The Value of a Master Lease January 05, 2009 In today's economic climate, commercial real estate owners are finding themselves forced to creatively position their properties to entice buyers or satisfy stricter loan underwriting requirements. Properties with cash flow deficiencies are vulnerable to outsized pricing and underwriting impairments. One of the tools an owner may employ to mitigate the impairment and enhance value is a master lease. In the context of a sale, a master lease is a lease of all or a portion of a property by the seller. The seller, as lessee, may pay the buyer rent on specifically designated existing vacant space, cover rent on space that becomes vacant after closing and/or fill the gap between actual rents and the rents that were used to price the property for sale. The term of a master lease will typically begin on the closing date and end either on a negotiated date or upon certain events occurring, such as the sublease of the vacant space to a third-party tenant. The expectation of a master lease is that the seller's subsidy in the form of rent should pay-
off with a several-fold appraised value enhancement as the prevailing cap rate is applied to the subsidized NOI. Leaving the issue of seller's credit aside for the moment, the master lease should similarly benefit a lender's underwriting of the property on a sale or refinancing. The quality of the master lessee's credit is increasingly important as credit markets have tightened. A limited liability seller or owner may have to expose its affiliates to some risk in order to provide the sort of credit enhanced cash flow subsidy that a lender will recognize for underwriting purposes. If the seller or owner does not have rated or otherwise obvious credit, all or a part of the master lease obligation can be secured by buyer holdbacks, deposits or letters of credit. In the context of a sale, the master lease is addressed in the sales contract, which will require the seller (or affiliate) to enter into the master lease at closing. Ideally, the form of master lease is pre-negotiated and is attached to the contract. Alternatively, the master lease may be negotiated during the buyer's due diligence period. Often, a portion of the purchase price is held back at closing and placed in escrow with the title company in order to fund or secure the payment of rent under the master lease. The balance of the funds in escrow, if any, may be disbursed to
seller when certain leasing or rental milestones are met for the property. The master lease will usually provide the seller with the right to seek out tenants for the master leased premises. The master lease will either specify minimum leasing terms for such third party leases or will set forth a mechanism whereby the seller presents the buyer with a lease proposal. The buyer will be obligated to enter into a lease that satisfies the agreed leasing terms or otherwise satisfies the mechanism for lease approval set forth in the master lease. In most master leases, the master lessee does not take actual possession of the leased premises and would not have responsibility for maintenance, repair or maintaining insurance. It can well be asked whether the master lease is a lease at all. Might it be viewed instead as a rent guaranty/cash flow subsidy that is nothing more than a reduction in the selling price? The answer depends on how you document the arrangement and who you ask. The IRS will ordinarily look to the substance rather than the form of the arrangement, and tax treatment may have both favorable and unfavorable implications to seller and buyer as further discussed below. For commercial law purposes, a master lease in true lease form creates rights that may
have to be extinguished through legal process. Master leases create all of the rights, remedies and defenses afforded tenants under local landlord/tenant laws. In the event of a master tenant default in the payment of rent, the master landlord would be required to institute eviction or similar proceedings in order to gain possession of the leased premises. This may be coupled with an action for the acceleration of the rent reserved under the master lease. Master leases will typically limit the remedy of rent acceleration to the discounted present day value of such rent. Furthermore, the master lessor may bound by certain common law and/or statutory duties to mitigate damages or defenses requiring that sums owed to the master lessor be reduced by a discounting factor. Finally, a master tenant could declare bankruptcy and benefit from the bankruptcy lease rejection mechanism and accompanying limitations on rental damages. All of this is obviously more involved than simply having the seller issue a rent guaranty. How much like a true lease a master lease will look will often follow from its primary purpose. Today's credit constricted market mandates master leases that look and feel like true tenant leases that will be credited by a buyer and lender rather than rent subsidies that might be given short shrift in underwriting, even though they provide the same economic
benefit. As suggested above, buyers and sellers should be mindful of the tax treatment of a master lease. It may advantage the seller to treat the master lease payments as true rent rather than as an adjustment to the selling price. Rental payments are usually ordinary and necessary business expenses which are deductible for income tax purposes. Subject to the federal passive loss restrictions, such rental deductions may offset ordinary income, which is taxed at marginal rates as high as 35%. If the seller were to treat the master lease payments as an adjustment to purchase price, it would reduce the capital gain attributable to the transaction. Since capital gains are taxed at 15% (25% on the gain attributable to recapture of depreciation), treating the payments as purchase price adjustments would result in a higher overall tax burden. For a buyer, master lease rents could be viewed as ordinary rental income or as a refund of purchase price. The tax treatment of master leases is less than clear given their non-possessory nature and the strong connection with the sale transaction. That said, documenting the master lease carefully can increase the likelihood that the intended tax consequences will be sustained. From a purely economic perspective, the negative impact of short term post-sale rental
payments under a master lease is likely to be outweighed by the benefit of a quick sale at a price that is reflective of the enhanced NOI that the master lease rents produce. In a crowded market, a property that is 100% leased (with the benefit of a partial master lease) may draw attention that an 85% property may not. Some say that a master lease only improves the optics of a property but not its fundamentals. That may well be, but in competitive markets, perception sometimes dictates the reality.