Coming off the post-pandemic dealership consolidation boom, industry experts expect dealership consolidators to remain steadfast in their efforts to gain additional market share and improve efficiencies through scale. Despite recent challenges related to increased macroeconomic uncertainty, persistently high interest rates, and real estate values being a hurdle for growing dealers (at times exceeding blue-sky values), we’ve seen an increasing need for creative solutions related to real estate in M&A transactions.
When acquiring the operations, consolidators are faced with two options for the real estate; acquire it with the business or lease it/assume an existing lease from the previous owner. While these options may seem fairly straight forward, leasing presents several nuances that can materially affect blue-sky values and operational flexibility. Below we discuss various scenarios that, when done correctly, will alleviate future headache and best position the dealer for continued growth and autonomy.
Buying Operations, Leasing from Real Estate Capital Partner (Sale-Leaseback)
By nature, the sale-leaseback is a capital efficient strategy that provides the dealer with access to a well-capitalized real estate partner to fund additional growth. When facilitated in conjunction with M&A processes, it also allows for an arbitrage opportunity or “over-fund” on appraised values that can be then applied to working capital requirements, used to minimize total equity spend, and/or as a means of limiting additional debt on the balance sheet. While it can serve as a significant growth catalyst, there are several lease terms that a dealer should consider with careful review before committing to a long-term obligation, including but not limited to:
• Change of Control & Assignment Language: This specific provision can serve as a prohibiting factor in a future decision to sell a dealership point and may grant the landlord unreasonable decision-making power over any future operator in that dealership point. Operators face stringent requirements to be relieved of financial lease obligations after the sale of a dealership, or in some cases an ongoing liability with no release. It is important to structure the lease such that operator retains flexibility to sell the dealership operations at some point in the future without landlord consent. Typically, this can be negotiated contingent on certain metrics that are agreed to at the formation of the lease (e.g., comparable location count, revenue, EBITDA, etc.).
• TI/Capex Provisions: Addresses near-term compliance updates or renovation costs by including tenant improvement allowances or landlord obligations to fund capex into the lease.
• Rental Escalations: Fixed, annual rental increases protect the predictability of long-term cash outlays and should be favored over variable metrics like CPI.
• Competitive Cap Rate: Ensure the rental rate and the effective cap rate reflect market norms and are indicative of sale-leaseback values rather than based on appraised value.
• No Personal Guarantees or Financial Covenants: Being an equity swap rather than a debt transaction, a sale-leaseback should not include any financial covenants and should not require personal guarantees from dealer principals.
Buying Operations, Leasing Real Estate from Prior Owner:
• Purchase Option: Unlike most institutional landlords, prior owners may be open to and/or require that a purchase option is included in the lease. Counsel should distinguish between capital and operating leases, as classification impacts accounting and tax treatment.
• Rent Determination: Negotiate a rent level that aligns with gross profit margins and/or market conditions to avoid the rent putting a burden on profitability.
Leasing real estate from the prior owner may provide short-term flexibility when acquiring the operations, however, without the access to capital and resources that an institutional/quasi-institutional real estate partner provides, operators may have to come out of pocket for renovations, future real estate acquisitions, and could be left with a more hands-on landlord.
Seller Disposes of Operations, Retains Real Estate:
Conversely, a dealer may decide to sell their operations and retain their real estate. This may be done for a number of reasons including granting the acquirer additional flexibility during the buy-sell process, or as a cash-flow stream for retirement. Unlike traditional, or more commoditized net-lease assets such as car washes, collision centers, oil change, etc., dealerships are typically greater price points and less liquid assets due to a low investment sales volume. Lease terms play a vital role in maintaining investment values and ensuring future salability. Below are some important lease terms that increase salability and attractiveness for future investors:
• Long-term, Absolute Net Lease (NNN): A long-term, absolute net lease puts all of the responsibilities on the tenant, allowing for passive ownership and helps to mitigate any conflicts that may arise
• Annual Increases: Building in predictable rental escalations throughout the duration of the term and option periods
• Market Rent: Set a rent consistent with local and national comparables – above-market rates can decrease a future buyer pool and inhibit a sale
• Guarantor Language: Collateralize the lease obligations with the lessee’s parent entity, if feasible, to protect long-term cash flows, increase properties values, and mitigate default risk
Conclusion:
Leasing real estate in M&A transactions enables growth without significant capital outlay, but given the long-term nature of most rental obligations, it requires an understanding of what’s fair and what’s overreaching. By being conscious of the contractual obligations involved, dealers can best position themselves for long-term operational control that leaves the business in a better position for sustained growth.
