Loss of residual property value is perhaps the major disadvantage of the sale-leaseback is that the seller transfers title to the buyer. Owners can minimize this disadvantage by including a repurchase option in the leaseback. However, a repurchase option changes how the sale-leaseback arrangement is reported for accounting purposes. The lease will be recorded as an asset and capitalized, and the obligation to make the future lease payments will be shown as a liability. At the end of a lease without any renewal options, the seller may have to negotiate an extension of the lease at current market rent or may be forced to relocate its business. The interest rate in a sale-leaseback arrangement generally is higher than what the owner would pay through conventional mortgage financing. The buyer assumes additional risks by financing 100 percent of the property’s fair market value. In addition, the buyer’s investment in the leased property may be less liquid or marketable than a loan. Finally, the cost of negotiating may be higher, because substantial time and effort may be required to tailor the transaction to the seller’s needs.
If the sale-leaseback transaction gives the seller an option to repurchase the property or if the seller retains substantial ownership rights, the Internal Revenue Service may view the transaction as a mortgage. In that case, the seller would not be allowed a deduction for rent but could deduct depreciation and a portion of the rent payments as interest. Perhaps the biggest risk that the buyer faces is that the seller will default on the lease, which would leave the buyer without a tenant. If the seller files for bankruptcy, the buyer is considered a general creditor. If the arrangement were a conventional mortgage, the buyer would be considered a secured creditor.
The drawbacks to the sale-leaseback structure from the buyer-lessor's perspective are similar to the risks typically associated...