Two cents: The sale & leaseback model alternative

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Conventional debt and equity financing models have become largely inaccessible amidst the economic slump that has been occasioned by the global financial crisis. The ramifications of this have been felt in Kenya where there has been a slow-down on lending to the private sector. This has inadvertently resulted in a deceleration of economic growth as traditional lenders have scaled back on loan disbursements. This has also been exacerbated by the capping of interest rates chargeable by banks and financial institutions which was introduced in 2016.

The decline in credit issuance and uptake has had an effect on the recent slowdown of Kenya’s economic performance due to the general election in 2017 which greatly affected the country’s economic outlook. These are clear manifestations of a paradigm shift needed in Kenya in the manner in which capital is raised by various entities. But there is hope, with the world economy bouncing back from the global recession in 2010, reforms have been made in the traditional financing models in Kenya. Against this backdrop, companies now have the recourse to explore alternative financing models to remain competitive and profitable.

Sale and Leaseback Transactions

Sale and leaseback financing has proved to be an attractive option for some companies that seek to keep up with their growth strategies. Essentially a sale and leaseback transaction involves a sale of an interest in property with a reservation on the possessory terms. The underlying characteristic of these kind of transactions is that, the seller acts as a lessee and they raise the capital through property that they hold by transferring the property to a buyer through sale. This transaction enables the seller to dispose of the property and obtain capital injection for the business, while maintaining the use of the same property at an agreed lease premium for a specified term. This is especially beneficial to a buyer who seeks to incur the least possible maintenance costs of the property.

Characteristics

A sale and leaseback financing model varies from traditional financing models because it typically entails:

  • A sale of assets by an entity that desires to raise capital from the property to an investor who seeks to achieve a low-risk, high yield investment
  • Simultaneous obtaining of a long-term lease of the property by the seller-lessee from the buyer-lessor which enables the continuing possession and use of the property by the seller-lessee in exchange for payment of rentals at an agreed premium
  • The retention by the seller-lessee of most of the risk and rewards incident to ownership save for the right to mortgage where the lease is an operating lease
  • Transfer of substantially all the risks and rewards incident to ownership where the lease is a capital lease.

Classification of Leases

Whether a lease shall be classified as an operating lease or a capital lease is usually agreed upon at the inception of the transaction. It is important to classify the lease the parties intend to enter into as both have different effects on the parties.

A lease will be classified as an operating lease where the rental premiums are considered as operating expenses in the seller-lessee’s book of accounts, and the property leased does not form part of the seller-lessee’s balance sheet. On the other hand, a capital lease is considered as a loan to the seller-lessee and stated as such in the seller-lessee’s books of account. Most leases in a typical sale and leaseback transaction will be operating leases. However, a capital lease would arise where there is a buyback agreement contained in the lease; there is a buyback option with a defined price in the lease; or the lease value is greater than ninety per cent (90%) of the value of the property.

Advantages and Disadvantages Certain advantages have been identified to inure with sale and leaseback financing model. One key motivation for adopting this financing model is the tax advantages that flow from these transactions. It has been noted that in majority of these transactions, the seller is usually motivated by the need to realise immediate loss which is used to offset the seller’s operating income. The seller in essence receives proceeds from the sale of a non-liquid asset, yet retains for a term the use and possession of the asset.

The seller in a sale and leaseback transaction obtains a greater amount of capital through a leaseback than when they opt for conventional types of borrowing. Needless to say, this financing model is essential in providing working capital to the seller-lessee who will realise approximately one hundred per cent (100%) of the market value of the property unlike debt and equity forms of financing which may not result in the same returns. This is especially important in markets experiencing fluctuations in conventional lending sources.

For the buyer-lessor, this financing model allows it to have a hands-off approach to the management of the property as it incurs no responsibility for the operational or managerial aspects of the property which is left to the seller-lessee.

A sale and leaseback transaction also comes with its fair share of challenges, a notable one being a high interest rate on the lease that the rental property may attract. Tax implications may also be evident with recent changes in the International Financial Reporting Standards.

The fact that the property is no longer under the ownership of the sellerlessee also means that the seller-lessee may have no say with regards to the interest that the buyer-lessor will charge on the leased property. This may in the long run mean that the seller-lessee has to incur higher costs in using and managing the property as this responsibility does not rest with the buyer-lessor. This denotes an inherent risk that is evident in many lease arrangements.

It is clear that the sale and leaseback financing model is an option Kenyan companies could consider in their quest to raise capital to finance their growth strategies in the market. Numerous advantages can be drawn from the adoption of this model, especially in light of the drawbacks of conventional financing models.

Moreover, this model is attractive to entities that are unable to attract a wide variety of financing. This financing model may be useful for companies that may want to accrue some capital to use for their expansion initiatives. Ultimately, these entities could benefit from unlocked real estate value, reduction in a company’s investment in non-core business assets, such as buildings and land and freeing-up of the entity’s cash in exchange for executing a long-term lease.