Sale-and-Leaseback: The importance of harmonizing the lease with the offer to purchase

This article was initially published in Espace Montréal magazine.

In the real estate market, a sale-and-leaseback transaction, or simply "leaseback," is a method of financing a business. In general, it consists in the sale of an immovable property owned by the corporation operating its business therein to a third-party buyer, carried out concurrently with the leasing of the same property to the seller under the terms of a commercial lease. In other words, through the leaseback of a property, the buyer becomes the landlord and the seller (operating corporation and original owner of the property) becomes the tenant.

Sale-and-leaseback is particularly well suited to sales of single-occupant retail or industrial properties where the occupant is the owner.

In a real estate market where industrial properties are in high demand and financing costs are rising, the popularity of sale-and-leaseback transactions is likely to increase.

This type of transaction offers several benefits for both parties. For the seller, the benefits include the opportunity to take advantage of rising real estate values in the current market and to use the profit from the sale to pay off debts or invest in its business. In addition, the seller, as tenant under the commercial lease entered into with the buyer, continues to operate its business in the same building and retains some control over it. This type of transaction can also have accounting and tax benefits for the seller-tenant, such as the possibility to deduct the rent paid from its income. For the buyer, the benefits include the opportunity to acquire a real estate asset which is guaranteed to generate a rental income for a medium or long term.

In these transactions, the lease becomes a key asset, protecting the seller-tenant's rights to remain in the building and to continue operating its business therein and therefrom while ensuring the buyer-landlord a certain return on investment through rent. Consequently, the lease between the parties must be carefully tailored to the transaction, and the terms and conditions of this lease must be consistent with the provisions of the offer to purchase notably those provisions of the offer relating to the seller's conventional representations and warranties and the legal warranties of quality and ownership.

Conventional representations and warranties

According to the principle of freedom of contract, the parties to an offer to purchase may add to, diminish or exclude entirely the effects of the legal warranties, provided they comply with certain guidelines. Moreover, an offer to purchase almost always contains conventional representations and warranties, being representations and warranties which are not provided for at law, but rather negotiated between the parties.

While some of the standard conventional representations and warranties do not require that any adaptation be made to the lease, others deserve special attention, including those concerning the state and condition of the property at the time of the sale. For example, the seller may represent and warrant in the offer to purchase that the property is, at the closing date, in compliance with all applicable legislation, or that it is not and has never been contaminated. The effects of such conventional representations and warranties are to replace, at least in part, the legal warranty of quality or to clarify its scope.

The legal warranty of quality

Even if an offer to purchase does not contain conventional representations and warranties by the seller regarding the property's state and condition, a sale can be made with the legal warranty of quality. Article 1726 of the Civil Code of Québec, which is the basis of said warranty, expressly deals with latent defects in the following terms:

"1726. The seller is bound to warrant the buyer that the property and its accessories are, at the time of the sale, free of latent defects which render it unfit for the use for which it was intended or which so diminish its usefulness that the buyer would not have bought it or paid so high a price if he had been aware of them.

The seller is not bound, however, to warrant against any latent defect known to the buyer or any apparent defect; an apparent defect is a defect that can be perceived by a prudent and diligent buyer without the need to resort to an expert."

This Article sets out the four criteria which must be met to conclude to the existence of a latent defect, namely that (1) the defect is serious to the extent of rendering the property unfit for its intended use; (2) the defect existed at the time of the sale; (3) the defect was hidden; and (4) the buyer had no knowledge of the defect.^[1]

While the notion of latent defect applies to traditional cases of damages or defects to the building, such as major yet inconspicuous cracks in the foundation, it also covers cases of contamination of the land on which the building is built,^[2] provided that the four criteria mentioned above are met.

The legal warranty of ownership

The sale of a property can also be made with the legal warranty of ownership, which can be combined with the legal warranty of quality. Under the legal warranty of ownership, a seller warrants to the buyer that the property is free of any private or public rights, except those declared to the buyer at the time of the sale. While this warranty applies to cases where a property is sold without a clear title, or where a hypothec that the buyer has not assumed subsists on the property, it also applies to cases where a property does not comply with the environmental legislation applicable at the time of the sale.^[3]

Lease provisions to adapt

If a property is sold with the legal warranty of quality or the legal warranty of ownership, or if the seller makes certain conventional representations and warranties regarding the state and condition of the property at the closing date, then certain provisions of the lease must be adapted accordingly including, without limitation, those listed below:

1. Condition of the property

Since, in a sale-and-leaseback, the tenant is a corporation which has been operating its business in the property for several months or years prior to the sale and is therefore familiar with the state and condition thereof, the lease generally contains provisions to the effect that the tenant accepts the property "as is". While these provisions are common in most commercial leases, they often need to be adapted for a leaseback in order to extend their scope.

Furthermore, if the sale is made with legal warranties or if the offer to purchase contains seller's representations and warranties regarding the state and condition of the property or of its equipment, then the acceptance by the tenant of the property in its "as is" state and condition should not be subject to latent defects, construction defects or non-compliance of the property with applicable legislation. Depending on the nature and extent of the warranties provided for under the offer to purchase, a seller-tenant could accept the property "as is", but subject to apparent defects and all latent defects the buyer-landlord was made aware of prior to the sale.

2. Environmental obligations

Each party's environmental obligations depend on the legal warranties and the seller's conventional representations and warranties provided for under the offer to purchase. Generally, tenants are responsible for any contamination they cause to the property or which is caused by their representatives, employees and other persons for whom they are responsible at law or to whom they allow access to the property during the term of the lease. However, if the seller represents and warrants to the buyer that, at the closing date, the property is not contaminated and complies with all applicable environmental legislation, then the lease should provide that the tenant is also responsible for any contamination of the property existing even prior to the commencement date of the lease, regardless of the cause of the contamination. The same applies if the parties have not excluded the application of the legal warranties.

3. Maintenance, repair and replacement obligations

Maintenance, repair and replacement obligations are often overlooked during the negotiation process of a commercial lease. However, these often costly obligations can impact the value of the building. In a "net," "double net," "triple net" or "entirely net" commercial lease, it is important to adapt the definition of the operating costs charged to the tenant based on each party's maintenance, repair and replacement obligations. It is also essential to specify which party is responsible for doing the maintenance, repair and replacement work and which party is responsible for paying the costs thereof; the party doing the work is not necessarily the one paying the bill.

In a sale-and-leaseback transaction, assigning responsibility for the work can be all the more important to each party. The tenant, on the one hand, may want the landlord to be responsible for doing most of the maintenance, repair and replacement work in the building, and therefore have the costs of such work included in the operating costs (and amortized if they are characterized as costs of a capital nature). Indeed, one of the reasons some corporations sell their property is that they no longer wish to take care of it, preferring to invest their time and money into their business. A landlord, on the other hand, may want the tenant to handle most of this work, at the tenant's costs, as is often the case under industrial leases.

In addition, the parties should ensure that their respective maintenance, repair and replacement obligations reflect the legal warranties or the seller's conventional representations and warranties provided for under the offer to purchase. For example, if the seller represents and warrants to the buyer that the building is, at the closing date, free of latent defects, the lease should provide that the tenant is responsible, at its cost, for carrying out the work necessary to correct any latent defect existing at the closing date. The landlord may also want to provide for an option to perform this work at the tenant's cost, plus an administration fee. If a latent defect affects a part of the building for which the landlord is responsible under the lease, such as the structure of the building for example, the lease must be clear with respect to the tenant's obligation to reimburse the costs incurred by the landlord to correct the defect; also, such costs should not be part of the operating costs. Indeed, the operating costs usually include only the amortized portion of such costs over the lease term, with the landlord not necessarily recovering the full amount of its expenses. This is because this amount is payable only in installments, with the risks that this entails. To amortize the costs of the repairs of a latent defect in a situation where the seller represented and warranted to the buyer that no such latent defect exists would go against the parties' intention in the offer to purchase.

4. Tenant insurance

The tenant insurance clause in the lease should be tailored to the tenant's obligations thereunder. For example, if the tenant is responsible for any contamination on, in or under the property, including the contamination existing before the commencement date of the lease, the landlord could require an environmental liability insurance from its tenant.

5. Other equipment

If the building is sold with specialized equipment used by the seller-tenant in the course of its business, then the lease must also provide that said equipment is leased to the tenant and specify which party is responsible for its maintenance, repair and replacement. If the offer to purchase contains legal warranties or seller conventional representations and warranties regarding the state and condition of said equipment, such warranties will have an impact on these obligations. On the contrary, if this equipment remains the property of the seller-tenant and some of this equipment is permanently attached to the building, it would be prudent to include in the lease a list of the equipment belonging to the tenant, and to specify if such equipment needs to be removed by the tenant at the end of the lease.

Conclusion

Considering the complexity of sale-and-leaseback transactions, the impact of the warranties provided for under the offer to purchase on the parties' relationship in the long term, and the importance of the lease for each party, it is highly recommended that the parties seek professional guidance from experts in the field, who will be able to advise them and ensure that the lease is in synch with the offer to purchase.