Sale and Lease Back30/12/2020
Sale and Leaseback is a simple financial transaction which allows a person to lease an asset to himself after selling it. Under the transaction, an asset previously owned by the seller is sold to someone else and is leased back to the first owner for a long term. The transaction thus allows a person to be able to use the asset and not own it. One usually makes a leaseback transaction for high value fixed assets such as real estate and goods like airplanes and trains. Sale and leaseback is shortly called as leaseback.
Leaseback, short for “sale-and-leaseback”, is a financial transaction in which one sells an asset and leases it back for the long term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done for fixed assets, notably real estate, as well as for durable and capital goods such as airplanes and trains. The concept can also be applied by national governments to territorial assets; prior to the Falklands War, the government of the United Kingdom proposed a leaseback arrangement whereby the Falklands Islands would be transferred to Argentina, with a 99-year leaseback period, and a similar arrangement, also for 99 years, had been in place prior to the handover of Hong Kong to mainland China. Leaseback arrangements are usually employed because they confer financing, accounting or taxation benefits.
For example, X owns a land. Under the leaseback transaction, X will sell the land to Y and will get a lease on the same land from Y for a long term.
Advantages of Sale & Lease Back financing
- Financing of the full investment amount
In the case of classic bank loans, it is usually expected that the investment will be partially financed by the company’s own funds. Banks value the asset based on “loan-to-value” calculations and thus only finance between approx. 60-80% of the acquisition costs. With a sale and leaseback, on the other hand, 100% of the investment costs are usually borne by the lessor.
- Continued access to the sold asset
Even after the asset has been sold, the company retains the full value in use through the simultaneous signing of a lease agreement, i.e. the company continues to have full access to the asset sold.
- Flexible conditions of the leasing contract
Both the term of the leasing contract and the retransfer of the asset at the end of the leasing period can be agreed individually. In the case of real estate, for example, expansion investments in the property as well as subleases can also be arranged together with the Lessor.
- Matching maturities
When an investment is financed by means of classic bank loans, the credit period and the useful life of the asset usually diverge. As a result, the loan is regularly repaid long before the actual end of the asset’s useful life, i.e. the redemption payments on the loan exceed the depreciation. In a sale and leaseback, on the other hand, the financing payments (repayment component) and imputed costs (depreciation based on the useful life of the asset) are balancing if the leasing period is chosen accordingly.
- No financial covenants
In contrast to traditional bank loans, a sale & lease back does not contain any financial covenants that have to be observed. The lessor obtains ownership rights by purchasing the leased asset and is the lessor through the leasing contract, but not a lender.
A company usually enters a leaseback transaction for accounting and taxation purposes. For example, a company may transfer its asset to the holding company but still will be able to use it. Also, transferring to holding company will allow the parent company to track the assets’ worth and profitability. Another example is, that in case of financial distress or when a company needs money for some purpose, instead of getting a loan or raising money from outside, a company can sell the asset. The buyer of the asset is someone who is only interested in a securing a long term investment and will lease the asset back to the company. This way the company gets the cash influx and will still be able to use the asset.
Advantages to the Lessee
Enables Expansion of the Business
If a company doesn’t have funds to own the asset, it can purchase the asset and enter a leaseback transaction. This way the company can get back 100% of the investment and still be able to use the asset. Similarly, in case when a company already owns an asset but wants some cash for expansion or even regular business use, the leaseback agreement will allow the company to get cash influx. This will also enable the company the to use the asset as before, by paying rent under the lease agreement.
Improve Company’s Balance Sheet
An asset purchased on debt affects the company’s balance sheet. The company can reduce its debt and improve balance sheet health by entering a leaseback transaction. This will improve the balance sheet in three ways. First, the liability on the balance sheet will reduce. Second, there will be an increase in current assets in the form of cash and lease agreement. Third, the asset turnover of the company will improve. The asset turnover will improve as the fixed assets will reduce but the revenue generating capability of the asset will still be in the hands of the company.
Reduction in Tax Liability
This works in two ways, the company which has now sold the asset and has it on lease, does not have to pay tax on any appreciation of the asset and also the rent outlet will reduce the profit in the profit and loss (p&l) account which will in-turn reduce the tax liability. Depreciation charge on the asset would has a similar impact on the p&l account. However, the depreciation amount will be lower than the lease amount. Also, there is no depreciation is charge on real estate assets like land.
One can avoid paying tax on the sale of asset, by re-investing the sale proceeds in the business or by buying another asset.
Once sold, the company is free from volatility risks of the asset that has to be borne in case of cyclical market variations.
Advantages to the Investor
Fair Return on Investment
The investor is buying an asset which the seller will be using in the future. The buyer’s interest will ensure that the asset is a fair investment which will provide a decent return on the investment.
Regular Stream of Income
The buyer does not have to worry about the return, as they have a reliable tenant for a long term. This ensures that the investment earns a fixed return on the property and has a continuous stream of cash flow.