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Sale and Leaseback – What Investors Should Know
What is Sale and Leaseback?
A sale and leaseback is a commercial real estate transaction in which the owner sells his property and signs a long-term lease with the buyer to become the tenant close to escrow. The seller retains the building for his business and receives the sale proceeds. While restaurants are a common sale and leaseback property, almost any owner-occupied single-tenant property, e.g. Properties such as car repair shops (Christian Brother Automotive), medical office buildings, etc. can be recovered through sale and leaseback. When you see the phrase “sign new lease to close of escrow” in a listing or property brochure, it’s likely a sale and leaseback.
Why sell and leaseback?
As an investor, sales and leasebacks can be a sign that a business owner is in financial trouble and may be forced to sell his/her most valuable asset. This is a valid concern as a financially strapped tenant may not be able to pay street rent and your property is vacant. However, there are several good reasons why a property owner may want to sell and lease back the property:
- Expansion of Finance Business.For example, Joe, a restaurant operator, has built 5 build-to-suit restaurants. All 5 restaurants are now open and have been running smoothly for the past 2-3 years. He now wants to build 3 more new restaurants. However, Joe will need capital for construction because the restaurant chain has its own unique building design such that it cannot rent any buildings. He can apply for a construction loan which can take up to 12 months from application to funding,… a very time-consuming process that requires many documents ranging from architectural drawings, permits, detailed construction bids, proof of workers’ compensation insurance, to business plans. . Besides, if lucky, he can get financing up to 70% of the projects total construction cost (including land acquisition cost) if he can overcome the hurdle of loan application. Alternatively, he could sell some or all of the existing restaurants at market value and sign the buyers to 20-year NNN leases. Thus, he can withdraw 100% of his equity in 5 restaurants. Therefore, a sale and leaseback is a very quick, smart and effective way for Joe to raise capital so he can focus on expanding his business. He may sell the property for more than it is worth and thus make a profit!
- Pay off debt and improve balance sheets.Real estate owned by a company is a depreciable asset which means less and less book value on the balance sheet. The IRS does not allow a company to adjust its balance sheet to a higher market value. By selling the real estate at a higher market value, it can lock in all the equity. This money can be used to pay off debt or expand the business or for research and development to strengthen the balance sheet. This can have a positive impact on the stock value. In lean years, some public companies may sell their real estate assets to meet analysts’ expected performance. Sometimes large shareholders may demand that the company sell its real estate assets to make the company more profitable in the short term.
- Reduce income tax.Walmart sells and leases back many of its stores from Walmart-owned real estate investment trusts as a way to reduce its income taxes.
What is important to investors?
In addition to location and various other factors, there are other financial aspects you should look into to determine how risky your investment is for these sale and leaseback properties. In general, the higher the risk, the higher the return you should demand or expect from the seller.
- Tenant’s Financial Statements: Seller can provide you 2 to 3 years previous income tax returns. Rent and other occupancy costs, e.g. You want a tenant with a profitable business after paying property taxes, insurance and maintenance costs. You also want to see higher and higher profits year after year. This will reduce the risk of the tenant not having the money to pay the rent. However, this may not be possible for businesses, e.g. A restaurant will be immediately profitable in the first few years, especially in a new location. In this case, the risk is high.
- Tenant’s business track record: You want to find out how long the tenant has been in business and how many locations they currently own. Business experience really counts. As a general guideline, the more locations an operator has, the higher the cap rate it will offer you.
- Guarantee of lease: The tenant often guarantees some type of lease so that if the tenant defaults on the lease, you can go to the guarantor’s property to recover the lost rental income. A long-term lease is only good if the entity guaranteeing the payment of the rent has strong assets and/or a good credit rating. A seller with multiple locations may structure his company in such a way that each location is owned by a single entity, e.g. A limited liability company (LLC) to limit its exposure to liabilities. All single components of the LLC are then owned by the parent company. In this case, a guarantee from a parent company is better than a guarantee from a single entity LLC. Sometimes you can also get a personal guarantee from the principal from the company. If the guarantor is a public company, its S&P credit rating is a good indication that you will likely receive rent checks in the future.
- Lease Terms: In a sale and lease back transaction, the lease terms are negotiable and may differ from those mentioned in the marketing brochure.
You generally want to get:
- A reasonable long-term lease, e.g. 10-20 years so you don’t have to worry about finding a new tenant for a while. In addition, long leases facilitate purchase financing.
- A triple net lease in which the tenant pays all operating expenses. This will reduce your investment risks as you don’t have much control over property taxes, insurance and especially maintenance costs. Ideally, you don’t want any landlord responsibilities or have to worry about anything, e.g. Replacing the roof, HVAC or parking lot.
- Some form of periodic rent increase, preferably 2% annually or 10% every 5 years to keep up with inflation. Apart from this, rent appreciation also ensures that the value of the property will increase when you sell it.
- Rent at or below market. This induces the tenant to stay there longer because he will pay higher rent elsewhere. If a tenant vacates a property, it is always easier to find a new tenant for the property when the rent is below market.
- Some level of clearance for possible future construction or remodeling of the property. Franchised restaurants need to remodel the restaurant into a new format to reflect the changing tastes of customers. And so the lease should be flexible enough to allow this up to a certain level. For example, the lease should state that any structural changes will require the landlord’s approval.
- Tenant’s financial statement, if required, specifically for the location you purchased. When you later need to refinance or sell the property, the tenant’s financial information, e.g. Sales revenue, profit and loss statements will be extremely important for lenders to provide potential buyers with favorable financing and the strongest offer.
Ideally, you don’t want these in a lease:
- Right of First Refusal (ROFR): This gives the lessee the option to purchase the property every time an offer is received by matching the same price. A ROFR makes the property less desirable when you want to sell it later. The buyer, after making the offer, has to wait for the tenant to decide if they want to exercise the option. This discourages some buyers from making an offer because they hesitate to spend time negotiating and then find out they can’t buy it because the tenant exercises the option. Additionally, if you have an all-cash offer from the buyer, you still give the tenant the option to buy and time to apply for a loan that could later be denied.
- Early termination right or kick out clause: This allows the tenant to terminate the lease upon partial damage to the property, e.g. 20% due to other risks or if the sales revenue does not reach a certain figure. As a landlord, you want a property that will provide constant income. And so, you don’t like a lease with an early termination clause. You want the tenant to make every effort to make repairs, rebuild the property and resume business. If you cannot remove this right from the lease, try to keep the loss percentage threshold as high as possible, e.g. 50%.
- Landowners have responsibilities when it comes to the environment. The main reason for this is that you are just a passive investor and have nothing to do with these issues.
- Ability to obtain favorable financing.There is no point in getting a good deal on a property and paying more for financing. Of course, if you buy a property in a small town in the middle of nowhere, getting a loan will be challenging and have a very high interest rate. If you buy a property with a non-franchised tenant with weak or non-existent financial statements, you will have a difficult time borrowing money. Please see “What Investors Should Know About Business Loans” Written by the same author.
Do’s and Don’ts
- Hire a CPA to review financial documents. Some financial information can be very complex. A tenant can have a good accountant prepare his tax return to show the IRS that his taxable income is low so he doesn’t have to pay more taxes. The franchisee’s income is more accurate due to the contractual obligation to the franchisee for the purpose of royalty recovery. For a non-franchised tenant, reported income may be lower than actual income because the tenant cannot report cash income. A CPA can give you an opinion about the tenant’s financial strength.
- Hire a professional real estate attorney to work on the lease. Make sure the lease addresses all potential legal issues that may arise over the next 10-20 years. A lease can be amended several times between the seller and the buyer during the negotiation process. And so, you can work with a lawyer who has a flat fee, e.g. Instead of charging $2500 per hour.
- Have a broker with sales and leaseback experience represent you. A sale and leaseback is a very complex transaction that requires an experienced broker with a CPA and attorney to guide you.
- Check the background of the tenant/seller.Since you have a long-term business relationship with a business that you don’t know much about, it’s probably wise to run a background check on the business owner and even criminal records to see if they have any red flags. A simple Google search should be the minimum.
Currently most, if not all, sale and leaseback transactions involve assets owned by individuals, private and public companies. However, public property, viz. There are no good reasons why libraries, schools, government office buildings cannot be structured as sale and leaseback transactions. It can be a way for cities, counties, states and even the federal government to raise money for critical projects or cover budget deficits without raising taxes. After all, government is a major tenant everywhere in the US.
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