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Article Excerpt
This paper investigates the phenomenon of sale and leasebacks as one way in which firms may use financial contracts to rearrange their organizational architecture. A theoretic model links the length of initial leaseback period to incentives to make noncontractible future investments in the lease relationship and predicts that firms choose shorter leases when landlords make relatively important investments. Using a sample of 71 sale and leaseback events from the 1990s, we document a significant mean abnormal return of 1.3% for shareholders of seller/lessee firms announcing relatively short leasebacks. The evidence suggests that firms may use sale and leasebacks to optimize their claims to real estate.
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In this study, we investigate integration decisions by firms who engage in the sale and leaseback of commercial real estate. In a sale and leaseback, the firm sells an asset but simultaneously enters into a lease for its continued use. Sale and leasebacks have historically been considered financial contracts. This study differs from prior research, however, because we dispense with the assumption that leasebacks are all long-term financial leases. (1) In particular, we hypothesize that contractual hazards first proposed by Coase (1937) influence the firm's decision to use long-term leasebacks (continued integration of the real estate within the firm) versus short-term leasebacks (nonintegration). As applied to commercial real estate markets, this work suggests that in certain cases it is efficient for investors other than the user of an asset to own commercial real estate.
Prior studies have found that announcements of sale and leasebacks are associated with positive wealth effects for seller/lessee firms and that these wealth gains are attributable to the reallocation of tax benefits from the ownership of a durable asset to a firm who values the benefits more highly than the seller (Slovin, Sushka and Polonchek 1990, Rutherford 1990, 1992, Alvayay, Rutherford and Smith 1995, Ezzell and Vora 2001). Alvayay, Rutherford and Smith (1995), however, provide evidence that the value of taxes expropriated from the government through sale and leasebacks was reduced by the Tax Reform Act of 1986. Absent significant tax consequences, the extant financial theory suggests that announcements of sale and leasebacks should be similar to other announcements of debt.
We develop a model of the sale and leaseback in which the length of the initial leaseback influences the incentives of both the seller/lessee and the buyer/lessor to make future noncontractible investments in activities related to the real estate. Lease length matters when the returns to investment are dependent on the continuation of the leasing relationship and the investors anticipate that some of the returns may be appropriated by their contracting partner at the end of the lease. We show both that the choice of a leaseback period is endogenous to the decision to enter into a sale and leaseback and that the optimal choice depends on the relative importance of one party versus the other in producing joint wealth. The model predicts that firms optimally choose shorter lease lengths when there are positive wealth gains to be captured relative to continued ownership of the asset.
Using a sample of 71 sale and leaseback events involving commercial real estate between 1990 and 2000, we use standard event study methodology to document that there were no abnormal returns to the shareholders of seller/lessee firms for our full sample on the day of a sale and leaseback announcement (day 0). When we divide the sample into short (less than or equal to 15-year) or long (greater than 15-year) leasebacks, we document a mean abnormal return of 1.3% for shareholders of seller/lessee firms in the short subsample. The mean abnormal return associated with short leasebacks is significantly different from zero at the 5% level of significance and is also different from the mean abnormal return to lessee firms announcing long leasebacks at the 1% level. In multivariate analysis, we control for alternative explanations of wealth gains including the tax hypothesis. In all cases, a categorical set of indicators for the length of the initial leaseback retain their magnitude and significance in explaining abnormal returns to lessee firms. We conclude that short leasebacks are used when the buyer/landlord is expected to make relatively important contributions to the value of the relationship, and that the use of sale and leasebacks may efficiently reorganize a firm's claim to its real estate.
This paper proceeds as follows. Next we briefly review related literature about the nature of the firm. Then we develop a theoretical model that demonstrates the relationship between lease length and value of the sale and leasebacks; in an Appendix we derive some our theoretical results. Given our theoretical predictions, we introduce our sample and methodology and report our empirical results. The last section concludes.
Related Literature
Beginning with Coase (1937), financial economists have long tried to understand the nature of the firm. Our research is related to recent work in transaction cost economics and property rights theory that explain the decision of firms to own certain assets. The theory of vertical integration suggests that firms should own assets when potentially incomplete contracts expose them to future opportunistic behavior by their contracting partners (Klein, Crawford and Alchian 1978, Williamson 1979). If real estate needs to be highly specialized to a particular manufacturing process, for example, the firm faces a hold-up problem when it anticipates that the landlord will expropriate some of the value of the specialized leased space from the firm in the future. (2) There may be excess value for the landlord to appropriate once the firm has invested in modifications to the property whenever the space has greater value in its use to the firm than in an alternate use. When the returns to investment are highest in the current use of the real estate, the investment is said to be specific to the lease relationship. The theory of vertical integration suggests that a firm maximizes value by owning the assets in which it optimally makes specific investments.
While the reasoning behind the theory of vertical integration is somewhat anecdotal, recent property right models beginning with Grossman and Hart (1986) provide more completely specified models that consider the organization of the firm. The property right models assume that contracts are incomplete and focus on how the structure of contracts, and especially the ownership of assets, affects the incentives of either party to undertake future, unforeseen or noncontractible investments that generate value in context of the relationship. The models of Hart (1995) and Whinston (2003), for example, focus on the relative marginal contribution of each party in generating surplus future value as a determinant of the optimal degree of integration between contracting parties.
With respect to sale and leasebacks, we create a property rights model that investigates the incentives created by different lengths of the initial leaseback period. (3) We assume that the tenant benefits from any investments made during the initial lease term, but the remaining surplus from the relationship is distributed between the parties through renegotiation at the end of that period. Therefore, the choice of an initial lease length ex ante alters the incentives of either party to invest in the relationship ex post. Longer leases provide favorable conditions for tenant investment while shorter leases create some additional incentives for the landlord to invest. (4) Depending on the marginal contribution of each party to the total value of the lease, de-integrating the firm with respect to the ownership of its real estate may be wealth enhancing.
Financial economists have offered several additional explanations for why financial contracting influences firm value. In particular, Myers, Dill and Bautista (1976), Lewellen, Long and McConnell (1976) and Alvayay, Rutherford and Smith (1995) hypothesize that the wealth effects of sale and leasebacks that utilize financial leases differ from stock price reactions to debt announcements because of the tax consequences of sale and leasebacks. When buyers and sellers have different tax rates and abilities to utilize asset depreciation allowances, sale and leasebacks allow parties to generate wealth gains by expropriating wealth from the government. The main body of empirical evidence about sale and leasebacks supports the hypothesis that financial leases are perfect substitutes for secured debt except for their tax consequences under U.S. tax laws prevailing until 1986. Table 1 presents a summary of the existing empirical evidence about sale and leasebacks (market reactions to various debt issues are included for comparison).
Changes in tax laws during the late 1980s and early 1990s may have reduced the tax advantages of sale and leasebacks. Alvayay, Rutherford and Smith (1995) examine a set of real estate sale and leasebacks from 1982-1989. They predict that tax changes in the Tax Reform Act of 1986 had a negative impact on the tax benefits of sale and leasebacks, and their event study found supporting evidence. Most recently, Ezzell and Vora (2001) provide evidence that lessee firms' tax rates are negatively related to average cumulative abnormal returns for lessee firms announcing sale and leasebacks between 1984 and 1991. The study did not separate the sample or otherwise examine how changes in tax rules affected the observed wealth gains, however. It should be noted that subsequent to all of these sample periods in 1993, depreciation recovery periods for real estate were lengthened once again, which might be expected to further reduce the tax benefits available to be traded in sale and leasebacks. (5)
Smith and Warner (1979), Krishnan, Sivarama and Moyer (1994) and Barclay and Smith (1995b)...
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