Real Estate Capital Basics – Land Sale Leasebacks
When non-depreciable assets may be contributed to a venture, a less known hybrid funding format may be practical –the Land Sale/Leaseback. Unlike joint ventures and participating/convertible mortgages, land (whether subordinated or not) becomes the pillar of forming other debt and equity terms.
The land sale-leaseback is a hybrid structure funded as a multi-tiered real estate transaction bifurcating land and improvements into individual elements of financing. Land sale-leaseback consisting of the following parties: (a) the land ownership; (b) land purchase investor; (c) the developer planning to construct new improvements or already owns existing improvements on the land; and (d) the funding source for the improvement on the land. In most cases the transaction will include related parties. For example, the land ownership group, typically the developer, sells the land to the investor and who immediately leases back the land to the developer; and finally a leasehold mortgage issued for the improvements by the funding source.
The leasehold improvement mortgage term is equal or shorter than the land lease and includes a number of formats. With the Land Sale/Leaseback scenario, the developer generally receives nearly all of the funds as multiple layers of the project are financed with maximum leverage. Land ownership usually requires land lease payments as first lien obligations resulting in an unsubordinated land sale-leaseback mortgage with subordinated leasehold mortgage. However, the leasehold funding source may demand the subordination of land payments, creating a subordinated land sale-leaseback leveraged with a standard mortgage. More often, land investors double up as the funding sources for leasehold improvements, forming a land sale-leaseback with leasehold mortgage.
Land banking, situations with longer-term holding horizons work well with land sale-leaseback fundings tied to new construction and higher-leverage refinancing. With land banking transactions developers gain control of land parcels requiring multiple phasing, typically three years or more. This time horizon requires financial patience since land is gradually developed in various phases, seldom generating any cash flow on the undeveloped stages. Therefore, staged land purchases matching development cycles are negotiated with staged releases of land parcels. In return, the land sellers are paid more to compensate for the “takedown” risks associated with partial sale transactions. Forms of compensation include reduced land rent payments with fixed rents plus bonus cash flow participation and project reversion proceeds.
As mentioned earlier, new construction ventures profitably suit land sale-leaseback fundings. Ownership creates maximum value opportunities on prime land; attractive longer-term yields are secured by funding sources. Upon project completion and cash flow stabilization, the developer pays land and leasehold debt service obligations to the appropriate funding sources. With full leverage generated by this hybrid funding format, the developer continues to pursue additional ventures without concentrating too much capital in any given venture.
Property owners of performing assets suffering from untapped equity and exhausted tax benefits fit well for with land sale-leasebacks. Owners can sell the land to an investor and transform idle capital into working funds as well as generate additional tax losses in the form of ground rent payments. Last but not least, land lease payments are classified as a deductible operating expenses.
Land is a non-depreciable asset, creating an ideal situation for non-taxable investors such as pension funds and endowments. Insurance companies and other financial institutions, acting as intermediaries, will often represent numerous tax-free investors. Also, governmental agencies occasionally use land sale leasebacks for attracting commercial realty investments into the area.
Funding sources and developers normally craft legal and tax documentation clearly defining debt and equity roles. Otherwise problems arise, particularly with land purchases. For instance, tax agencies will view Land Sale/Leasebacks as tax-dodging instruments if the developer’s land repurchase option lacks provisions to reflect market conditions at the time of purchase.
Timing is critical with Land Sale/Leasebacks as prime developable parcels will be financeable during favorable capital market conditions. Otherwise constrained funding markets dramatically reduce land financing options. Of course, such conditions will also impact other hybrid funding opportunities requiring new construction.