Episode 026: Nothing But Net - NNN Show HOW CAN A SALE-LEASEBACK WORK FOR YOU?
TRANSACTING SALE-LEASEBACKS FOR NET LEASE REAL ESTATE
Hosts Michael Flight and Adam Carswell on the Nothing But Net – NNN Show.
January 17, 2022 | HOW CAN A SALE-LEASEBACK WORK FOR YOU?
In this episode, hosts Adam Carswell and Michael Flight are joined by Christopher Drzyzga, Vice President at Voit Real Estate Services, to discuss how investors conduct sale-leaseback transactions that benefit both the buyers and sellers of Triple Net real estate. Chris explains the essentials of doing sale-leaseback transactions and why they may suit real estate investors better than the typical sale of a property, especially with medtail and last-mile distribution facilities. Michael, Adam and Chris also touch on the benefits of this type of real estate deal, including acquiring a fully leased asset from the first day of the lease term, capital improvement of the property from the tenant’s commitment to its upkeep, and Cap Rate Compression circumstances. They also emphasize the advantages of having skilled brokers to help investors properly transact with a sale-leaseback, like understanding the unique tax benefits. Closing the show, Chris, Adam and Michael share the key component of choosing a great property to perform a sale-leaseback transaction and give alternative investment options, such as Installment Sales.
Learn more about International Investing and all things Triple Net on other episodes of The Nothing But Net – NNN Show. This show is a podcast all about the benefits of acquiring and owning Net Lease Properties (also known as NNN, Triple Net, Triple-Net Single-Tenant or Single-Tenant Triple-Net Lease properties). Listen to or watch this podcast on the Liberty Real Estate Fund Nothing But Net YouTube channel.
Chris Drzyzga on Sale-Leaseback Transactions
A topic that often gets overlooked in the real estate sector is that of the sale-leaseback. As the property investor of a sale-leaseback, you are basically financing the expansion of a tenant, or the operations of a tenant, and solving their problem of lack of capital so they get to stay in their space. Chris Drzyzga, Vice President and Commercial Real Estate broker at Voit Real Estate Services, helps to explain the ins and outs of this type of real estate deal on Nothing But Net – NNN Show 26. With his background at Voit, a regional brokerage that has been around for 50-plus years with six offices in Southern California, Chris is an excellent guest to explore the aspects of sale-leasebacks with the Nothing But Net community.
Benefits of California’s Industrial Real Estate Market
Voit is primarily known for Industrial Real Estate leasing, sales and development, with over 250 brokers that may also deal with the multifamily, office and retail sectors. Southern California is one of top three industrial markets in the country, arguably if not the globe. Developers can’t build fast enough, whether it’s Orange County, Los Angeles oor the Inland Empire, which is one of the really big hubs for industrial real estate. But, there has been a 1½ – 2% vacancy for the last handful of years, and sale prices are through the roof. Lease rates have been appreciating substantially, but they’re finally caught up to the sale pricing, which is going to grow sales.
California has traditionally been a huge aerospace manufacturing, airplane manufacturing and technology marketplace. But, the most popular industrial properties right now are last-mile distribution logistics, with a very dense demographic base in California. However, there is the ongoing trend of manufacturers moving to more friendly jurisdictions, like Texas.
Businesses like Amazon and Target need to be able to fulfill orders in a timely manner, which creates more demand for these facilities. Some investors also convert and retrofit retail shopping centers into last-mile distribution real estate, granted the properties meet the requirements of an industrial property. Distribution centers need higher ceiling heights, correct and sometimes better dock access – the clear height and dock loading is pivotal.
The Fundamentals of a Sale-Leaseback Transaction
So, what is a sale-leaseback? The sale-leaseback transaction is where a business owns the real estate they occupy and later makes the decision to sell the real estate to an investor. Once the investor has possession of the property, the seller becomes the tenant and signs a long-term lease with that investor. So, the business owner (now the tenant) uses those sales proceeds typically to expand operations, buy equipment and make any improvements they deem necessary. The investor, in turn, acquires a 100% leased asset from day one, and the business doesn’t have to incur any of the costs or the downtime and disruption that comes with relocating a business.
The main reason investors transact with sale-leasebacks is to free up capital. The sale-leaseback started to gain traction in the late 1970s. Primarily, large corporations would sell the real estate to an investor and use those proceeds to expand the business. At the same time, sale-leasebacks were also an interest rate arbitrage to a certain extent. Property owners could go to a bank and get a loan for 8% interest or, instead, sell the real estate to an investor at a 7% cap rate and pocket the 100 basis-point spread to put the capital to more productive means.
The most likely candidate for sale-leasebacks is a business that has a specialized facility. It is either very difficult or very costly to duplicate some industrial property types. People who are looking to reduce their debt, have a lower risk profile or even just want to become more of a passive investor in real estate will look at sale-leasebacks as a very viable option.
Many of the owner-users who bought real estate a number of years ago have dramatically appreciated assets now with windfall profits. Business owners that may be three to five years away from retirement with 10-plus years into the real estate cycle look to a sale-leaseback. That way, they can get their proceeds, lower their risk profile, have less management responsibilities and comfortably live out retirement once the lease term expires.
Tax Advantages of Sale-Leaseback Deals
There are some great opportunities that business owners and investors can take advantage of doing a sale-leaseback transaction. You, as the seller/tenant can take the sale proceeds and pay your capital gains taxes, or you can do a 1031 exchange and defer that capital gains tax. Additionally, if the person owns the property, they may own it outright with no debt, which means they are paying 100% taxes with some depreciation but no interest payment benefits. But, if someone does own a property with debt on it, they are not taking advantage of the equity in their property. By selling with a sale-leaseback, they call all the equity out of their property and can use it for capital improvements on the real estate holding.
The owners/sellers of a sale-leaseback property can also write off 100% of their lease payments without having to pay down principal, which cannot be written off. If investors have other businesses, leasing the property is also a great option for them because of the minimal management structure of the deal.
Obstacles to Sale-Leasebacks
The biggest hurdle in doing a sale-leaseback transaction is establishing the rental rate. In the recent past, there have not been many sale-leasebacks occurring simply because the rental rate appreciation hasn’t kept up with the sale price appreciation. When you apply a market cap rate to your net operating income, the property ends up being worth less to an investor than it would be to another owner-user. For most of these business owners, real estate is not their primary business and the idea of selling the property to someone for less than it’s worth is not the most exciting proposition. So, this resulted in very few of these types of transactions taking place over recent years. However, investors have been reevaluating business models and real estate needs, especially over the last 18 to 24 months, that make sale-leasebacks look much more appealing.
The actual real estate property is pivotal to the business’s success. So, tenants that are looking for quality space and willing to pay premium rents have great options in the space. On the other hand, the investor community is willing to accept a lower return in exchange for quality tenants and stable income streams – this is known as Cap Rate Compression. These two forces colliding really put the sale-leaseback transaction back as a really viable option for both parties.
Investor Benefits of Sale-Leasebacks
With sale-leaseback transactions, investors are acquiring a 100%-leased asset on day one. If you are an investor and you want to acquire a property, you may see some vacancies then have to choose you. From there, you will most likely be underwriting for a period of time to backfill that vacant space. But with sale-leasebacks, investors already have a tenant that’s been working on the property for years and has significant capital improvements they want to make. The tenants’ commitment to the building and/or sub-market is already established in the property.
You can think of a sale-leaseback transaction like a value-add, except you are doing all of your work upfront with the property, establishing the value by underwriting the tenant, the organization and the likelihood of them moving. Especially with Triple Net leases, the tenant is responsible for all of the maintenance, management and expenses, which keeps them motivated to keep the property in good condition with an already-established client base at that location.
A multitude of investors look into sale-leasebacks, from big household-name investors and developers to business owners that are closing up their 1031 exchanges and other assets. People are putting capital to work by diversifying into other asset classes. For example, Angelo Gordons headquartered in Newport Beach partners with local operators and investors on a regular basis.
Establishing a Solid Rental Rate
When establishing the rental rate of a sale-leaseback property, a major factor is having a team with market expertise in their sector of real estate. Investors need to understand market lease rates, sale prices, what the existing inventory is, what new product is in the pipeline, when that product is going to be delivered, what kind of building it is and what kind of tenant they are seeking out. Understanding these various dynamics helps investors to figure out the right market lease rate. The industrial market is in high demand, so the investor/landlord has their pick of the tenants. Once there is an agreed upon rental rate, a long-term lease can be established with annual increases for higher returns.
A local broker who is a market expert is also going to be a very important part of your investment team to know the best properties. Great brokers are going to know the best businesses and tenants in your market, while also knowing the market data (i.e., lease rates, sale prices, cap rates, what’s under construction, etc.).
Typical Sale-Leaseback Real Estate Properties
Sale-leasebacks are common in the manufacturing and even medical (medtail) arenas of real estate., right, you have the single tenant medical buildings. The industrial logistics properties have occasional sale-leaseback transactions, but it is not nearly as prevalent as the manufacturing and medical offices properties.
Situational awareness is key to choosing the right sale-leaseback property. Understanding the acquisition date, the property specifications, relevant lease structure and sale comps, you can even tell what kind of loan a seller has and can even back into some of the remaining loan balances in certain scenarios. So, before reaching out to sellers (potential tenants), you (the investor) should have this information to not only build credibility but to have an efficient and effective conversation with the business owner.
Advantages of an Installment Sale
An Installment Sale, also known as seller financing, is where the seller is acting as their own bank. In this scenario, the buyer and seller agree on a property price, a down payment and the terms of the loan via a promissory note and secured by a first deed of trust. This lets both parties agree on the loan terms without the restrictions and limitations that a traditional third-party lender would place on them. The buyer has the same opportunity to evaluate the credit worthiness of the borrower. They also get to collateralize the deal with the property that they have owned for a number of years and are familiar with, which oftentimes makes the installment sale a less risky option than a 1031 exchange because of the familiarity factor.
The first and main criteria that must be met for an installment sale is that the property has little to no debt. It will be very difficult to transact with seller refinancing if there is a substantial amount of debt on the real estate. Those ready to do an installment sale are potentially looking for a steady income stream and don’t necessarily need the lump sum of the capital right away. They often have a highly appreciated asset, may be tax adverse or are looking to reduce their risk profile, much like the sale-leaseback investors. The sale-leaseback transaction has definitely been more popular this past year than installment sales.
Other Investment Options
The type of transaction an investor chooses to do is dependent on their particular needs. If an investor’s core business is real estate, a 1031 exchange into a new asset may suit them very well. But if real estate isn’t the main focus of business and you are really just looking for passive income, Triple Net deals are great options. A Delaware Statutory Trust (DST) is also another good option that allows an investor to trade property into a passive asset.
One of the drawbacks to a 1031 exchange is that investors are buying into a new property that they are not as familiar with, which brings in other limitations. The installment sale turns into a good backup plan to a 1031 exchange because, as soon as the investor closes the transaction, the maintenance and management responsibilities become that of the tenant. You are now the lender, so you are replacing your rental income stream with that of loan payments to carry none of the risk. If you pay as you go with a 1031 exchange, you are going to pay your proportionate share of the capital gains as you receive it, and the interest payments are taxed at the ordinary income rate as well. Investors have to decide what kind of transaction they want to complete very early on in the real estate deal because, if they close the sale, they can’t go back and renegotiate that deal after. Property owners that have owned buildings for a while may be unwilling or unable to incur the expenses that come with deferred maintenance such as roof replacements and HVAC systems. If they are unable or unwilling to incur that cost, an installment sale becomes a good option because there is a need in the market for quality properties.
Chris Drzyzga, Commercial Real Estate Broker
Chris is a Vice President in Voit’s Irvine office. He has a wide range of experience in all property classes and transaction types; which includes leasing on behalf of landlords and tenants, purchase and sales, ground-up development and redevelopment. Chris specializes in representing tenants, landlords, business owners, and investors throughout Southern California in office, medical office, and industrial property transactions; He has personally completed over 200 transactions and has been involved in over $300 Million in total consideration for transactions throughout the Western United States. His responsibilities include but are not limited to local market expertise, business development, short & long-term planning, financial analysis, and transaction management. He is a go-getter; his drive, work-ethic, attention to detail and superior customer service enables his success in everything he pursues. Chris, a Las Vegas, NV native has resided in Southern California since 2008. He graduated from Loyola Marymount University, Los Angeles with a Bachelor of Arts degree in Business Administration with an emphasis in Finance. His favorite hobbies include music/concerts, athletics, trying different cuisines, reading, and traveling.
Contact Chris Drzyzga:
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About the Podcast Hosts:
Michael Flight was named the Godfather of Blockchain Real Estate by Forbes Crypto. Michael achieved that distinction by co-founding Liberty Real Estate Fund, the World’s First Net Lease Security Token Fund, creating the Blockchain Real Estate Summit. More recently co-founding Invest On Main (IOM.ai) the Real Estate & Alternative Asset marketplace of the future and AcceleratedLaw a faster, cheaper way to create and tokenize securities offerings!
Michael is a real estate entrepreneur and real estate tokenization pioneer who is an expert in retail real estate investment, redevelopment and real estate on the blockchain. He started his commercial real estate career in 1985, and then co-founded Concordia Realty Corporation in 1990, which continues to partner with some of the world’s most well-known banks, insurance companies, hedge funds and institutional investors in many successful investments.
Liberty Real Estate Fund LLC is The World’s First Single-Tenant Net-Lease Security Token FundTM, joining 30 plus years of institutional real estate investment experience with blockchain technology to deliver very stable, diversified, tax efficient returns combined with liquidity, security and transparency.
Liberty is a real estate investment fund that acquires Single-Tenant Net-Leased (NNN) essential business retail, auto service and medical properties in the United States. It is designed for investors to achieve: Geographic Diversification; Industry Diversification; Tenant Credit Strength and is built with hard assets that have intrinsic value. Our portfolio of Net Lease properties is constructed with brand-name Essential Businesses operating in high growth markets throughout the United States. These Net Lease assets have long term contractual rents backed by excellent brand name, well capitalized companies.
Liberty is focused on investing in high quality, well located Single-Tenant Net-Leased (NNN) properties in targeted high growth, low tax areas of the United States. The portfolio has been specifically designed to provide stable, recession resistant income combined with inflation protected wealth preservation and equity growth.
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