The proceeds repay debt, the lease creates a new one, and the leverage you report depends on which definition of debt the reader uses.
Only by the gap between the sale proceeds and the lease liability the transaction creates. On an illustrative company with 480.0m of net debt and 120.0m of EBITDAR, a 200.0m sale and leaseback at a 6.0 per cent rent yield appears to cut leverage from 4.00x to 2.63x on a pre-IFRS 16 covenant, but only to 3.71x once the 161.5m lease liability is counted. Above a 7.28 per cent rent yield it does not deleverage at all.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Sale and leaseback is often sold to a board as a deleveraging tool: the company owns real estate it does not need to own, sells it, repays debt, and the ratio falls. The ratio does fall, on one definition. The question is which definition the lenders, the rating analyst and the next buyer of the business will use, and the answer is increasingly the one in which the lease is debt.
| Input | Value |
|---|---|
| EBITDAR (earnings before rent on the new lease) | 120.0 |
| Net debt before the transaction | 480.0 |
| Leverage before | 4.00x |
| Sale price | 200.0 |
| Rent yield to the buyer | 6.0% |
| Initial rent | 12.0 |
| Fixed annual rent uplift | 1.5% |
| Lease term | 20 years |
| Transaction costs | 2% |
| Net proceeds, all used to repay debt | 196.0 |
| Incremental borrowing rate, and cost of the debt repaid | 5.5% |
Net debt after repayment is 480.0 less 196.0, or 284.0m, on every definition. What changes is whether the lease is counted as debt, and whether the rent is deducted from EBITDA.
Frozen GAAP: net debt ÷ (EBITDAR − rent) = 284.0 ÷ 108.0 = 2.63x
IFRS 16: (net debt + lease liability) ÷ EBITDAR = (284.0 + 161.5) ÷ 120.0 = 3.71x
Rent multiple: (net debt + 8 × rent) ÷ EBITDAR = (284.0 + 96.0) ÷ 120.0 = 3.17x
The lease liability is the present value of the fixed rents at the incremental borrowing rate: twenty payments starting at 12.0m and rising 1.5 per cent a year, discounted at 5.5 per cent. In Excel, with years in A2:A21, =SUMPRODUCT(12*1.015^(A2:A21-1)/1.055^A2:A21) returns 161.5. Fixed uplifts belong in the liability; index-linked increases do not until they occur.
The frozen GAAP figure is what an older loan agreement that excludes lease liabilities will report, and it is the number that usually appears in the board paper. It is flattering twice: the debt has gone, and the new obligation that replaced it is invisible except as a smaller EBITDA. The IFRS 16 figure is what the published accounts will show. The eight-times-rent figure is the older analyst convention, still used by some lenders and in many credit models; it sits between the two here because eight times rent, 96.0m, is less than the 161.5m present value of a twenty-year lease.
| Definition | Debt counted | EBITDA used | Leverage |
|---|---|---|---|
| Before the transaction | 480.0 | 120.0 | 4.00x |
| Frozen GAAP covenant | 284.0 | 108.0 | 2.63x |
| Eight times rent | 380.0 | 120.0 | 3.17x |
| IFRS 16, lease liability included | 445.5 | 120.0 | 3.71x |
Read the IFRS 16 line as the economics. The company received 196.0m and took on an obligation worth 161.5m at its own borrowing rate. The real deleveraging is the difference, 34.5m, and it exists only because twenty years of rent, discounted at the company's own borrowing rate, are worth less than the price the buyer paid. The buyer is paying for the buildings it keeps at the end of the lease; the company has given those up. The lease liability is 80.8 per cent of the price: roughly four-fifths of the price is, in substance, a twenty-year loan secured on the buildings.
Fixed-charge cover tells the same story from the income side. Before the transaction, 26.40m of interest was covered 4.55x. Afterwards the company pays 15.62m of interest and 12.0m of rent, 27.62m in all, covered 4.34x. The interest saved, 10.78m, is less than the rent that replaced it.
| Case | Lease liability | Frozen GAAP | IFRS 16 |
|---|---|---|---|
| Rent yield 5.0% | 134.6 | 2.58x | 3.49x |
| Rent yield 6.0%, base case | 161.5 | 2.63x | 3.71x |
| Rent yield 7.0% | 188.4 | 2.68x | 3.94x |
| 15-year lease at 6.0% | 132.0 | 2.63x | 3.47x |
| 25-year lease at 6.0% | 185.9 | 2.63x | 3.92x |
| Proceeds paid out as a dividend | 161.5 | 4.44x | 5.35x |
Three things stand out. The frozen GAAP ratio barely moves with the rent, from 2.58x to 2.68x, so a covenant written that way gives the seller little reason to resist a higher rent for the same price. The IFRS 16 ratio is sensitive to both rent and term: at the same price, a longer lease adds liability, so the buyer would have to pay materially more for the extra term just to leave IFRS 16 leverage unchanged. And at a 7.28 per cent rent yield the lease liability equals the net proceeds, so IFRS 16 leverage is exactly where it started, at 4.00x. Above that, the transaction adds leverage on the measure the market will read.
The common mistake is to present the frozen GAAP ratio without the lease, and to compare the rent with nothing. A board that sees leverage fall from 4.00x to 2.63x is approving a different transaction from one that sees it fall to 3.71x. The second ratio is the one a rating analyst, a refinancing lender or a buyer of the company will compute, because each of them treats a twenty-year rent obligation as debt with a different label.
Check the covenant definitions before the heads of terms. If the facility agreement excludes lease liabilities from net debt, the leaseback will improve covenant headroom immediately; but the rent comes off covenant EBITDA, and rent cover at the entity that signs the lease becomes the ratio that binds. The rent cover calculation is the other half of this test.
A sale and leaseback converts real estate into cash and a lease, and the lease is debt in all but name. It deleverages by the proceeds less the present value of the rent: here 34.5m on a 200.0m sale, enough to move IFRS 16 leverage from 4.00x to 3.71x. Run all three definitions side by side before the board sees one of them. The free workbooks for the book carry rent cover at group and at the signing entity, and the sale-leaseback model template lays out the seller's side.
Usually in substance, yes. Under IFRS 16 the seller records a lease liability equal to the present value of the fixed rents, 161.5m on a 12.0m rent with 1.5 per cent uplifts over twenty years at 5.5 per cent. Most credit analysts add that liability, or a multiple of rent, to net debt, so the transaction mostly swaps one form of debt for another.
Because rent is no longer an operating expense: it becomes depreciation and interest on the lease liability, both below EBITDA. EBITDA therefore stays at 120.0m instead of falling to 108.0m. The leverage ratio uses the higher EBITDA but also the higher debt, which is why it lands at 3.71x rather than the 2.63x a pre-IFRS 16 covenant would show.
Leverage rises. Net debt stays at 480.0m and the 161.5m lease liability is added, so IFRS 16 leverage goes from 4.00x to 5.35x. Even on a frozen GAAP basis it rises to 4.44x, because EBITDA falls by the 12.0m of new rent. A leaseback that funds a distribution is a borrowing, whatever the accounts call it.
This article is one calculation from Sale and Leaseback. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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