2004 V32 4: pp. 619–643

REAL ESTATE

ECONOMICS

The Wealth Effects of Sale and Leasebacks:New EvidenceLynn M. Fisher∗

This paper investigates the phenomenon of sale and leasebacks as one way inwhich firms may use financial contracts to rearrange their organizational archi-tecture. A theoretic model links the length of initial leaseback period to incen-tives to make noncontractible future investments in the lease relationship andpredicts that firms choose shorter leases when landlords make relatively im-portant investments. Using a sample of 71 sale and leaseback events from the1990s, we document a significant mean abnormal return of 1.3% for sharehold-ers of seller/lessee firms announcing relatively short leasebacks. The evidencesuggests that firms may use sale and leasebacks to optimize their claims toreal estate.

In this study, we investigate integration decisions by firms who engage in thesale and leaseback of commercial real estate. In a sale and leaseback, the firmsells an asset but simultaneously enters into a lease for its continued use. Saleand leasebacks have historically been considered financial contracts. This studydiffers from prior research, however, because we dispense with the assumptionthat leasebacks are all long-term financial leases.1 In particular, we hypothesizethat contractual hazards first proposed by Coase (1937) influence the firm’sdecision to use long-term leasebacks (continued integration of the real estatewithin the firm) versus short-term leasebacks (nonintegration). As applied tocommercial real estate markets, this work suggests that in certain cases it isefficient for investors other than the user of an asset to own commercial realestate.

Prior studies have found that announcements of sale and leasebacks are asso-ciated with positive wealth effects for seller/lessee firms and that these wealthgains are attributable to the reallocation of tax benefits from the ownershipof a durable asset to a firm who values the benefits more highly than theseller (Slovin, Sushka and Polonchek 1990, Rutherford 1990, 1992, Alvayay,Rutherford and Smith 1995, Ezzell and Vora 2001). Alvayay, Rutherford and

∗Massachusetts Institute of Technology, Cambridge, MA 02139 or lfisher@mit.edu.

1 Financial leases are defined by Copeland and Weston (1983) as leases that are separablefrom maintenance activities, are noncancelable and which fully amortize the leased asset.

620 Fisher

Smith (1995), however, provide evidence that the value of taxes expropriatedfrom the government through sale and leasebacks was reduced by the Tax Re-form Act of 1986. Absent significant tax consequences, the extant financialtheory suggests that announcements of sale and leasebacks should be similarto other announcements of debt.

We develop a model of the sale and leaseback in which the length of the initialleaseback influences the incentives of both the seller/lessee and the buyer/lessorto make future noncontractible investments in activities related to the real es-tate. Lease length matters when the returns to investment are dependent on thecontinuation of the leasing relationship and the investors anticipate that someof the returns may be appropriated by their contracting partner at the end ofthe lease. We show both that the choice of a leaseback period is endogenousto the decision to enter into a sale and leaseback and that the optimal choicedepends on the relative importance of one party versus the other in produc-ing joint wealth. The model predicts that firms optimally choose shorter leaselengths when there are positive wealth gains to be captured relative to continuedownership of the asset.

Using a sample of 71 sale and leaseback events involving commercial real estatebetween 1990 and 2000, we use standard event study methodology to documentthat there were no abnormal returns to the shareholders of seller/lessee firms forour full sample on the day of a sale and leaseback announcement (day 0). Whenwe divide the sample into short (less than or equal to 15-year) or long (greaterthan 15-year) leasebacks, we document a mean abnormal return of 1.3% forshareholders of seller/lessee firms in the short subsample. The mean abnormalreturn associated with short leasebacks is significantly different from zero at the5% level of significance and is also different from the mean abnormal returnto lessee firms announcing long leasebacks at the 1% level. In multivariateanalysis, we control for alternative explanations of wealth gains including thetax hypothesis. In all cases, a categorical set of indicators for the length of theinitial leaseback retain their magnitude and significance in explaining abnormalreturns to lessee firms. We conclude that short leasebacks are used when thebuyer/landlord is expected to make relatively important contributions to thevalue of the relationship, and that the use of sale and leasebacks may efficientlyreorganize a firm’s claim to its real estate.

This paper proceeds as follows. Next we briefly review related literature aboutthe nature of the firm. Then we develop a theoretical model that demonstratesthe relationship between lease length and value of the sale and leasebacks;in an Appendix we derive some our theoretical results. Given our theoreticalpredictions, we introduce our sample and methodology and report our empiricalresults. The last section concludes.

The Wealth Effects of Sale and Leasebacks 621

Related Literature

Beginning with Coase (1937), financial economists have long tried to under-stand the nature of the firm. Our research is related to recent work in trans-action cost economics and property rights theory that explain the decision offirms to own certain assets. The theory of vertical integration suggests thatfirms should own assets when potentially incomplete contracts expose themto future opportunistic behavior by their contracting partners (Klein, Crawfordand Alchian 1978, Williamson 1979). If real estate needs to be highly spe-cialized to a particular manufacturing process, for example, the firm faces ahold-up problem when it anticipates that the landlord will expropriate some ofthe value of the specialized leased space from the firm in the future.2 Theremay be excess value for the landlord to appropriate once the firm has investedin modifications to the property whenever the space has greater value in itsuse to the firm than in an alternate use. When the returns to investment arehighest in the current use of the real estate, the investment is said to be specificto the lease relationship. The theory of vertical integration suggests that a firmmaximizes value by owning the assets in which it optimally makes specificinvestments.

While the reasoning behind the theory of vertical integration is somewhat anec-dotal, recent property right models beginning with Grossman and Hart (1986)provide more completely specified models that consider the organization of thefirm. The property right models assume that contracts are incomplete and focuson how the structure of contracts, and especially the ownership of assets, affectsthe incentives of either party to undertake future, unforeseen or noncontractibleinvestments that generate value in context of the relationship. The models ofHart (1995) and Whinston (2003), for example, focus on the relative marginalcontribution of each party in generating surplus future value as a determinantof the optimal degree of integration between contracting parties.

With respect to sale and leasebacks, we create a property rights model thatinvestigates the incentives created by different lengths of the initial leasebackperiod.3 We assume that the tenant benefits from any investments made dur-ing the initial lease term, but the remaining surplus from the relationship is

2 The hold-up problem arises from the fact that the firm may not, in fact, invest in aproject if some of the returns are expected to be captured by the landlord.3 There is good precedent for expecting lease length to vary with hold-up problems.See Klein, Crawford and Alchian (1978), Mulherin (1986) and Joskow (1987), amongothers. We also assume that options to renew the contract are priced in the initial contract,but that a right to renew does not avoid the renegotiation of the exact terms of the contractwhen the first lease expires.

622 Fisher

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 ofeither party to invest in the relationship ex post. Longer leases provide favorableconditions for tenant investment while shorter leases create some additional in-centives for the landlord to invest.4 Depending on the marginal contribution ofeach party to the total value of the lease, de-integrating the firm with respect tothe ownership of its real estate may be wealth enhancing.

Financial economists have offered several additional explanations for why fi-nancial contracting influences firm value. In particular, Myers, Dill and Bautista(1976), Lewellen, Long and McConnell (1976) and Alvayay, Rutherford andSmith (1995) hypothesize that the wealth effects of sale and leasebacks thatutilize financial leases differ from stock price reactions to debt announcementsbecause of the tax consequences of sale and leasebacks. When buyers and sell-ers have different tax rates and abilities to utilize asset depreciation allowances,sale and leasebacks allow parties to generate wealth gains by expropriatingwealth from the government. The main body of empirical evidence about saleand leasebacks supports the hypothesis that financial leases are perfect substi-tutes for secured debt except for their tax consequences under U.S. tax lawsprevailing until 1986. Table 1 presents a summary of the existing empiricalevidence about sale and leasebacks (market reactions to various debt issues areincluded for comparison).

Changes in tax laws during the late 1980s and early 1990s may have reduced thetax advantages of sale and leasebacks. Alvayay, Rutherford and Smith (1995)examine a set of real estate sale and leasebacks from 1982–1989. They predictthat tax changes in the Tax Reform Act of 1986 had a negative impact on the taxbenefits of sale and leasebacks, and their event study found supporting evidence.Most recently, Ezzell and Vora (2001) provide evidence that lessee firms’ taxrates are negatively related to average cumulative abnormal returns for lesseefirms announcing sale and leasebacks between 1984 and 1991. The study didnot separate the sample or otherwise examine how changes in tax rules affectedthe observed wealth gains, however. It should be noted that subsequent to allof these sample periods in 1993, depreciation recovery periods for real estate

4 That financial leases can allow tenants to exercise considerable control over real estateanalogous to ownership of the asset seems likely in the case of sale and leasebacks.Anecdotal evidence suggests that “the seller-lessee brings the property to the table andconsequently possesses more significant bargaining power than an average tenant in atypical lease negotiation. Accordingly, a seller-lessee can use its leverage to negotiateleases that allow it to control maintenance and alterations, have substantial and variedassignment and subletting rights, enjoy lengthy initial and renewal terms and control theoperation of the property” (Fodor and Kiely 2003, p. 4).

The Wealth Effects of Sale and Leasebacks 623

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624 Fisher

were lengthened once again, which might be expected to further reduce the taxbenefits available to be traded in sale and leasebacks.5

Smith and Warner (1979), Krishnan, Sivarama and Moyer (1994) and Barclayand Smith (1995b) note that financial leases may mitigate costs to the lessor indefault relative to the costs of a secured lender. Since the lessor is technicallythe owner of the asset, the lessor has better priority than a lender who holds amortgage lien if the lessee goes into default or bankruptcy. Krishnan, Sivaramaand Moyer (1994) and Sharpe and Nguyen (1995) provide empirical evidencethat firms with high costs of capital are more likely to lease. In addition, Barclayand Smith (1995a) find that firms suffering greater asymmetric informationproblems (and therefore a higher cost of capital) are more likely to utilizeshort-term debt financing. If credit-constrained firms are more likely to leaseand to utilize shorter debt maturities, then controlling for whether selling/leasingfirms are credit constrained may be an important robustness check of any resultslinking leaseback length to wealth gains.

Our sample of real estate sale and leasebacks provides an opportunity to em-pirically examine the integration decision of the firm for several reasons. Mostimportantly, the nature of the transaction requires firms to explicitly choosea lease length, and as mentioned previously, we observe both short and longleaseback arrangements by public firms over real estate in the 1990s. Second,while market contracts including leases are well known to incur other contract-ing costs, namely agency costs, there are good reasons to believe that thesecosts are mitigated in the case of commercial leases over durable real estateassets, which allows us to focus mainly on the integration decision.6 Third, bydefinition, the seller/lessee already owns the real estate and continues to occupythe space after the sale and leaseback deal is in place. Therefore, the sale andleaseback event is not confounded by the disposition of the seller/lessee firm’suse of the asset. Finally, sale and leasebacks offer interesting evidence aboutthe relationship between capital structure and the theory of the firm as recentlyinvestigated by Zingales (2000) and Smith (2001).

5 Our sample of sale and leasebacks includes only two observations that occur prior to1993 and only one of these has sufficient information to calculate a proxy for its taxrate, so we are unable to investigate how tax benefits of sale and leaseback potentiallychanged after 1993.6 Recent theory and empirical evidence suggest that there exist sources of economicgains from commercial real estate leasing which may dominate expected agency costs.According to Benjamin, de la Torre and Musumeci (1998, p. 223) the “primary factorsin favor of leasing are the abilities of landlords and property managers to eliminatefree-rider problems, to exploit economies of scale, and to specialize in the valuation,maintenance and disposal of commercial property.”

The Wealth Effects of Sale and Leasebacks 625

A Sale and Leaseback Model

In this section, we develop a theoretic model to guide our investigation. Themodel is closely related to recent work by Hart (1995) and Whinston (2003)in which contracts are assumed to be incomplete. At time 0 in our model,the seller/lessee and the buyer/lessor decide to enter into a sale and leasebackagreement. They agree on all contractible events and settle on a market transferprice, which the buyer pays the seller at time 0. The parties simultaneouslycreate a lease that is a single-tenant, triple net lease with a fixed rental paymentat the beginning of the lease period. The length of the initial leaseback periodis x, where we normalize the lease relative to the remaining economic life ofthe improved real estate, 0 < x ≤ 1.7 One issue with the lease is that some futureinvestments by the seller/lessee and the buyer/lessor cannot be written into thecontract ex ante.8 For example, the lessee may be unable to fully anticipate futureneeds with respect to business operations at this location. The lessee may needto make modifications to the real estate itself or invest in marketing for a newproduct that that will be sold from this location. A lessor, on the other hand,may consider investment in new technologies to improve the productivity of thebuilding. Hart (1995) describes an incomplete contract as one that will “havegaps, missing provisions, or ambiguities, and so situations will occur in whichsome aspects of the uses of non-human assets are not specified” (p. 29). Even ifsome investments are anticipated, their exact magnitude and affect on businessrevenues may not be describable ex ante.

As is common in the literature, we assume that both the tenant and the landlordcan observe each other’s investment level and cost functions, but, even if antic-ipated, some investments are either too complicated to write into a contract orunverifiable to a third party and therefore the investments are noncontractible.Even more simply, some investments may simply not be anticipated at time 0.We denote the noncontractible level of investment by the tenant and landlord byi ∈ R+ and e ∈ R+, respectively, and the cost of investment by ci (i) and ce(e).We assume that the cost functions are convex in their arguments.9 Noncon-tractible investments are assumed to include a whole range of investments ineither the real estate itself or the activities of the firms at the particular location.

7 We assume that renegotiation is costly and therefore a series of “spot” contracts issufficiently costly to be ignored.8 Some future investments are contractible and are therefore able to be written intothe lease. For example, tenant improvements are a common investment included inthe initial lease. Whinston (2003) shows that neither sunk nor contractible investmentsaffect the likelihood of integration. For clarity, we suppress contractible investmentsin the following model assuming that appropriate transfer pricing has already beenestablished.9 See, for example, the assumed functional form in Whinston (2003).

626 Fisher

While the noncontractible investments in question can be made any time duringthe initial leaseback period, we assume that the timing of the investments areexogenously determined, and to simplify the model, we assume that all invest-ments are made immediately following the sale and leaseback agreement attime 0. We also assume for simplicity that renegotiation occurs at time x. Eachparty’s discount rate is assumed to be 0, and there is no risk of default. Let therevenue generated during the remaining life of the real estate asset from theinvestment i when the tenant and landlord continue in their leasing relationshipbe denoted by R(i) and the revenue from the buyer/lessor’s noncontractibleinvestment be denoted by S(e), where R(0) = 0 and S(0) = 0. Denote totalrevenues from the relationship after noncontractible investments have beenmade by π = R(i) + S(e) and let these revenues be evenly distributed over theremaining life of the real estate. We assume that ∂R/∂i ≥ 0 and ∂S/∂e ≥ 0.

Whether or not the parties realize the total revenue stream from their noncon-tractible investments may depend on whether or not the parties continue intheir relationship after time x. Denote by r (i) ≥ 0 the tenant’s total revenuefrom investment if the investment is made in the current location but realizedin the tenant’s next-best market lease, and by s(i, e) ≥ 0 the landlord’s rev-enue from noncontractible investments made now but realized in his next-bestleasing arrangement. The extent to which R(i) differs from r (i) and S(e) froms(i, e) captures the degree to which investments are specific to the sale andleaseback relationship. Using the prior example of an investment in marketingfor retail goods sold at the site, suppose that the advertisements included theaddress of the tenant’s current location when the investment was made. Thepayoff to this investment would be reduced if the tenant were to move to a newsite. The revenues may not be diminished completely since awareness of theproduct was generated, but even if she relocates right across the street, the ex-pected revenues will be reduced by the cost of the inaccurate information aboutthe tenant’s location. If the tenant’s noncontractible investment is in real estateimprovements, then there may be no value of this investment in an alternatelease for the tenant. Notice that the buyer/lessor’s investment, e, does not affectthe payoff of the tenant’s outside option, r, since the tenant’s next-best alterna-tive involves another landlord and building. On the other hand, the landlord’salternate revenue stream may be influenced by the investments made by bothhimself and the prior tenant (to the extent that the tenant’s investments were inthe real estate).10

10 Prior to the sale and leaseback agreement, had the seller/tenant merely hired a managerto operate the property, the owner/tenant could have fired the manager in the event ofdisagreement and hired a new manager with a payoff from the continued use of the assetof r (i, e). The manager’s payoff in such scenario would have been unaffected by theowner/tenant’s investments, s(e).

The Wealth Effects of Sale and Leasebacks 627

We assume that each party’s investment is at least as valuable in the context ofthe current relationship as compared to alternative trading relationships in thesense that ∂R/∂i ≥ (∂r/∂i) + (∂s/∂i) and ∂S/∂e ≥ ∂s/∂e, and that π ≥ r + s,so that it is efficient for the parties to renew the lease at time x. We are concernedwith the value of the next-best alternatives r and s, not because we expectthe tenant and landlord to fail to renew the lease, but because the value ofeach party’s alternative affects the surplus to be negotiated over at time x,and therefore affects the incentives of each party to undertake noncontractibleinvestments. Although we assume that the parties create the initial sale andleaseback agreement under competitive conditions, once specific investmentshave been made, they find themselves in a bilateral monopoly whenever theymust renegotiate the contract because each party can “hold up” the other througha threat of nonrenewal. We assume that both parties anticipate renegotiation andNash bargaining over any surplus from their relationship (and that each has equalbargaining power). Define the total surplus value generated by noncontractibleinvestments as V ≡ π − r − s.

The choice of lease length alters the proportion of the surplus that each partyexpects to claim in renegotiation in the following way. Since we assume thatleaseback involves a triple net lease with the rent paid to the landlord at time 0,the tenant realizes all of the revenue generated by noncontractible investmentsmade by herself and the landlord during the first lease term. Recall that the maincharacteristic of this model is that the sale and leaseback contract is incompletein some way. The exact magnitude of the surplus that results from decisionstaken in these unspecified situations will not be known at time 0 and thereforecannot be explicitly written into contract. Therefore, each party recognizes thatat time x they will negotiate over the remaining revenue from noncontractibleinvestments made during the initial lease and split any surplus above and beyondthe “threat point” of their outside options. We have assumed that revenues areevenly distributed through time; therefore the remaining surplus is (1 − x)V .

The main implication of the model is that the choice of x influences the value ofthe relationship through the incentives it creates for each party to undertake non-contractible investments. The total revenue from noncontractible investmentsis therefore rewritten as π = R(i(x)) + S(e(x)). To see this point more clearly,consider that immediately following time 0 and given a lease of length x, thetenant optimally and noncooperatively chooses i according to

maxi

xπ + (1 − x)

(r + 1

2V

)− ci (i).

Here, the tenant’s objective function is comprised of the proportion of noncon-tractible total revenue that is realized during the initial lease period, plus for

628 Fisher

the remaining period, the value of her investment in the next-best alternativeplus one-half the surplus value of the relationship, less her costs of investment.Substituting V ≡ π − r − s, we obtain

1

2(1 + x)

∂R

∂i+ 1

2(1 − x)

(∂r

∂i− ∂s

∂i

)= ∂ci

∂i. (1)

Denote by i(x) the solution to (1).

For the landlord, the problem is

maxe

(1 − x)

(s + 1

2V

)− ce(e).

The landlord’s objective function is comprised of the payoff that he negotiatesat time x. The payoff includes the remaining value of his investment in thenext-best alternative plus one-half of the relationship’s surplus value, less thecost of his investment. The landlord’s optimal (and noncooperative) investmentlevel solves

1

2(1 − x)

(∂S

∂e+ ∂s

∂e

)= ∂ce

∂e. (2)

Denote by e(x) the solution to (2).

Notice that i(x) is increasing in the length of the lease. Correspondingly, thelessor’s optimal noncooperative investment level, e(x), is decreasing in leaselength. In addition, given the assumptions of the model, if x = 1, then e(x) = 0,which means that a long-term lease over the remaining economic life of the realestate evokes no noncontractible investment by the lessor.

The socially optimal levels of seller/lessee and buyer/lessor investment, i∗ ande∗, solve

maxi,e

R(i) − ci (i) + S(e) − ce(i).

Our model is again consistent with the idea that a long-term lease is analogousto ownership of the asset by the seller/lessee. Referring to (1), if x = 1, theseller/tenant invests in a socially optimal manner and i(x) = i∗. If x < 1, how-ever, the seller/lessee’s choice of noncontractible investment level is generallyless than the socially optimal level. Importantly, we find that for any choice of x,the buyer/lessor’s choice of noncontractible investment level, e(x), is generallyless than the socially optimal level, e∗. This result occurs because the lessor’s

The Wealth Effects of Sale and Leasebacks 629

payoff is always reduced by having to wait until the end of the lease to negoti-ate and receive a return on investment, and even then the lessor only receivesa proportion of the relationship-specific return. These claims are derived in theAppendix.

Now consider the value of a sale and leaseback. When a firm owns and occupiesits real estate prior to time 0 (in the sense of fee simple ownership), we assumethat there are no contracts involving any other parties with respect to the realestate. Denote the value that accrues to the firm from noncontractible investmentin the real estate when the firm decides not to sell at time 0 by WR = R(i∗) −ci (i∗).11 Define W0 as the joint wealth resulting from a sale and leasebackagreement with respect to the same real estate at time 0,

W0 = R(i(x)) − ci (i(x)) + S(e(x)) − ce(e(x)).

The change in total wealth attributable to the real estate that results from a saleand leaseback agreement is, therefore,

W0 − WR = [R(i(x)) − ci (i(x))] − [R(i∗) − ci (i

∗)] + [S(e(x)) − ce(e(x))].

(3)

Equation (3) yields the first empirical prediction of the sale and leasebackmodel.

Remark: If a sale and leaseback has an initial lease of length x = 1, then thereis no change in total wealth from the sale and leaseback agreement relative tocontinued ownership of the asset by the seller/lessee.

This observation follows directly from the fact that when x = 1, i(x) = i∗ ande(x) = 0. Therefore, when x = 1, (3) is equal to 0.

Recall that i(x) is increasing in x, while e(x) is decreasing in x. A decrease in x istherefore expected to increase the landlord’s investment level while decreasingthe tenant’s optimal and noncooperative choice of investment. Given that weexpect the parties to optimize the sale and leaseback contract, the model yieldsa second empirical prediction:

11 Notice that here, as throughout this model, we have suppressed the value of anycontractible or sunk investments.

630 Fisher

Result: The seller/lessee and buyer/lessor optimally choose x < 1 if and onlyif the net marginal gain of an increase in the buyer/lessor’s investment is greaterthan the net marginal loss from the seller/lessee’s decreased investment.

This result can be derived by taking the total differential of (3). The change intotal wealth is positive with respect to a decrease in x if and only if

∂S

∂e

∣∣∣∣ ∂e

∂x

∣∣∣∣ − ∂ce

∂e

∣∣∣∣ ∂e

∂x

∣∣∣∣ ≥ ∂R

∂i

∂i

∂x− ∂ci

∂i

∂i

∂x.

If the change in total wealth is negative for any x < 1, then by the reasoningabove, the seller/lessee and buyer/lessor are always better off by choosing acontract with x = 1. We conjecture that the exact nature of marginal returnsand costs are likely to vary with the identity of the lessee and lessor and perhapswith the use of the real estate.

Consistent with Hart (1995), the implications of the model suggest that optimalorganizational form may depend on the relative importance of investments byone party versus another. If the buyer/lessor makes important noncontractibleinvestments in the relationship, the choice of a relatively short lease as opposedto a long-term financial lease is wealth enhancing. Below we investigate theempirical implications of the model.

Data and Methodology

The Sample

For the years 1990–2000, 158 announcements of real estate sale and leasebackswere identified from the Dow Jones Interactive service. Given this set of events,further searches were performed across other publications and the Lexis-Nexisindex to identify the first public announcement of the sale and leaseback. Anevent qualified for this sample if the public announcement referred to a saleand leaseback involving particular (identified) assets owned by the selling firmprior to the agreement. Further screening required that firms report the lengthof the initial leaseback period and that the lessee firm was a public firm forwhom CRSP data was available. Twelve sale and leaseback announcements areassociated with other announcements for lessee firms on the same day (day 0).In particular, six announcements are concurrent with earnings reports, four areassociated with announcements of multipart financing deals and two sale andleaseback announcements are concurrent with other business announcements.12

12 Both of the lessee firms in this category are financial institutions selling/leasing officebuildings. No significance in these correlations was discerned in further analysis.

The Wealth Effects of Sale and Leasebacks 631

Given that we believe these confounding events to be idiosyncratic, we retainthe events in our sample, but identify the observations for further tests to ruleout some type of systematic information content.

The sample is comprised of 71 events involving 69 different lessee firms. Manyevents involve multiple buildings or properties. These events fall in a time framethat is almost completely distinct from prior studies. Ezzell and Vora’s (2001)sample has the most recent observations and covers the period 1984–1991; onlytwo events in our sample occur prior to 1994. Summary statistics are reportedin Table 2. The average reported value of the deals is $39 million, which issignificantly smaller than the size of transactions reported in prior studies (seeTable 1). The mean value of sale and leaseback transaction relative to themarket capitalization (value to equity or V/E) of the lessee firm is 36%, whichis greater than the 22% found in Slovin, Sushka and Polonchek (1990).13 Ofthe publically traded buyer/lessors identified in the sample, 25 are Real EstateInvestment Trusts (REITs). Five of the lessee firms are financial institutions.

We have also identified the type of real estate space involved in these transac-tions from the newspaper announcements and SEC filings (see Table 2, Panel C).In the context of our theoretic model, we suspect that the type of real estate mayproxy for the nature of the landlord’s versus the tenant’s future investment activ-ity. For example, Smith (2001) states, “If office buildings are less firm-specificthan manufacturing or research facilities, office buildings should be leased morefrequently” (p. 10). Interpreting “less firm-specific” from the viewpoint of thelessee firm in our model, we might expect the value of the lessee’s investment inthe business or asset to be relatively less valuable than the landlord’s for certaintypes of properties. Referring to Panel C of Table 2, office and hotel sale andleasebacks demonstrate the shortest initial lease periods of 12 years on average,while retail leases are quite long, averaging 20 years. The average initial leaseterms for R&D and manufacturing, light industrial and warehouse and assistedliving space fall in an intermediate range, while restaurants and entertainmentproperties are more closely aligned with retail space in terms of average leaselengths. Panel D also reports summary statistics for the sample according towhether the reported leaseback period is for 15 years or less, between 15 and25 years or greater than 25 years.

Our model suggests that altering the length of a leaseback results in a trade-offbetween landlord and tenant investment incentives, and that lease lengthalone may fall short of providing optimal incentives when both parties makeimportant investments. Recent work by Wheaton (2000) and others on retail

13 The median transaction value to market capitalization for our sample is 21%, however.

632 Fisher

Table 2 � Summary statistics.

Panel A: Market capitalization of lessee firms ($M)Mean $2,511Median $92

Panel B: Distribution of transaction valuesValue ($M) Frequency$0–$20 38$21–$30 7$31–$40 4$41–$50 1$51–$100 8$101–$150 4>$150 3

Panel C: Statistics by property typeMeanMarket Value # REIT

Type N Cap. ($M) ($M) L/A Term LessorFull Sample 71 2,511 39.08 61% 15 23Office 13 11,968 56.33 62%∗ 12 1Retail 11 133 37.92 65% 20 5R&D/Manufacturing 16 134 10.88 62% 15 1Hotel 7 1,145 142.32 58% 12 6Assisted Living 8 379 19.23 44% 14 8Distribution/Warehouse 6 1,201 27.07 55% 15 0Restaurant 5 88 8.36 63% 17 4Entertainment 3 131 55.90 66% 17 0Land 2 16 3.45 52% 18 0

Panel D: Statistics by lease lengthMeanMarket Value # REIT

Type N Cap. ($M) ($M) L/A Term LessorLong 6 1187 50.51 0.76 26 2Intermediate 19 259 25.36 0.65 20 5Short 46 3613 43.60 0.58 12 18

Panel A reports the mean and median market capitalization for the lessee firms in thesample. Panel B desribes the distribution of sale and leaseback events according to theirreported value. Panel C describes the type of commercial real estate sold and leased asreported in the Wall Street Journal, Lexis-Nexis or in SEC filings. Panel D reports samplestatistics for short (less than or equal to 15 years), intermedate (greater than 15 and lessthan 25) and long leases (greater than or equal to 25). The value of the sale and leasebacksevents are reported for 65 of the 71 events in the Wall Street Journal, Lexis-Nexis or SECfilings. Mean value to equity is the average of the ratio of transaction value to lessee firmmarket capitalization. Market capitalization is taken from CRSP for each firm for the monthend prior to the event date. Also reported in Panel C and D are the mean transaction value,the mean Liabilities/Assets, average initial lease terms and the number of deals that report aREIT as the buyer/lessor.∗Liabilities/Assets reported for non-financial firms only.

The Wealth Effects of Sale and Leasebacks 633

leasing suggests that landlord and tenant investments are highly specializedto their relationship. An interesting interpretation of retail leases may be thatoptimal incentives for the retail tenants may be created through the use oflong-term leases while incentives for the landlord are introduced through othermeans, namely percentage leases.

Methodology

Standard event study methodology is employed to discern whether the surpriseannouncement of a sale and leaseback is accompanied by a significant change instock prices on average for lessee firms. We calculate abnormal and cumulativeabnormal returns (CARs) over windows of varying length around the event. Theabnormal return for each firm around the event date is calculated as the residualfrom a market model. Daily returns for 150 days (from day −250 to day −101relative to the event day 0) are used to estimate market models. Abnormalreturns are cumulated over various intervals and the mean abnormal returnand CARs are reported below. Mean standardized abnormal returns and meanstandardized cumulative abnormal returns are used to calculate univariate teststatistics (Mikkelson and Partch 1986). We also utilize multiple regression tofurther sort our results and competing hypotheses. Tests for heteroskedasticityin the errors are rejected in all of the specifications reported below.

Empirical Analysis

Given our sample of sale and leaseback events, we want to test the predictionsof our property rights model that long-term financial leases are associated withno change in shareholder wealth, while shorter leasebacks are accompanied bypositive wealth events for shareholders. To do so, we must decide in a practicalsense what short and long mean. The longest leaseback in the sample is for30 years, and so we might regard 30 years as the lease length corresponding tox = 1 in the sale and leaseback model. As a practical matter, most real estateinvestment analyses use 10 years as a sufficiently “long” period of analysiswhen considering buy and hold strategies. Due to the fact that we are partiallyconstrained by the number of observations in the tails of the lease length distri-bution and the fact that our reported lease lengths tend to cluster around 5-yearmultiples, we evaluate several possible definitions, using as a cut-off 10-, 15-,20- and 25-year lease lengths.

Univariate Results

We begin by examining abnormal and cumulative abnormal returns aroundevent day 0. For the sample as a whole, there are no average abnormal orcumulative abnormal returns that significantly differ from zero (Table 3). In

634 Fisher

Table 3 � Average (cumulative) abnormal returns for lessee firms.

Interval Mean z-stat. p-value

(−3, 0) 0.0111 0.9631 (0.34)(−2, 0) 0.0055 0.8440 (0.40)(−1, 0) −0.0046 0.3537 (0.72)0 0.0005 0.6254 (0.53)(0, 1) 0.0004 0.0835 (0.93)(0, 2) −0.0019 0.1689 (0.87)(0, 3) −0.0019 0.1689 (0.87)

Univariate statistics are reported for the average cumulative abnormal returns (CARs)to shareholders of lessee firms around announcements of sale and leasebacks ofcommercial real estate. Seventy-one sale and leaseback events involving 69 lessee firmswere identified from the Dow Jones Interactive Service for the years 1990–2000. Theabnormal returns for each event day are calculated as the prediction error of individualfirm market models estimated over days (−250, −101) using return data from CRSP.Abnormal returns are cumulated over various intervals, and the mean of the sampleCARs are reported below. Z-statistics and p-values for tests of whether the mean of thestandardized CARs is equal to zero are also reported.

Table 4, we proceed with our univariate analysis by dividing the sample ac-cording to various definitions of Short and Long lease lengths (less than orequal to 10 or 15 years and less than 20 years). We find that lessee firms re-porting Short leasebacks under all three definitions experience significant andpositive abnormal returns on the day of the sale and leaseback announcement. Inparticular, when we classify a Short leaseback as less than or equal to 15 years,the lessee firms realize a 1.3% abnormal return. We find that the lessee firmsannouncing correspondingly Long (greater than 15 year) leasebacks experiencenegative abnormal returns on day 0. A t-test for whether the means of the ab-normal returns for these two subsamples are equal is rejected at the 1% levelof significance.

The average abnormal returns for Long (greater than 15-year) leases are sig-nificantly negative (at the 10% level), which does not appear consistent withthe prediction of our model. In the final panel of Table 4, we divide the Longsubsample further and examine the abnormal returns to lessee firms reportingleasebacks between 15 and 25 years of length and 25 years or longer. Theintermediate length leasebacks are associated with significantly negative av-erage abnormal returns, while the longest leasebacks are not associated withabnormal returns. It should be noted that only six lessee firms announce lease-backs that are 25 years or longer, but that the separation of these abnormal re-turns from the intermediate leasebacks increases the magnitude and statistical

The Wealth Effects of Sale and Leasebacks 635

Table 4 � Day 0 average abnormal returns for lessee firms according to leasebacklength.

Tests for EqualityAbnormal Returns in Subsamples

Lease Term Mean z-stat. N t-stat.

Short <=10 years 0.0152 2.06 22 −1.74Long >10 years −0.0061 −0.62 49Short <=15 years 0.0130 2.07 46 −2.51Long >15years −0.0226 −1.76 25Short [0, 15] 0.0130 2.07 46Intermediate (15, 25) −0.0309 −1.89 19Long [25, 30] 0.0037 −0.23 6

Univariate statistics are reported for the abnormal returns to shareholders of lesseefirms from announcements of sale and leasebacks of commercial real estate accordingto whether the initial leaseback is for a Short or Long term (given various definitions).Seventy-one sale and leaseback events involving 69 lessee firms were identified fromthe Dow Jones Interactive Service for the years 1990–2000. We also report t-statisticsfor tests of whether the mean abnormal returns of the two subsamples (Short vs. Long)are equal.

significance of the average abnormal returns associated with intermediate lengthleasebacks.14

Regression Results

We undertake multivariate analysis, reported in Table 5, to discern whethershorter leasebacks are still correlated with wealth gains once we control for otherpotential determinants of abnormal returns. In particular, we noted previouslythat some announcements of sale and leasebacks were concurrent with otherannouncements about lessee firms. In a previous section, we also identifiedtwo hypotheses from the corporate finance literature that may explain stockmarket reactions to the information in sale and leaseback announcements. Inparticular, credit-constrained firms may benefit from a relatively lower cost ofcapital provided by sale and leasebacks as opposed to other forms of financing.The tax hypothesis suggests that sale and leasebacks may be valuable when thecontract allows parties to trade the tax benefits associated with durable assets.

14 Parsing abnormal returns by property type is tempting, but given the small samplesizes, it is difficult to say much in terms of statistical significance about these estimates.Average abnormal returns calculated according to the type of property are positive forthe property types that have average lease terms that are less than or equal to 15 yearsand negative for average lease terms that are greater than 15 years (see mean lease termsin Table 2). The relationship between average lease lengths and property types may beexplainable in the context of our model if certain property types systematically benefitmore or less from the specific investment activity of the tenant versus the landlord.

636 Fisher

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The Wealth Effects of Sale and Leasebacks 637

Finally, we know that a subset of lessors are REITs, and we want to controlfor any source of systematic variation that may arise when seller/lessees dodeals with this class of lessors. The dependent variable in our regressions isthe day 0 abnormal return (AR) for lessee firms, and we estimate the followingregression,

AR = β1(lease length) + β2(confound ) + β3(constrained )

+ β4(REIT ) + β5(tax) + ε.

We utilize several categorical indicators for lease length. We experimented withusing the actual term of the initial lease (and its log) in the regressions, and theresults generally correspond with the results reported in Table 5. However,lease lengths generally cluster around multiples of 5 in our sample, and uponcomparison we find that the dichotomous indicators Short, Intermediate andLong offer greater explanatory power in our analysis. The indicator Short isequal to 1 if the initial lease term is reported to be 15 years or less and equalto 0 otherwise. The indicator Intermediate is equal to 1 if the lease length isbetween 15 and 25 years in length and Long is equal to 1 if the lease lengthis at least 25 years. Throughout our regression analysis, intermediate is theomitted category. Specification 1 in Table 5 simply verifies our conclusionsfrom Table 4 and suggests that lease length helps to explain about 8% of thevariation in abnormal returns in the sample.

We then examine potential noise around the event. We categorize concurrentannouncements on day 0 according to whether lessee firms (1) announce newdebt financing in addition to the sale and leaseback of real estate, (2) announcefirm earnings and (3) announce other events concerning the lessee firm. Noneof these indicators alone or in combination with others prove to be significantlydifferent from zero in regressions that include the indicators for lease length, butthe announcement of new debt (as distinct from the sale and leaseback financing)generally improves the explanatory power of the model and the addition of thisindicator is reported in specification 2. Removing these observations from thesample and rerunning specification 1 does not significantly change the results.

To capture whether or not a firm might be considered financially constrained,we obtain the ratio of lessee firm liabilities to assets for the year end priorto the sale and leaseback event from the firms’ financial statements becausedata for all of the firms were not available on COMPUSTAT. The coefficienton the measure of liabilities to assets is positive, which suggests that firmswith greater financial constraints may benefit more from sale and leasebacks.

638 Fisher

However, the coefficient is not significantly different from zero. Also, noticethat the coefficient on Short is no longer sufficient by itself to overcome thenegative intercept of the model and result in a positive prediction of abnormalreturns. Further examination reveals, however, that for all but one firm in theShort subsample, when the Liabilities/Assets coefficient multiplied by the firm’sL /A ratio is added to the intercept, the coefficient on Short results in a positivepredicted abnormal return for Lessee firms. In results not reported in Table 5,we enter the market capitalization of the lessee firm as an alternate proxy forcredit constraints under the assumption that smaller firms may face more creditconstraints in accessing financial markets. Running the regression when usingmarket capitalization did not add any additional information, nor did it alter thesigns or significance of other independent variables.

In specification 4, we control for whether or not the lessor is identified as a REIT.Assuming that the identity of the landlord and tenant may add information aboutthe importance of their respective investments, we seek to identify whether thereis some systematic information to be had in the identity of the buyer/lessor.The indicator for REIT, however, is never significant in explaining abnormalreturns from day 0. In all specifications where we included the REIT indicator,the coefficient on the indicator was negative. In results not reported in Table 5,we also consider other characteristics of the lessee firms, in particular whetheror not the firm was a financial institution that may have additional regulatoryconstraints on its liabilities and assets. There are five such lessee firms in theanalysis, and the indicator is never significant and did not alter the sign orsignificance of any of the other coefficients. We also investigate whether thetype of property in conjunction with lease lengths might influence the observedabnormal returns, but with no significant results. Ultimately, we estimate the fullmodel, absent taxes, in specification 5. For all reported L /A ratios, lessee firmsreporting short initial leasebacks are predicted to experience positive abnormalreturns.

As a final test, we are able to identify a proxy for the lessee firm’s tax rate usinginformation from COMPUSTAT. Following Ezzell and Vora (2001), we createa proxy for the tax rate by dividing operating income before depreciation by thetaxes paid for the year prior to the sale and leaseback announcement. We expectthat lessee firms with lower tax rates may be less able to utilize the deprecationtax benefits of real estate ownership. Therefore, events for seller/lessee firmswith lower tax rates are expected to be associated with greater wealth gains,all else equal, if sale and leasebacks allow parties to trade tax benefits andexpropriate revenue from the government. Tax information is only availablefor 45 of our sample firms, and in specification 6 of Table 5 we report nosignificant evidence of a link between taxes and wealth gains, although the signof the coefficient is positive as predicted.

The Wealth Effects of Sale and Leasebacks 639

Table 6 � Firm organization and credit constraints.

1 2

OLS Regressions Coeff. t-stat. Coeff. t-stat.

Intercept −0.0401 −2.66 −0.0495 −2.63Short 0.0445 2.88 0.0577 2.61

Short × High L /A 0.0048 0.28Intermed × High L /A 0.0313 1.20

Long 0.0309 1.13 0.0532 1.79Other Debt Ann. 0.0458 1.57 0.0407 1.36High L /A 0.0129 0.91Adj. R2 0.0931 0.0890p-value of F Statistic 0.03 0.05N 71 71

This table reports OLS regression results when using the abnormal return for event day 0for lessee firms as the dependent variable. Independent variables include a dichotomousvariable for lease lengths: Short (less than or equal to 15 years), Intermedate (greaterthan 15 and less than 25) and Long (greater than or equal to 25). Intermediate isthe omitted category. Another dichotomous variable, Other Debt Announcement, isequal to 1 if the announcement of the sale and leaseback was accompanied by anannouncement of other debt arrangements on day 0. High Liabilities/Assets is equal to1 if the firm’s L /A ratio is greater than the sample median. High L /A is also interactedwith the proxies for lease length. All of the lessee firms with long leasebacks have aL /A ratio greater than the sample median. The adjusted R2 and p-value of the F-statisticare reported for each regression.

We are unable to explain the consistently negative abnormal returns reportedfor leasebacks with intermediate length leases. In Table 6, we attempt to dis-cern if credit constraints can provide any additional explanation by creatingan indicator that is equal to 1 if the lessee firm’s Liability/Assets ratio isgreater than the median of the full sample. In particular, in specification 2of Table 6, we allow the coefficient of this indicator to vary according tolease length. Of note, all six of the Long leasebacks have L /A ratios thatexceed the sample median; therefore, no interaction term is entered into theregression for this category. We are still unsuccessful in explaining the nega-tive returns associated with intermediate lease lengths, and although not sta-tistically significant, the coefficients for high L /A indicator are consistentlypositive.

Discussion of Results

In summary, announcements of sale and leasebacks where the initial leaselength is less than or equal to 15 years are consistently associated with positivewealth effects for the shareholders of lessee firms. The results suggest that firms

640 Fisher

should own real estate in which they make highly specialized investments, butthat more generic real estate may optimally be owned by investors who arenot the end users of the asset. While the signs of other potential explanatoryvariables are consistent with expectations, none are statistically significant oralter our primary findings. In particular, our results are consistent with thefindings of Alvayay, Rutherford and Smith (1995) that the tax benefits of saleand leasebacks may have been reduced by changes in the U.S. tax code relativeto the environment which prevailed during the early to mid-1980s. The longestleasebacks in the sample exhibit behavior consistent with our prediction for truefinancial leases, but we are unable to explain the significantly negative returnsto lessee firms who enter into leasebacks for between 15 and 25 years. Themodel predicts that these firms would have clearly been better off by choosingsufficiently long leases, and perhaps by choosing even shorter ones.

We are unable to say definitively how the leases in these events were classifiedon the lessee firms’ financial statements. There may be some incentive forlessee firms to negotiate deals that can be construed as operating as opposedto capital leases. In particular, leasebacks construed as operating leases mayremove debt and depreciation associated with the real estate from the firm’sbalance sheet. Among other restrictions, operating leases must last for lessthan 75% of the remaining economic life of an asset. Therefore, if operatingleases remove debt from liabilities and provide future flexibility in obtainingadditional finance, then this incentive might influence the choice of leasebacklength. The results of our empirical analysis suggest that firm managers needto balance the economic impact of altering the firm’s claims with the value offinancial restructuring.

Our study has additional limitations related to the lack of more detailed infor-mation about actual contracts, especially with respect to provisions that mightalter the incentives of tenants and landlords. Our model of the sale and leasebacksuggests that the choice of lease length involves a trade-off in incentives suchthat other contractual features may be valuable in optimizing the relationship.Finally, our sample size is relatively small, which limits the statistical power oftests when we attempt to stratify the sample.

Conclusions

The theory of the firm has long predicted that firms will own assets in whichthey make specialized investments. While prior studies investigated the financialadvantages of sale and leasebacks, we investigate the phenomenon of sale andleasebacks as one way in which firms may contract to rearrange their organiza-tional architecture. Our model predicts that firms optimally de-integrate the firmwith respect to its real estate by using short leasebacks when the buyer/lessor’s

The Wealth Effects of Sale and Leasebacks 641

noncontractible future investments are relatively valuable. The model also pre-dicts that the true financial leasebacks are analogous to continued ownershipof the asset by the seller/lessee firm and that, absent any credit constraints ortax incentives, the wealth effects of announcements about the longest leasebackwill be similar to the announcement of debt and close to zero.

Empirically, sale and leasebacks with leases of less than or equal to 15 yearsare associated with 1.3% abnormal returns to lessee firm shareholders on theday of announcement and this wealth effect is larger than the gains reportedin prior studies of sale and leasebacks during the late 1980s and early 1990s.Leasebacks for 25 years or longer do not affect the wealth of lessee firms in thissample, and further work is necessary to understand the apparently nonoptimalchoice of intermediate lease lengths by some firms.

Special thanks to Harold Mulherin, Austin Jaffe, Abdullah Yavas, Chris Muscarella, EdCoulson, C.F. Sirmans, Bill Wheaton, David Geltner, participants of the 2002 AREUEAAnnual Conference and Meeting, participants of seminars at Washington State Univer-sity, Western Washington University, MIT, the University of Wisconsin and the Universityof Georgia and three anonymous referees for helpful comments and suggestions.

References

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Appendix

Claim: When x = 1, the seller/lessee’s noncooperative choice of investmentlevel is equal to the socially optimal level. When x < 1, the seller/lessee’s choiceof noncontractible investment level, i(x), is generally less than the sociallyoptimal level, i∗.

Derivation: The socially optimal levels of seller/lessee and buyer/lessor in-vestment solve

maxi,e

R(i) − ci (i) + S(e) − ce(i). (a)

The Wealth Effects of Sale and Leasebacks 643

The first order condition for (a) with respect to i is

∂R

∂i= ∂ci

∂i. (1′)

Denote by i∗ the solution to (1′).

Now notice that when evaluated at x = 1, (1) reduces to (1′) and i(x) = i∗.Assuming that ∂s/∂i ≥ 0, an inspection of (1) and (1′) reveals that when x < 1,i(x) ≤ i∗.

Claim: For any choice of x, the buyer/lessor’s choice of noncontractible in-vestment level, e(x), is generally less than the socially optimal level, e∗.

Derivation: From the social function (a) above, we find that the first ordercondition with respect to e is,

∂S

∂e= ∂ce

∂e. (2′)

Denote by e∗ the solution to (2′). Then (2′) is equivalent to (2) if and onlyif ∂S/∂e = ∂s/∂e. Therefore, when ∂S/∂e > ∂s/∂e, e∗ > e(x) for any choiceof x.