The rent is not the cost of a leaseback; the cost is the rent plus the building handed over at the end, and the extra 40 per cent of proceeds is the most expensive money in the deal.
A sale and leaseback is cheaper than a mortgage only if the building will be worth little to the seller when the lease ends. Its true cost is the IRR of the proceeds received, the rent paid and the property given up at the end. On an illustrative 50,000,000 building sold at a 6.00 per cent yield with rent indexed at 2.0 per cent for 20 years, that cost is 8.13 per cent, against 5.58 per cent for a 60 per cent mortgage. The leaseback raises 19,550,000 more cash, and that extra money costs 11.00 per cent.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Leaseback proposals are usually compared on the initial yield: 6 per cent of rent against 5.5 per cent of interest, half a point apart. That comparison leaves out two cash flows, the rent indexation and the building, and between them they decide the answer.
| Input | Sale and leaseback | Mortgage |
|---|---|---|
| Property value | 50,000,000 | 50,000,000 |
| Investor's yield / interest rate | 6.00% | 5.5% |
| Initial rent / interest | 3,000,000 | 1,650,000 |
| Rent indexation, a year | 2.0% | |
| Term, years | 20 | 20 |
| Amount raised | 100% | 60% LTV |
| Transaction costs / arrangement fee | 1.5% | 1.0% |
| Value at the end: forward rent at an exit yield of | 6.00% | kept by the owner |
0 = net proceeds − Σ rentt ÷ (1 + c)t − residual20 ÷ (1 + c)20
Residual20 = rent in year 21 ÷ exit yield
Solve for c, the seller's cost. In Excel, put the proceeds as a positive in year 0, each year's rent as a negative, subtract the residual in year 20, and use =IRR(). Do the same for the mortgage: net loan in, interest out, principal repaid in year 20. The owner keeps the building under the mortgage, so no residual is subtracted.
Step 1, the leaseback. The seller receives 50,000,000 less 1.5 per cent, 49,250,000. It pays 3,000,000 of rent in year 1, rising to 4,370,434 in year 20: 72,892,109 in total. At the end it no longer owns a building whose rent would be 4,457,842, worth 74,297,370 at a 6.00 per cent yield. The IRR of those flows is 8.13 per cent, close to the shortcut of initial yield plus indexation, 8.00 per cent.
Step 2, the mortgage. 30,000,000 at 60 per cent, less a 1.0 per cent fee, puts 29,700,000 in the bank. Interest is 1,650,000 a year and the principal is repaid in year 20. The cost is 5.58 per cent.
Step 3, the difference. Subtract the mortgage flows from the leaseback flows. The leaseback raises 19,550,000 more today, costs 1,350,000 more in year 1 and gives up 47,017,803 more in year 20: the residual less the 30,000,000 the mortgage would have repaid. The IRR of that difference, the cost of the extra money, is 11.00 per cent.
On these assumptions the leaseback is the dearer source of capital by 2.55 points overall, and its marginal 40 per cent of proceeds costs what equity costs, not debt. That is not a reason never to do one. It is a reason to know which number is being compared: the 6.00 per cent initial yield is not the cost of anything.
Without indexation the arithmetic changes but the logic does not. With a flat rent and the building still worth 50,000,000 at the end, the leaseback costs 6.13 per cent: the yield plus the transaction costs. Indexation is not a detail of the lease; it is two points of the seller's cost of capital.
| Investor's yield | Residual 100% | 75% | 50% | 0% |
|---|---|---|---|---|
| 5.50% | 7.38% | 6.60% | 5.68% | 2.90% |
| 6.00% | 8.13% | 7.38% | 6.47% | 3.79% |
| 6.50% | 8.86% | 8.11% | 7.23% | 4.64% |
The residual moves the answer far more than the yield. A specialised building that will be obsolete when the lease ends, a residual near zero, makes the leaseback cheap capital: 3.79 per cent at a 6.00 per cent yield. A well-located warehouse that holds its value makes it expensive. The incremental cost of the extra proceeds falls from 11.00 per cent at a full residual to 9.71 per cent at 75 per cent and 7.91 per cent at 50 per cent; it reaches 10 per cent at a residual of 80.0 per cent.
The same logic explains why investors price these deals on rent cover and covenant rather than on property alone. The investor is buying the tenant's promise to pay an indexed rent for twenty years, plus a building; how to calculate rent cover in a sale and leaseback shows how the first half is tested, and whether a leaseback beats the tenant's bonds prices it against the tenant's own debt.
Compute the leaseback's cost as an IRR that includes the residual: 8.13 per cent here, against 5.58 per cent for the mortgage, with the extra proceeds costing 11.00 per cent. It is cheap capital only for buildings the seller will not want, or could not finance, at the end. Sale and Leaseback takes one nine-building portfolio from the seller's chosen rent to the part of the price that is not property, and the free workbooks for this case carry the rent, the residual and the covenant arithmetic as live formulas.
The internal rate of return of the seller's cash flows: net proceeds in, rent out each year, and the property value given up at the end of the lease. On an illustrative 50,000,000 building at a 6.00 per cent yield with 2.0 per cent indexation over 20 years, that is 8.13 per cent, close to the initial yield plus indexation of 8.00 per cent.
When the building will be worth little to the seller at the end of the lease, or when the seller cannot borrow against it on similar terms. On an illustrative case the leaseback costs 8.13 per cent if the residual holds its value and 3.79 per cent if it is worth nothing, against 5.58 per cent for a mortgage at 60 per cent loan-to-value.
Because it sells 100 per cent of the value rather than lending against 60 per cent. On an illustrative 50,000,000 building the leaseback raises 49,250,000 net and the mortgage 29,700,000. The extra 19,550,000 costs 11.00 per cent a year when the residual is counted: priced like equity, not like debt.
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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