By James Mitchell, Cushman & Wakefield
Prior to the 2008 great financial crisis (GFC), auto dealers were pretty laid back when it came to the structure of their leases. The GFC changed everything. Under high financial stress, landlords became more concerned with protecting their own wallet than maintaining their relationship with their tenant.
When tenants went to landlords looking for temporary rent abatement, they discovered that most landlords – under pressure themselves to stay in compliance with their debt covenants – were not willing to compromise. Tenants learned that when they don’t control their real estate costs, the combination of declining operating profit and fixed rental expense can be disastrous.
What can a tenant do to protect him/herself during hard times? The key to mitigating the disadvantages of leasing while retaining the benefits – the major benefit being improvement in return on capital by keeping real estate off the balance sheet – is a well-structured purchase option (“PO”). It is critical to persuade an owner of the real estate to grant a PO.
The only time a tenant has any leverage is when the lease agreement is being negotiated, usually at the following junctures:
- Lease renewal
- Execution of a sale-leaseback deal
- Entering into a buy-sell where the seller wishes to retain the real estate.
In our view, it is well worth it to give concessions in other parts of the lease, such as higher rent, to get a PO.
Once agreement for a PO is secured in principle, how should it be structured? The key considerations are the timing of option exercise and the pricing methodology.
A tenant must find an acceptable balance of interests. Landlords typically want the longest lease term they can get, while tenants want maximum flexibility to purchase the dealership real estate at the most convenient time. A reasonable middle ground is a PO at the end of the initial lease term and at the end of each renewal option. A widely used standard lease agreement has an initial term of fifteen years with subsequent renewal options at 5 to 10 years.
As for pricing methodology, a tenant once again needs to think in terms of a balance. A tenant will want as much certainty as possible as to what he or she must pay for the property. Ideally, he/she would like a fixed price. However, it is unlikely any landlord will agree to a fixed price. We have found the easiest compromise is to agree on a pre-set appraisal process at the time the lease is being negotiated, with a price floor (a price level under which the appraised value cannot go below).
As a general principle, you should try to keep the valuation process clear and simple. One approach that meets this test is the three-appraiser method. The specific application of this concept varies case by case and can get very granular, but the general concept is this: the landlord chooses an appraiser (the “Landlord’s Appraiser”), the tenant chooses an appraiser (the “Tenant’s Appraiser”) and then the Landlord’s Appraiser and the Tenant’s Appraiser agree upon the hiring of a third appraiser.
Each of the three appraisers will provide an appraisal to the landlord and tenant presenting their fair market value of the property. The ultimate valuation is the average of the two closest values. In the event the values of (a) the difference between the highest appraised value and the next lower appraised value, and (b) the difference between the lowest appraised value and the next higher appraised value, are equal, then the fair market value will be the average of the three appraisals.
Finally, the valuation method should stipulate that:
- The real estate valuation should be based on the continued use of the property as an automobile dealership;
- The purchase should be on a fee simple basis, i.e., the current market value of the land and building, without consideration to the lease in place.
Getting a PO from a landlord is tough because it makes their process of financing the property more difficult. The typical complaint you will hear from a landlord is that their bank will not grant a mortgage on a property leased to a tenant with a PO. This is simply not true. The reality is that banks will provide a mortgage, but at a higher interest rate if a PO is in place; therefore, agreeing to a higher rent may be necessary to offset the added cost to the landlord.
In the end, leases are negotiated with purchase options all the time. Make sure you are one of the tenants to get one.
Cushman & Wakefield Dealership Capital Services (DCS) specializes in buy/sell transactions, partner buyouts, equity solutions, debt restructuring and sale-leasebacks. James Mitchell has over 20 years of automotive industry experience. He can be reached at james.s.mitchell@cushwake.com or (202) 407-8120.
