A Lot But Not Enough
A while back we looked at a business that was generating decent cash but didn’t have much in the way of growth prospects. In fact, in real terms, it was likely to shrink over the next decade or so. That’s fine. Because when that’s the case, so long as you pay the right price, you can still get your capital back and earn a solid return (shoutout half-lives).
As we dug in, though, we discovered that the owner had previously owned the real estate the business operated out of, but had sold it to a REIT 24 months earlier as part of a sale-leaseback transaction. This is to say that simultaneously with selling a significant asset, the business entered into a contract to pay to use it. The business then paid that cash out to ownership as a very hefty special dividend and went on its merry way.
I don’t know if at the time they did the sale-leaseback ownership contemplated selling the business itself, but now here they were trying to do just that with expectations that the lease – they were not doing GAAP accounting so no lease liability was on its balance sheet – would be part of the transaction.
Leases, of course, are normal and ordinary. If you want to reduce the upfront cost of starting a business or run a business from real estate someone else owns, you lease it. But leases can come with a lot of different terms. For example, the amount you agree to pay is an important one, both in total and per square foot. So is the duration of the lease, or how long you agree to occupy the space. It’s also important to know whether or not and how and when it renews. And also who’s on the hook to repair what things as they break. When it comes to leases, there are a lot of trade-offs and details to negotiate.
But in the context of this sale-leaseback and why it became problematic, two elements mattered most: cost and duration. Because when the business sold its real estate, it got a baller price for the asset (hence the very hefty dividend). The reason was that, in return, it agreed – actually guaranteed – to lease the property back for 20 years at an initial 10% cap rate with 5% annual escalators.
Running those numbers – and we’ve talked about compounding monsters – it looked like the business would be loss-making within 10 to 15 years because of the increase in rent expense and might still have another decade to service the obligation.
We broke it to ownership that they had already sold the business.
If you’re a tenant, the perfect lease is a daily one at a fair price tied to inflation that renews automatically and lets you walk away with no penalty. If you’re a landlord, it’s a 20-year one with above-market escalators the tenant can’t escape.
Ownership in this situation had been paid a lot to agree to an incredibly landlord-friendly lease. But because they now had to run the thing for 18 more years in order to service the obligation that enabled that very hefty special dividend (and still might end up underwater), I’d argue they hadn’t been paid enough.
– Tim
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