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Reviewing Sale and Leaseback Transactions: Mechanism for Raising Productive Potential Noriko Ashiya Meikai University, Faculty of Real Estate

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1. Introduction

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In modern literature on real estate finance, it is accepted as fact that the current development of international accounting standards is leading towards a situation, in which the use of off- balance sheet finance through financial leases is becoming more difficult. Observing this, Grönlund, Louko and Vaihekoski (2008) examined other motives for sale and leaseback transactions; they studied more recent data using a sample of more than one hundred companies in the pan- European market, and empirically concluded that sale and leaseback could also be seen as a mechanism for revealing the hidden value of companys asset to the market.

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They also examined whether the sale-and- leaseback effect varies across property types; they collected information about the property types for the same sample; they empirically found that the said mechanism of the sale and leaseback transaction, or positive valuation effect of the transaction that will reveal the hidden value of the companys asset, differs on the basis of the property types. However, as they pointed out, not all the data included information about the property types that were sold.

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So, to counter this problem, they handpicked the corresponding information to complete the sample. In this study, in stead of enriching the data set, I will adopt a theoretical approach; with a model setting that indicates the rate of capital depreciation to clearly reflect the property types, I intend to fill the gap between the literature and details of recent sale and leaseback transactions.

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In contrast with Grönlund et al. (2008)s six different categories such as hotel, logistic, and so on, my classification will not have a definite category; in the model for this study, rates of capital depreciation, which will be supposed to have a wide range from low to high, will also be supposed to reflect various kinds of categories. The rate of capital depreciation, as studied in the following, will be shown to be a key factor that may determine the advantages in the use of corporate real estate sale and leaseback transactions.

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In short, this study has two objectives. The first is to formulate the advantages in the use of off-balance sheet financing through corporate real estate sale and leaseback transactions. The other, based on the above derived formulae, is to obtain criteria that make it possible for the company to choose the best property for such selling and leasing of corporate real estate.

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Note that, only through operational leases, will a company be able to guarantee such advantages; as described at the beginning, the use of off- balance sheet finance through financial leases is becoming more difficult. Therefore, for the purpose of the study, I will suppose that the company in the model executes an operational-type lease.

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It will be shown that the relative ratio of the chosen propertys rate of capital depreciation and real interest rate would determine such advantages in the sale and leaseback transactions; Table 1 presents a numerical example; it shows the combination of the two factors, the rate of capital depreciation and the nominal interest rate, which makes it possible for the seller-lessee company to decrease the capital cost; from the point of view of the company, such a decrease meets the higher level of the optimal quantity of capital, and, therefore, new investments will be encouraged.

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Based on general economic theory, a company produces on the principle of profit maximization; it chooses an amount of Optimal Capital Stock, with which the amount of production will also be optimal, and so the profit will be maximized. From a long-term perspective, the amount of capital stock will be adjusted in a positive direction, and so, the company, with more Optimal Capital Stock, could produce more, i.e., increase the output.

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These findings suggest a role for corporate real estate sale and leaseback as a mechanism for raising a companys productive potential. Subsequent to the transaction, the seller-lessee company would have another way to increase the efficiency of the use of its corporate capital (corporate real estate), even though the current amount of capital stock is seen as optimal in view of the companys principle to maximize its long-term profit.

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Moreover, these findings will be applied to an analysis for Europe. Since the model in this paper sets the nominal interest rate as given and exogenous, the model can also be seen to suppose an economy that simply reflects the key characteristics of the economy in the Euro zone. For the model, this study assumes a given and exogenous type of nominal interest rate, which, from the seller-lessee companys point of view, is uncontrollable by itself, and tends to be unfit for its favorable business surroundings. In addition, recall that this study will adopt a theoretical approach and intends to complement the missing information prior to the Grönlund et al. (2008)s pan- European sample of sale and leaseback transactions, i.e., information about the property types.

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This is why the findings of this paper contrast with those in the study of Grönlund et al. (2008)s. They used pan-European data and empirically presented an aspect of a value revealing mechanism in the corporate real estate sale and leaseback transaction; this study extends the traditional theory of firms in the Euro-zone-like setting and theoretically presents an aspect of a value creating mechanism in the same sale and leaseback transaction.

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As for the analytical aspect, in this study, I will adopt an accounting point of view; I will focus on a case in which the company can use the off-balance sheet finance and abstract such advantages from a system of taxation. The setting is in line with the findings of Grönlund et al. (2008) that the tax savings were not the only motivation for sale and leaseback transaction; it makes it possible to highlight the seller companys status of the capital held, and so the roles of the capital cost, capital accumulation, and corresponding motive for new investments will also be highlighted.

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2. Formula that Calculates the Off-balance Sheet Advantages

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2.1. Economic framework, terms and expressions To formulate the advantages in the use of off- balance sheet finance through corporate real estate sale and leaseback transactions, I use a general economic framework. I assume the representative company engages in the production of Y (output) using its production technology comprised of K (capital) and L (labor); the companys objective is to maximize its (profit).

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Note that the term capital, in the model, possesses a meaning equivalent to real estate. This simple assumption makes it possible to extend the said general model in the more specific context of a corporate real estate sale and leaseback transaction.

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To evaluate the corporate real estate sale and leaseback advantages, I need a setting that clearly presents the link between the current business areas of the seller-lessee company and amounts of capital being utilized in corresponding areas.

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For this, firstly, I assume that the company has two types of capital, Core Capital Kf and Non- Core Capital K0, in the ratio of (1–α) : α. Core Capital is the capital that is being utilized for the core business of the company, such as plants or factories. Non-Core Capital is for the companys non-core business, such as the operation of administrative offices.

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Secondly, I assume that the company has already maximized its profit, not only from the short term perspective but also from the long term perspective. This assumption implicitly supposes a situation in which the company already holds the most desirable quantity of capital stock (Optimal Capital Stock); and therefore, the company does not have an incentive to make new investments or make new capital accumulations.

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That is, the Optimal Capital Stock K* equals the total of Kf and Ko, denoted by K. Core Capital is defined as Kf = (1–α) K* and Non-Core Capital is defined as Ko = α K*.

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To get clear and plausible results, I select two other factors to model the corporate real estate sale and leaseback transaction: the risk burden rate of the seller-lessee company, denoted by β, and the rate of increase in the payment for the capital after the sale and leaseback transaction, denoted by γ.

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In addition, according to the general theory, I need the nominal interest rate, denoted by i, and real interest rate, denoted by r. To substitute the nominal interest rate into the real interest rate, I use the Fisher Equation, i = r + πe, where the symbol πe denotes the inflationary rate.

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Note that the model distinguishes the general price, denoted by P, and the unit capital price, denoted by Pk. Another expression for πe is ΔP/P, where P represents the change in the general price. In contrast, with the expression of Pk/Pk, where Pk represents the capital gain, I express the change in the unit capital price.

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As for the capital depreciation, the model assumes that the capital depletes at a rate δ (the rate of capital depreciation). Thus, δ PK expresses the amount of capital depletion. The expression iPk represents the companys opportunity cost, which is equivalent to the interest income that would have been earned if the company had not acquired any new capital, but, instead, had invested the same amount.

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Note that the model denotes two kinds of capital costs. The company must pay the cost per unit of utilizing capital (Unit Capital Cost), denoted by R, prior to the undertaking of the sale and leaseback transaction; the company must pay R^, subsequent to the same transaction.

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Based on the discussions in the introduction, the model in this study sets the nominal interest rate as given and exogenous, which implicitly assumes that the nominal interest rate in the model works as the unit policy interest rate applied in the Euro zone. It also assumes the Fisher equation, which provides the method of substitution between the nominal interest rate and the real interest rate, to be valid.

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To get an accurate and plausible conclusion, it is important to select a right variable that measures the diversity of the properties sold and leased. In contrast with Grönlund et al. (2008)s study, which classified the transactions into six different categories on the basis of the property type sold and leased, I use the rate of capital depreciation as a representative factor. As explained in the introduction, the range of the rate of capital depreciation will be a clear reflection of such property types.

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2.2. Scheme for sale and leaseback transaction (Insert Figure 1 around here)

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2.3. Off-balance sheet advantages The Unit Capital Cost prior to the undertaking of the sale and leaseback transaction, denoted by R, is calculated using equation (1) below. R = iP K - P K + δ P K (1) The Unit Capital Cost subsequent to the undertaking of the sale and leaseback transaction, denoted by, is calculated using equation (2) below. R^ = (1–α)(iP K -P K +δP K ) – α{[iP K -(1–β)P K +δP K ]–(1+γ)P K } (2)

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Then, the difference between equations (1) and (2), which equals the amount of the unit-capital-cost-advantage in the use of off- balance sheet finance, is determined as: – α [2(iP K - P K + δ P K ) + βP K – (1+γ) P K ] (3) Note that, when the sale and leaseback causes cost deduction, a sign in (3) is negative. So, to represent such an advantage in sale and leaseback transactions more intuitively, I removed a minus sign from (3) and call it the Off-Balance Sheet Advantage.

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3. Criteria to Choose Properties for Sale and Leaseback

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3.1. Off-balance sheet advantage condition Based on the discussions in the introduction, with the analytical framework presented in the former section, one of the criteria that makes it possible for the seller-lessee company to choose the best property for corporate real estate sale and leaseback transactions is obtained as follows: Theorem 1 (Positive Off-Balance Sheet Advantage Condition): (4)

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Proof: Since a negative sign in (3) implies that the seller-lessee company could achieve a decrease in the capital cost, put a sign of inequality, <, on to (3). By rearranging the condition, (4) can be obtained simultaneously. Q.E.D.

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Theorem 1 implies that the rate of increase in the capital price must be kept within a certain range so that the seller-lessee company expects cost reduction and fund raising via off-balance sheet financing. From the point of view of the company, an increase in the capital price has two implications: negative and positive. While the cost of leaseback rises, the capital gain, which, in the present model, is supposed to be earned in proportion to the companys risk burden rate of β(×100)%, will also rise. Theorem 1 shows that the change in the lease payment and change in the capital price should have certain values and relations.

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3.2. Condition in real terms To study the findings of Theorem 1 (Positive Off-Balance Sheet Advantage Condition) further, I use the Fisher Equation to transform (4), written with the nominal interest rate, into an equation with the real interest rate. Theoretically, a condition in real terms has a direct impact on the possible alternative strategies of the modeled company. Thus, such a transformation allows me to detect key factors that the company should consult in order to obtain the advantages in the use of off-balance sheet finance through the sale and leaseback transactions. As explained in Section 2, this study assumes the validity of the Fisher Equation.

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To highlight the key factors, I set the following two assumptions: γ = 0 and β = 0. The condition γ = 0 applies to the case where there are no increases in rent, and conveys the fact that the lease payment incurred from a leaseback transaction is equivalent to the opportunity cost arising from using the same quantity of capital. The condition β = 0 applies to the case in which the seller-lessee company bears a zero risk burden rate.

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In addition, to simplify the model, I assume Pk/Pk = ΔP/P, i.e., the rate of increase in the price of capital equals the rate of increase in general prices. Recall that the present model starts with an assumption that the seller-lessee company has already maximized its long-run profit. In other words, the model takes a long-term perspective. Since, in the long run, the condition Pk/Pk = ΔP/P generally holds, even though the present model sets the same assumption of Pk/Pk = ΔP/P, the generality of the findings will be maintained.

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Under these assumptions, the Positive Off-Balance Sheet Advantage Condition, presented in Theorem 1, is transformed into: Theorem 2 (Positive Off-Balance Sheet Advantage Condition in Real Terms): (5)

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Proof: Substitute the following conditions, γ = 0, β = 0 and Pk/Pk = ΔP/P in (4), and use the Fisher Equation. Then, with a slight rearrangement, (5) can be obtained simultaneously. Q.E.D.

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Theorem 2 implies that when the sum of the two factors, the nominal interest rate and the rate of capital depreciation, rises above a certain level, the seller- lessee company could achieve a decrease in the capital cost. From the point of view of the seller company, such a decrease meets the higher level of the optimal quantity of capital, and, therefore, new investments will be encouraged.

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Note that (5) can also be transformed into. And, to interpret this condition, recall that the present model sets the nominal interest rate as given. Since the model assumes the validity of the Fisher Equation, under those settings, the real interest rate will also be a given variable.

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This is why this study can take the right hand side of,, as given, and can re-interpret the formula as follows. The formula shows that the relative ratio of the chosen propertys rate of capital depreciation and real interest rate, expressed by, would determine the off- balance sheet advantages in the corporate real estate sale and leaseback transactions.

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3.3. Criteria for choosing the best property As a final study, I examine further the insights of Theorem 2. Since Theorem 2 is expressed in real terms, as explained above, it has a direct impact on the economic activity of each unit. It highlights two factors, the rate of capital depreciation, denoted by δ, and the real interest rate, denoted by r, and so, I can present Figure 2 (strategies of the seller-lessee company) which also highlights the said two factors.

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As explained in Section 2, with the setting of given nominal interest rates, the real interest rate r is determined by π e. So, to depict Figure 2, I converted the conditions expressed with r, into those with π e. In so doing, note that, π e can generally be seen as the most important economic indicator. In the model of this study, also in Figure 2, π e indicates the business environment given to the company.

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(Insert Figure 2 around here)

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Theorem 3 (Criteria for choosing the best property): 1 st criterion: δ (rate of capital depletion) is high. 2 nd criterion: sign of π e (rate of increase in general prices) is negative, i.e., deflation. 3 rd criterion: inflation, but positive sign of π e is low, i.e., low inflation with high r (real interest rate).

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Theorem 3 makes clear the link between the companys possible strategies and its business surroundings. It shows which kind of property the company should choose for sale and leaseback transactions, according to the move on the general price. And not that, as presented in Figure 2, higher/lower π e implies lower/higher r, which implicitly determines the seller-lessee companys business environment in the Euro-zone-like economy.

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3.4. Numerical example To clearly show the insights of Theorem 3, I take the following example presented in Table 1. Table 1 calculates, which corresponds to, the expression on the left-hand side of (5), presented in Theorem 2. (Insert Table 1 around here)

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4. Summary

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In this study, I have examined the advantages in the use of off- balance sheet financing through the sale and leaseback transactions. My theoretical findings indicate that the impact of off-balance sheet finance will be realized as a stimulus for investments, even though the seller-lessee company has already achieved its objective of maximizing profit from a long term perspective. This result was obtained in a model that reflects the economy in Euro-zone, i.e., the economy that sets a common and unique policy interest rate for various member countries. For the model, this study assumed a given and exogenous type of nominal interest rate, which, from the seller-lessee companys point of view, is uncontrollable by itself, and tends to be unfit for its favorable business surroundings.

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Recall that this study adopted a theoretical approach and intended to complement the missing information prior to the Grönlund et al. (2008)s pan-European sample of sale and leaseback transactions, i.e., information about the property types. That is, I took a different approach to link the information of the property types sold and leased to the actual sale and leaseback transactions. This is why I called the findings of this study a mechanism for raising the companys productive potential, in contrast with Grönlund et al. (2008)s finding of the sale and leasebacks mechanism for revealing the hidden value of a companys assets to the market. As for the analytical aspect, I adopted an accounting point of view; I focused on a case in which the company can use the off-balance sheet finance and abstract such advantages from a system of taxation. It should also be noted that former studies such as Slovin et al. (1990) and Alvayay et al. (1995) empirically found the advantages from the system of taxation.

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My main findings are summarized as follows. First, for the seller-lessee company to expect the off-balance sheet advantages in the use of the corporate real estate sale and leaseback transactions, the rate of increase in the capital cost, Pk/Pk, must be kept within a certain range,.

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Second, the relative ratio of the sold and leased propertys rate of capital depreciation and real interest rate would determine the capital cost advantage in the sale and leaseback transactions; when the sum of the two rises above a certain level, a company could achieve a decrease in the capital cost.

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Finally, based on the criteria presented in Theorem 3, the company could choose the best property to be sold and leased. Simply put, Theorem 3 suggests the following criteria: for the company to choose properties with high δ for sale and leaseback transactions; for the company to check the sign of π e so that it could estimate r and the corresponding business environment; if the sign is positive, low inflation would be preferable for the company to obtain off-balance sheet advantages.

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The limitation of this study could also be summarized as follows. As Table 1 showed, the possible combination of δ and r does not always satisfy (Theorem 2). Or, for the company to always expect the off-balance sheet advantages, r might be above, for example, 50%; only within the limited range of r, the condition will be valid.

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Why did such a gap between theory and practice emerge? The possible explanation is that this gap came from the setting of the present model, which focused on the roles of δ and r in the advantageous sale and leaseback transactions. As explained above, my simple model made the present analysis tractable and made it possible to clearly show the criteria for the company to choose the best property for the sale and leaseback transactions.

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Thus, it would be of interest to detect the other key factors that may fill the said gap between theory and practice. For this, one possible extension is the inclusion of the said tax saving effect, sale and leaseback advantages from the system of taxation. In this study, as shown in Section 3, I could present the suggestive finding: when the sum of the rate of capital depreciation and the real interest rate rises above a certain level, a company could achieve a decrease in the capital cost; intuitively, the greater each of the two factors, the more probable the company could obtain the off-balance sheet advantages. For further research, a simulation would play an important role.

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Thank you very much indeed. Reviewing Sale and Leaseback Transactions: Mechanism for Raising Productive Potential by Noriko Ashiya Meikai University, Faculty of Real Estate

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