The lease is signed by an operating subsidiary and the price is quoted on the group. A survival-weighted cash flow shows what the guarantee bridging the two is worth.
A parent company guarantee is worth the difference between the price of the lease on the parent's default risk and its price on the risk of the entity that actually signs it. On an illustrative 20-year leaseback at 4.0 million a year, a full-term guarantee from a group with a 1.0 per cent annual default probability, over a subsidiary at 4.0 per cent, is worth 9,617,988, 14.7 per cent of the 65,651,587 guaranteed price. Capped at five years, the same guarantee is worth 3,875,290.
Worked in full in Sale and Leaseback by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a sale and leaseback the property is usually owned and occupied by an operating subsidiary, and it is that subsidiary which sells the building and signs the lease. The marketing materials quote the group: its rating, its profits, its rent cover. The rent is paid by the subsidiary unless someone else promises to pay it. The guarantee is that promise, and its terms, its cap and its duration are the part of the price that is negotiated last and priced least.
All figures illustrative, in euros. The probabilities of default are annual and constant; the discount rate is a property rate without a credit premium, because the credit risk is carried in the cash flows.
| Input | Value |
|---|---|
| Rent in year 1 | 4,000,000 |
| Annual indexation | 2% |
| Lease term, years | 20 |
| Discount rate | 5.5% |
| Annual default probability, signing subsidiary | 4.0% |
| Annual default probability, group guarantor | 1.0% |
| Building value if the tenant fails (vacant, net of void and costs) | 30,000,000 |
| Value at lease expiry if the tenant has paid throughout | 40,000,000 |
1. The survival-weighted cash flow. In each year the tenant either pays the rent, with the probability that it has survived so far, or fails, in which case the landlord gets the building back empty.
Value = Σ St × Rentt × DFt + Σ St−1 × h × Dark × DFt + S20 × Residual × DF20
St = (1 − h)t, DFt = 1.055−t, Rentt = 4,000,000 × 1.02t−1
Excel, years in A2:A21: =SUMPRODUCT((1-h)^A2:A21*4000000*1.02^(A2:A21-1)/1.055^A2:A21) for the rent line
2. Price it on each credit. With the guarantee the rent stops only if the group fails as well, so the stream carries the group's 1.0 per cent. Without it, the subsidiary's 4.0 per cent.
| Case | Rent | Building back on default | Residual | Price | Initial yield |
|---|---|---|---|---|---|
| Rent certain | 56,082,605 | 0 | 13,709,159 | 69,791,763 | 5.73% |
| Group guarantee, full term | 51,117,173 | 3,321,598 | 11,212,816 | 65,651,587 | 6.09% |
| Guarantee capped at 5 years | 44,625,099 | 8,216,462 | 7,067,328 | 59,908,889 | 6.68% |
| Subsidiary alone | 39,256,058 | 10,718,058 | 6,059,481 | 56,033,598 | 7.14% |
The full-term guarantee is worth 65,651,587 less 56,033,598: 9,617,988, or 14.7 per cent of the guaranteed price, and 105 basis points of initial yield. Expected credit losses take 5.9 per cent off a certain rent stream with the guarantee and 19.7 per cent without it. Over twenty years the subsidiary has a 44.2 per cent chance of still paying at the end; the guaranteed lease has 81.8 per cent.
The five-year cap shows where the value sits. It covers only the first five of twenty years. The defaults it misses, and with them the later, indexed rents and the residual value that only a surviving tenant delivers, fall in years six to twenty, so it captures only 3,875,290, 40.3 per cent of the full guarantee. A buyer offered a capped guarantee in place of a full one is being offered well under half of it.
| Variant | Price without guarantee | Guarantee worth | Share of guaranteed price |
|---|---|---|---|
| Subsidiary default 2% | 62,022,411 | 3,629,176 | 5.5% |
| Subsidiary default 4% | 56,033,598 | 9,617,988 | 14.7% |
| Subsidiary default 6% | 51,383,635 | 14,267,952 | 21.7% |
| Vacant value 20,000,000 | 52,460,912 | 12,083,475 | 18.7% |
| Vacant value 40,000,000 | 59,606,284 | 7,152,502 | 10.7% |
The guarantee matters most where the subsidiary is weak and the building is hard to re-let: exactly the specialised production sites that are most often sold and leased back. Here the first-year rent is 13.3 per cent of the vacant value, so a default swaps a rent stream worth far more than the empty building for the empty building itself.
The model treats a guaranteed lease as failing only at the group's rate. In practice a group rarely survives the failure of its main operating subsidiary unscathed, and a guarantee can be released on a sale of the subsidiary. Both make the 9,617,988 a ceiling, which is why the release and change-of-control wording belongs in the lease abstract beside the cap.
Testing rent cover on group profits and pricing on the group's credit when the guarantee is capped, time-limited or absent. The book's own case makes the point with rent cover: the group covers the rent many times over, while the entity that signs the lease covers it far fewer, and only one of them is liable. The test at each level is set out in how to calculate rent cover in a sale and leaseback, and the credit spread the rent implies in whether a leaseback pays more than the tenant's bonds.
The book separates the part of a leaseback price that is property from the part that is one company's credit, and the free workbooks for this case run the same hazard-rate cash flow on a nine-building portfolio.
Close, if it covers the full term and every obligation, and the parent is the stronger credit. Limits matter: a guarantee capped at five years on the illustrative 20-year lease is worth 3,875,290 against 9,617,988 for the full term, 40.3 per cent of it, because most of the default risk sits in the later years.
A higher vacant value makes default less costly, so the guarantee protects less. On the illustrative lease the full-term guarantee is worth 12,083,475 if the empty building is worth 20 million, 9,617,988 at 30 million and 7,152,502 at 40 million. Specialised buildings, which are hard to re-let, are where a guarantee earns most.
Price both cash flows and compare. On the illustrative lease the guaranteed price of 65,651,587 is an initial yield of 6.09 per cent; with the subsidiary alone the price is 56,033,598, a 7.14 per cent yield. The 105 basis points come from the default probabilities, not from a rule of thumb.
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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