Advantages of a Sale Leaseback to Prepaid Rent
There are two conventional ways companies find capital: debt or equity. However, there are other ways, including selling assets. A sale leaseback transaction is one of those types of transactions. A closely related term is prepaid rent, but it does not help a company raise capital.
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Sale Leaseback
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A sale leaseback is the sale of property a company owns to an investment firm, from which the company immediately lease the property back. This is done if a company wants to free up capital for acquisitions or other growth strategies. For example, a company owns an office complex that it fully occupies. The value of the office is $10 million. The company sells the office to an investment firm for $10 million and then leases the offices back for $40,000 a month.
Prepaid Rent
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Prepaid rent is paying cash for rent ahead of the time period the property is used. This is very common with real estate companies as they receive rent on the first of the month in advance. Sometimes, however, a company may pay rent multiple months ahead of time for various reasons, such as a discount on rent or as a favor for a real estate company with which it has a close relationship.
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Capital Freed Up
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The functions of a sale leaseback and prepaid rent are totally different. One involves receiving capital while the other is spending capital. The big advantage for a sale leaseback is that it frees up capital for a company while prepaid rent is a use of capital. The capital can be used to pay down debt, grow the company, acquire assets or companies, buy back shares, or pay a dividend to shareholders.
Accounting Ratios
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The accounting return ratios have the potential of increasing because of the leaseback transaction because of better balance sheet leverage. This is because a lease is a form of off-balance sheet financing, so it does not show up as a liability on the balance sheet. And the assets shrink because the asset is sold. This could only work, though, if the cash is distributed to shareholders or assets shrink. For example, a company earns $20 million a year in net income and has $100 million in shareholder's equity for a return on equity of 20 percent. The company has a $10 million property on its books that it sells for $10 million in cash and then immediately issues a $10 million dividend to its shareholders. The company now has to pay $500,000 a year for lease payments, so net income slips to $19.5 million a year, excluding taxes. The new shareholder's equity balance is $100 million minus $10 million or $90 million. The new return on equity is $19.5 million divided by $90 million or around 21.7 percent.
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References
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