Commonly Asked Questions About A Bond Net Lease Transaction

What is a bond net lease?
What is the difference between a net lease transaction and a sale/leaseback transaction?
How does a bond net lease differ from a conventional real estate lease?
How long is the basic term of the lease?
What are the corporate lessee's renewal term options?
How is the rent calculated under a bond net lease?
Are there any percentage (or other performance or contingent) rents?
Are the rents fixed for the full term of the bond net lease?
Can the fixed rents be stepped?
Can there be a "free" rent period?
Are there any offsets to or defenses against the payment of the rent?
Are there any financial covenants contained in the lease?
Are there any other restrictions over the general business operations of the corprate lessee contained in the lease?
Will we finance construction?
If there is a construction risk, why is it worth it for the corporate lessee to take it?
What are the corporate lessee's restrictions on the use and operation of the property?
Can the lessor interfere with the corporate lessee's use of the property?
What will the bond net lease prohibit the corporate lessee from doing that would not be prohibited under a conventional leasing or mortgage arrangement?
What restrictions are there on the corporate lessee in making alterations and additions to the property?
Can those additions and alterations be financed through the net lease structure?
What is the impact of the bond net lease transaction on the balance sheet of the corporate lessee?
What is the after-tax cost of the transaction to the corporate lessee?
In what ways is the bond net lease transaction preferable to a direct mortgage financing?
What benefits of ownership is the corporate lessee giving up?
Can the corporate lessee receive any residual rights or benefits in the property?
Can the corporate lessee have an option to purchase the property?
Can the corporate lessee terminate the lease for any reason before the end of the lease term?

COMMONLY ASKED QUESTIONS ABOUT A BOND NET LEASE TRANSACTION

1. What is a bond net lease?

A bond net lease is the equivalent of a bond issued by the corporate lessee. Under the lease, there are no defenses against payment of the rent, and the lease is non-cancelable. The corporate lessee assumes all of the obligations, risks, and costs of the real estate and pays the owner an absolute net rent. In the event of a major casualty or condemnation, the corporate lessee must continue paying rent. However, if the casualty or condemnation makes the property uneconomic, it may elect to terminate the lease provided that it pays the lessor an amount at least equal to the lessor's unamortized investment in the property.

2. What is the difference between a net lease transaction and a sale/leaseback transaction?

There is no difference between a net lease and a sale/leaseback. The form of lease is exactly the same in both cases. In the case of the net lease transaction, the corporate lessee has never owned the property before entering into the lease.

In a sale/leaseback transaction, the corporate lessee owns the property immediately prior to the transaction, sells the property to the lessor and simultaneously leases it back from the lessor.

3. How does a bond net lease differ from a conventional real estate lease?

The major difference is that under a conventional real estate lease, the corporate lessee will have the right to terminate the lease in the event of a major casualty or condemnation without having to make any payment to the lessor. In addition, the lessor under a conventional real estate lease may have responsibility for roof and structural repairs or other maintenance and management responsibilities.

4. How long is the basic term of the lease?

The basic term is typically between 15 and 25 years.

5. What are the corporate lessee's renewal term options?

The corporate lessee usually has the right to extend the lease for 4 or 5 renewal terms of 5 years each at rents equal to the fair rental value of the property.

6. How is the rent calculated under a bond net lease?

The net rent during the basic term of a bond lease will be sufficient to amortize the lessor's investment in the property (inclusive of the lessor's equity capital and any debt financing), together with interest. In calculating the rent, the implicit interest rate will usually be at least equal to the corporate lessee's direct borrowing rate.

7. Are there any percentage (or other performance or contingent) rents?

No.

8. Are the rents fixed for the full term of the bond net lease?

Yes. However, in some transactions, there is an allowance for periodic resets of the basic rent, if elected by the corporate lessee (for example, after 5, 10 and 15 years).

9. Can the fixed rents be stepped?

Yes, the fixed rents may be stepped, if elected by the corporate lessee, so long as the lessor's investment in the property is fully amortized by the end of the lease term together with interest.

10. Can there be a "free" rent period?

Yes, if elected by the corporate lessee, there may be a rent-free period up to 12 months as long as the lessor's investment in the property is fully amortized by the end of the lease term together with interest. However, this rent-free period is not the norm for sale/leaseback transactions.

11. Are there any offsets to or defenses against the payment of the rent?

No. The lessee has no right to terminate and will continue to pay rent regardless of any circumstance, including condemnation and casualty.

12. Are there any financial covenants contained in the lease?

The necessity of including any financial covenants in the lease depends upon the credit standing of the corporate lessee. For example, a lease with a corporate lessee rated NAIC 3 (i.e., below investment grade) will generally contain both net worth and event risk covenants. Event risk covenants will provide the lessor protection against events that result in a major change of ownership in the corporate lessee, a major decline in the corporate lessee's business or a major decline in the net worth of the corporation.

13. Are there any other restrictions over the general business operations of the corporate lessee contained in the lease?

Not typically.

14. Will we finance construction?

Yes, under appropriate circumstances, in particular, if the corporate lessee takes responsibility for construction. This will eliminate the need for separate construction financing.

15. If there is a construction risk, why is it worth it for the corporate lessee to take it?

If the developer takes the construction risk, the developer will be compensated in the form of higher rents. By taking the construction risk, the corporate lessee is able to minimize its payments.

16. What are the corporate lessee's restrictions on the use and operation of the property?

There are no restrictions on the corporate lessee's use of and operation of the property in its business.

17. Can the lessor interfere with the corporate lessee's use of the property?

No.

18. What will the bond net lease prohibit the corporate lessee from doing that would not be prohibited under a conventional leasing or mortgage arrangement?

Nothing.

19. What restrictions are there on the corporate lessee in making alterations and additions to the property?

There are no restrictions on the corporate lessee so long as the alterations and additions do not reduce the fair market value of the property.

20. Can those additions and alterations be financed through the net lease structure?

Yes.

21. What is the impact of the bond net lease transaction on the balance sheet of the corporate lessee?

In a properly structured bond net lease transaction, the corporate lessee can upgrade its balance sheet significantly.

First, in the case of a sale/leaseback, the corporate lessee is converting an illiquid asset into cash. It will also be able to increase its net worth by the difference between the sale price and the book value of the property, after adjusting the result for taxes on the gain. (The recognition of this increase in net worth will probably have to be spread over the term of the lease.)

Second, the corporate lessee should not have to show any increase of debt on its balance sheet, since it is not borrowing money. Accordingly, the lease obligation should not have to be recorded directly as a long-term obligation or liability on its financial statements. This is what is called off-balance sheet financing.

22. What is the after-tax cost of the transaction to the corporate lessee?

The after-tax cost is the rent minus the value of the rent deduction. The rent is fully deductible, including that portion of the rent allocable to the land.

23. In what ways is the bond net lease transaction preferable to a direct mortgage financing?

There are several advantages:

First, in a bond net lease transaction, the corporate lessee is effectively receiving 100% financing of the real estate. Under a traditional mortgage arrangement, the corporate lessee could typically finance up to 80% of cost or value of the real estate.

Second, in a bond net lease transaction, the corporate lessee will be able to deduct all rent payments, including the rent allocable to the land. Only the interest portion (not the principal) of the debt service payments under a mortgage financing is deductible.

Third, since the corporate lessee will not have to show any increase in debt on its balance sheet, it will significantly upgrade its financial statement.

24. What benefits of ownership is the corporate lessee giving up?

By leasing instead of owning, the corporate lessee is giving up the value of the residual interest in the property at the end of the lease term.

25. Can the corporate lessee receive any residual rights or benefits in the property?

Even though the corporate lessee does not own the property, in some instances the corporation can share the residual rights and benefits.

26. Can the corporate lessee have an option to purchase the property?

Subject to the continuing involvement provision of FASB 98, the corporate lessee can have an option to purchase the property. If the corporate lessee exercises this option, the purchase price will have to approximate fair market value.

27. Can the corporate lessee terminate the lease for any reason before the end of the lease term?

The corporate lessee can terminate the lease due to major casualty or condemnation and, in some cases, if the property is no longer useful in its business. In the event of such termination, the corporate lessee must make a rejectable offer to purchase the property for the lessor's unamortized investment in the property. If the offer is accepted, the property will be conveyed to the corporate lessee. If it is rejected, the corporate lessee can terminate the lease without making any further payment to the landlord.