imposed upon the tenant, for example li- ability for structural repairs and replace- ments, the more net and carefree, thus from a financing perspective, the more desirable the credit tenant lease will be. There are psychological hurdles. Having acted for a buyer and eventual landlord on several occasions, a recur- ring theme I notice when negotiating documents is the reticence of the owner/ soon-to-be tenant to give up the control of the real estate the owner has enjoyed for many years. While owning the property, there may be mortgage financing legally committing the tenant to many obligations typically found in credit tenant leases. Neverthe- less, on a day-to-day basis, the landlord- tenant relationship tends to be much more interventionist and hands-on than the lender-borrower relationship. The intensity level increases in multi-tenant properties, as to preserve and hopefully increase economic value, thus the land- lord must provide peaceable enjoyment to all of its tenants, a process which often requires policing and juggling. So as a prospective buyer, don't be sur- prised by reactions like "I don't have to do this" or "I don't want you down my back every day when I become the ten- ant." When negotiating the agreements, look at the negotiation and closing of the transaction as the start of a long-term partnership. Like any business partner- ship, this one will have a much greater chance of success if it gets off on the right foot. The negotiation process and tone play a most influential role here. When to negotiate the lease Real estate transactions are difficult enough to consummate and then close. Particularly when dealing with a reticent seller, there is an understandable tempta- tion on the part of the buyer to outline the major lease terms in the purchase- and-sale agreement and make the closing conditional upon finalizing the form of lease, often with language such as "each party acting reasonably." In my experience, this is a recipe for disaster and ultimately disappointment. In a regular real estate transaction, after closing, buyer and seller generally part company. In sale-leaseback, the buyer and seller enter a long-term, landlord-tenant relationship, which is no different than if the landlord owns the building and the parties have to negotiate the terms and conditions of their future relationship. The tenant knows that its control of the bargaining process ends once the lease is agreed upon, and will not want to sell until it obtains whatever it requires, both financially and operationally. The landlord is trying to entice the owner to sell, often in the face of competitive mar- ket forces. Yet the best document package to prepare and freeze at purchase time purchase agreement is executed is one that is complete and includes the nego- tiated lease. That way, each party knows exactly what it is getting in advance, and the buyer proceeds with its due diligence of the property as if the transaction did not contain the lease component. Matters that may seem trivial to the real estate de- veloper may very well be so significant to the seller, as a future long-term tenant, it is ready to let the deal collapse if it does not get what it is looking for. Another critical element to freezing the lease is the future financing. In leveraged deals, as the buyer will be financing the lease and its net cash flow, the mortgage advance will, of necessity, be conditional upon the mortgage creditor approving the lease prior to the advance. Obviously if the landlord and tenant are negotiating the lease, the landlord, in its capacity as a borrower, will not have a final version of the lease to show the lender until the tenant has signed off. The pressure of meeting the lease negotiation deadline, the mortgage advance dead- line, and the property closing deadline squeezes the buyer on the lease negotia- tion. This may cost money or lost oppor- tunity in the future or, if material enough, may risk being rejected by the lender. IH Fredric Carsley is head of the real estate group at Montreal's De Grandpré Chait. Go to www.dgclex.com/en/publications/ index.asp?IDpub=111 for a complete version of this article. INHOUSE FEBRUARY 2009 • 9