Sale-leaseback transactions have become more prevalent in the car wash space in recent times so you might be wondering what they are and whether they make sense for you to consider. In this article, I will explain what a sale-leaseback transaction is, walk you through a sample sale-leaseback transaction, discuss the pros and cons of this method of financing, and discuss some important terms to keep in mind when negotiating a sale-leaseback transaction. The bottom line is that a sale-leaseback can be a powerful tool for you to grow your car wash chain faster with less capital required.
So, what is a sale-leaseback? In short, it’s when an owner of an asset sells it to someone else and leases it back from the buyer so that the seller can still use it but doesn’t have a lot of capital tied up in it. (You’ll see “owner,” “seller,” “operator,” “developer,” and “tenant” used interchangeably when referring to the person who sells the car wash and leases it back from the buyer. The buyer will also be called the “landlord.”)
The resulting lease from such a transaction is usually for a long period of time (e.g., 20 years with multiple three- or five-year extension options). The rent usually increases during the term of the lease and it is usually a “triple net” lease, which means the seller/tenant not only pays rent to the buyer/landlord, but also pays the real property taxes, insurance, and maintenance costs.
In our world of car washes, raw land could cost $500,000 to $2 million or more. In addition, the building and improvements to the land could potentially cost millions more. We won’t get into the equipment cost as part of this discussion because the operator usually retains full ownership of the equipment as part of a sale-leaseback. You will have several million dollars tied up in a car wash that you could put back in your pocket in a sale-leaseback transaction and use to open more sites.
So how much cash can you really get from a buyer of your property in a sale-leaseback transaction? We should first note that a sale-leaseback transaction usually occurs after a site has opened and has stabilized (i.e., after it reaches some level of maturity in terms of revenue and income). In the most basic form, the value for a sale-leaseback transaction is determined by the rent that will be paid and the capitalization rate (“cap rate”). The capitalization rate or “cap rate” is the rate of return a buyer expects to generate on the purchase of the real estate. It’s usually expressed as a percentage (e.g., “6 percent cap rate”) and is calculated by dividing the net operating income of the site by the amount paid for the site.
The rent will be a percentage of the stabilized income (usually between 20 percent and 50 percent). Therefore, if the stabilized income is $750,000, the triple net rent might be agreed upon at $300,000 (40 percent of $750,000). Since it’s “triple net” rent, we will treat it the same as net operating income here for purposes of this article. If the triple net rent is set at $300,000 per year and the cap rate is 6 percent, the purchase price for the property will be $5 million (or the rent of $300,000 divided by the cap rate of 6 percent).
The cap rate is highly negotiable and can vary based on the intrinsic value of the underlying real property, the historical track record of the developer/operator, the percentage the rent is of the overall income, and the type of buyer — institutional buyer like a REIT v. an individual buyer like a 1031 buyer as explained below. The sale price of $5 million can be more than you spent on the cost of the land, building, and improvements. This is especially true if you are the seller — the buyer may, in some instances, not want to pay more than the value of the underlying asset in case they had to sell it to an owner and/or operator other than you or someone other than another car wash operator, but that’s a whole different can of worms that we won’t get into here.
TYPES OF BUYERS
You may be curious about the different types of buyers in a sale-leaseback transaction. Generally, there are private parties (e.g., someone who sold their property and is looking to place their sale proceeds in a 1031 exchange. Internal Revenue Code Section 1031 allows a seller to defer paying capital gains taxes on a sale if that person reinvests the proceeds from that sale in a like kind property of equal or greater value within a certain period of time) and institutional buyers such as REITs (A REIT, or Real Estate Investment Trust, is a company, oftentimes controlling a large pool of money from many different investors, that buys real estate such as car washes from operators and leases them back to the operators). You will usually obtain a higher sale price and better ancillary terms from a private buyer than from a REIT, but a REIT can offer certain benefits that a private buyer can’t. For example, sale-leaseback transactions with a private buyer usually occur one at a time and only after a site is up and running, but with a REIT partner, you can sell many sites in a single transaction and even have an agreed upon formula in advance for the purchase of future sites and have them help you with funding new sites during the purchase and development phases.
PROS AND CONS
It may seem at times in this article that I’m shilling for the sale-leaseback industry in general or for REITs in particular. Let’s be clear — I’m not. Let’s take a look at what my partner, George Odden, wrote in a previous article published in the August 2021 issue of Auto Laundry News: “Owned Versus Leased Real Estate — Owning the real estate will always be more valuable to a buyer than leasing. This is inherently obvious, but a numerical example is helpful. Let’s use Wash B and their $1 million EBITDA, or in this case you can call it EBITDAR as it is owned and no rent is charged, so effectively the value is before rent. Instead of selling the business, the owner may decide to sell the property and building and lease it back from the buyer. He or she might agree to pay $300,000 in rent, leaving $700,000 in EBITDA. Commercial real estate such as a car wash is valued by cap rate, which is the rate of return a landlord receives on their investment. A decent cap rate right now is around 7.0, so if an investor is willing to accept a 7 percent return that means they would be willing to pay $300,000/.07 = $4.3 million for the property. So the owner has $4.3 million in their pocket and EBITDA of $700,000. The multiple on the remaining $700,000 will be lower than the multiple they would have received on the $1 million EBITDA as that method of funding is no longer available to the new buyer.”
So, as you can start to surmise, there are pros and cons to a sale-leaseback transaction. In the pro column, not only can you free up cash to grow faster or to have a liquidity event even absent any growth motivation, but you also have less debt so your balance sheet looks better and you have certain tax advantages (e.g., you can write off the entirety of lease payments as an expense as opposed to the principal portion of debt payments that are not deductible as an expense). There are also cons, such as you don’t own the real property in fee simple and, therefore, you may limit your value and optionality at exit time; also, you will have steady rent increases over the course of the lease, even though your price increases and operating efficiencies will likely counter the rent increases.
A sale-leaseback might not always be right for you, but if you can free up capital to open more new sites than you would otherwise be able to, and if your resulting enterprise value (i.e., the exit value of your chain of car washes) is higher by using sale-leaseback financing and growing your number of sites and your EBITDA, it is definitely an option worth carefully considering. But beware, don’t negotiate your sale price based on rents that start too high or escalate too quickly or they may not be sustainable. Also, make sure you factor into your analysis how sale-leaseback financing fits into your overall strategy of growing, operating, and selling your chain.
As with many important business decisions, be sure to consult your tax advisors before consummating a sale-leaseback transaction.
Jordan Geotas is a partner with Ardent Advisory Group, a leading investment bank specializing in the sale of multi-site car wash chains. You can contact Jordan at Jordan@ArdentAdvisoryGroup.com.