A strike above today's price looks like a premium to the buyer; set against the values the building could have at expiry, it is a cap on its upside.
Price it as what the buyer gives up: the expected excess of the building's value over the strike at expiry, discounted to today. On an illustrative 50,000,000 leaseback with a fifteen-year lease, a seller option to buy the building back at 55,000,000 takes 6,700,000 of expected value out of the residual, and the buyer must cut its price by 2,313,876, 4.63 per cent, to keep its 7.35 per cent return. A strike set 10 per cent above today's price is not a premium for the buyer. It is a cap on its upside.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Sellers ask for buyback options because they want the building back if it matters to the business, or because they want to share in its appreciation. Buyers often agree because the strike looks generous against today's price. The calculation below shows why that comparison is the wrong one: the strike should be compared with the range of values at expiry, not with the value at signing.
| Input | Value |
|---|---|
| Price paid by the buyer | 50,000,000 |
| Initial rent (6.0% yield) | 3,000,000 |
| Fixed uplift | 2.0% a year |
| Lease term and option date | 15 years |
| Repurchase price (strike) | 55,000,000 |
| Buyer's discount rate | 7.0% |
The value of the building in fifteen years is uncertain, so it is set out as four scenarios. They are illustrative; in practice they come from the residual analysis that any leaseback buyer should already have, covering re-letting, obsolescence and the yield at exit.
| Value at expiry | Probability | Seller's gain if it exercises | Buyer keeps |
|---|---|---|---|
| 40,000,000 | 20% | 0 | 40,000,000 |
| 52,000,000 | 30% | 0 | 52,000,000 |
| 62,000,000 | 30% | 7,000,000 | 55,000,000 |
| 78,000,000 | 20% | 23,000,000 | 55,000,000 |
| 57,800,000 | expected | 6,700,000 | 51,100,000 |
The seller exercises only when the building is worth more than the strike. In the two lower scenarios it walks away and the buyer keeps a building worth 40,000,000 or 52,000,000. In the two upper ones it pays 55,000,000 for something worth more. The buyer bears every downside scenario in full and has its upside cut at the strike.
Expected payoff = Σ probability × max(value at expiry − strike, 0)
0.30 × 7,000,000 + 0.20 × 23,000,000 = 6,700,000. In Excel, with values in A2:A5 and probabilities in B2:B5: =SUMPRODUCT(B2:B5,(A2:A5>55000000)*(A2:A5-55000000)).
Without the option the buyer pays 50,000,000, collects rent rising from 3,000,000 to 3,958,436 in year 15, and expects a residual of 57,800,000. That is an IRR of 7.35 per cent. With the option, at the same price, the expected residual falls to 51,100,000 and the IRR to 6.84 per cent: 50 basis points lost to a clause that costs the seller nothing at signing.
To keep 7.35 per cent, the buyer discounts the rents and the capped residual at that rate. The price that results is 47,686,124, a reduction of 2,313,876, or 4.63 per cent. Discounted at the buyer's 7.0 per cent hurdle instead, the option is worth 2,428,388, 4.86 per cent of the price. Either way the order of magnitude is the same: a buyback at 110 per cent of today's price is worth close to a twentieth of the deal. How the cap rate on the rest is solved is in what cap rate to pay for a sale and leaseback.
| Strike | Expected payoff at year 15 | Value today at 7.0% | Price keeping 7.35% | Price reduction |
|---|---|---|---|---|
| 50,000,000 | 9,800,000 | 3,551,971 | 46,615,524 | 3,384,476 |
| 55,000,000 | 6,700,000 | 2,428,388 | 47,686,124 | 2,313,876 |
| 60,000,000 | 4,200,000 | 1,522,273 | 48,549,510 | 1,450,490 |
| 65,000,000 | 2,600,000 | 942,360 | 49,102,078 | 897,922 |
| 70,000,000 | 1,600,000 | 579,914 | 49,447,433 | 552,567 |
| 78,000,000 | 0 | 0 | 50,000,000 | 0 |
Even a strike at 140 per cent of today's price, 70,000,000, still costs the buyer 552,567 of price, because one scenario in five still puts the building above it. The option is free only when the strike sits above every value the buyer thinks plausible. A repurchase at market value, set by an independent valuation at exercise, transfers no expected value at all, which is why buyers prefer it. Under US GAAP a fair-value strike on a non-specialised building can also preserve sale accounting; under IFRS a seller's call generally blocks it whatever the strike.
The scenarios and rates are illustrative. Where the option is exercisable at several dates, or the strike is indexed, the same logic applies to each date, and a binomial tree or simulation replaces the four rows.
The rent, residual and buyer's return for this kind of deal are laid out in the free workbook for this case.
Yes, but it has a price and an accounting consequence. In the illustrative case a fixed buyback at 55,000,000 after fifteen years is worth 2,313,876 to the seller. Under IFRS a seller's repurchase right generally means control has not passed, so the transaction is accounted for as a financing rather than a sale.
In expectation, no. If the repurchase price is the building's market value at exercise, the buyer receives exactly what it gives up, so the expected payoff is 0 and no price reduction is needed. The seller still gains certainty of access to the building, which can matter more to it than the money.
Above every value the buyer thinks plausible at expiry. In the illustrative scenarios even a 70,000,000 strike, 140 per cent of the price, still costs the buyer 552,567 of price, because one scenario in five puts the building at 78,000,000. Only at 78,000,000 does the expected payoff fall to 0.
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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