Economists continue to debate whether a recession is coming, but most agree some kind of market correction is on the horizon. As a result, some business owners — especially those who own their buildings — are considering getting out while the getting is good.
Having an exit strategy in mind when investing in income-producing commercial real estate is imperative regardless of market conditions, but with the Phoenix market at the height of the real estate cycle, property owners can maximize their returns through a sale-leaseback.
Under a sale-leaseback, the owner sells a property to a real estate investor, then rents it from the new owner in a long-term agreement. It’s a win-win that minimizes stress for both parties: The seller enjoys an influx of cash to use in operating the business or purchasing another property, and the buyer has cash flow without having to find a new tenant.
When a Sale-Leaseback Makes Sense
It’s an especially sound strategy for property owners planning to retire in the next 10 years — selling while prices are high enables them to receive maximum value and, when the lease expires, they can renew or vacate without concern for market conditions or finding a quality tenant.
The strategy is also appealing in industries like healthcare, where a private equity firm wants to acquire a practice but doesn’t want the real estate. Physician owners can sell the practice to the private equity firm, sell the building at max value to an investor and focus on what they enjoy most: practicing medicine.
Sale-leasebacks are also great for businesses looking to expand as they enable owners to take the proceeds from one property and invest in others elsewhere. However, understanding three things helps in making strategic decisions:
- Capitalization rates: Determined by taking the property’s net operating income and dividing by the value of the asset, cap rates reflect the risk and quality of an investment. Buyers use them to gauge if the price offered is reasonable compared to other sales. Cap rates are currently on the low end, but rise along with interest rates. When they rise, valuations decrease, so it’s generally best to sell when they are low and buy when they are high.
- Tax advantages: When structured properly with a 1031 exchange, a sale-leaseback allows sellers to defer the capital gains taxes indefinitely by rolling the proceeds into one or more properties. Income-producing investment properties purchased in a 1031 exchange should be held for one to two years to be considered investments worthy of tax-deferred treatment that qualify for long-term capital gains if sold thereafter for the proceeds. The law permits investors to sell sooner, but duration of ownership can be a mitigating factor when audited.
- Negotiating favorable lease terms: A sale-leaseback allows the seller to write in important clauses ahead of time, including no relocation, signage rights and free parking.
Real estate continues to be an excellent investment, especially as people continue to flock to Arizona. But when an owner is ready to sell, consulting with an advisor who understands the owner’s investment goals positions property owners to not only favorably counter short-term market uncertainty, but also benefit long term.
Trisha Talbot is the managing principal at healthcare real estate investment services firm DOCPROPERTIES, a Scottsdale company that connects physicians with expansion goals to investors seeking income-producing healthcare properties.
Did You Know: In the medical office building market alone, Q1 sales totaled $158 million — up 163% year-over-year, with 1Q22 cap rates averaging 6.21% and representing a 115-basis-point reduction over 1Q21.