What is Leaseback?
Leaseback is a financial transaction wherein the company sells its asset and then takes the same on lease from the purchaser. It implies that the seller becomes the “lessee” and the purchaser becomes the “lessor”. This type of sale and leaseback transaction is done on mutual understanding of both parties, and all the terms and conditions are predefined in the agreement.
Reasons for Sale/Leaseback Transaction
- Lessee or Seller Perspective: The seller (lesseeLesseeA Lessee, also called a Tenant, is an individual (or entity) who rents the land or property (generally immovable) from a lessor (property owner) under a legal lease agreement. ) wants to free the cash involved in the property or assets to use for other purposes but still wants to use such assets or property.
- The Lessor or Buyer Perspective: Generally, purchasers (institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.) involved in these types of transactions are finance companies, leasing companies, or institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples. looking for a good investment with a good return.
Key Elements of Leaseback Transaction
The following are critical elements of leaseback.
- Need of Capital: When a company needs capital for future investments, they will go for leaseback transactions.
- Excess Capital and Looking for Good Investments: Purchasers or lessors enter this transaction only to make a good return on their investment.
- Strong Tenant: Investors who buy and give on lease want a relatively more robust tenant who can meet their obligations and safeguard the investments. Similarly, a strong tenant can sell their assets at a higher rate and profit from the transaction.
- Long Term Lease: Generally, in sale and leaseback transactions, lease terms are of 10 years or more to benefit the lessor and lessee. Lessee will benefit from using the assets uninterrupted, and lessor will get the lease rent for a more extended period without risk.
- Triple Net Lease: This is one of the conditions which the lessor wants to include in the sale and leaseback agreement. In a triple net leaseTriple Net LeaseTriple Net Lease is a type of lease agreement in which the lessee (tenant) agrees to also pay for other property-related expenses such as insurance of the building, maintenance of the building, property taxes in addition to the rent., the lessee takes responsibility for incurring operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit., maintenance costs, insurance costs, and any other cost, just like the owner of the assets. The investor will only enjoy the rental income unbothered.
- High Interest on Loans: If the rate of interest of the loan is higher than the lease rental expenses, companies can opt for this to reduce the costs.
Example of Sale and Leaseback Transaction
Now we will understand sale & leaseback transactions with the help of a practical example:
A few years ago, airline companies used this type of arrangement to control the cost of planes and operating expenses. It came as a result of immense pressure to reduce the ticket price to capture the market and competition.
Therefore, they bought planes, sold them to the leasing companies, and immediately took them back on lease. By that arrangement, airline companies started getting cash-free and spread the cost over the life of the plane. They utilize the cash generated from the sale of planes to meet the operational costs and reduce the liabilities.
- The seller can avoid the capital cost associated with assets and still use those assets.
- It can save the time and administrative cost associated with the assets as it will be taken care of by the purchaser or lessor.
- Reduce tax liability because lease paymentsLease PaymentsLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. are tax-deductible expenses.
- Reduce the overall income of an organization.
- Improve the company’s balance sheetThe Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. by avoiding debt by this transaction and increase the current assets generated through the sale of assets in cash.
- Improve working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" by investing in other things or for day-to-day operating expenses.
- If the property has a longer life, it will become a costly affair for the seller because the total lease payment will be more than the cost of the assets over the year.
- The company will not get the benefit of depreciationBenefit Of DepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. since they do not own the property.
- The seller would not get the appreciation benefit if the value of assets sold increases in the future, like land and building.
- The sale of assets will reduce the company valuation, making it useful for a future loan.
- Loss of control over assets as lease rent will increase at the time of renewal of the agreement.
Sale & Leaseback transaction is only an arrangement for reducing capital expenditureThe Capital ExpenditureCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. without compromising the availability of assets. Organizations with a cash balance shortage and unable to meet day to day operating expenses or companies which are in their initial phase and focusing on business expansion use this type of transaction to unclog their capital assets and use that cash elsewhere.
On the other side, investors enter into this arrangement because they want a good return on their investment. In addition, they feel secure because of the long lease term and are also relieved from all responsibility by mentioning the triple net lease clause in the agreement.
This has been a guide to what is Leaseback and its meaning. Here we discuss example of sale and leaseback transaction along with advantages & disadvantages. You can learn more about financing from the following articles –