It’s Time for the NCUA to Update its Sale-Leaseback Guidance

It’s 1981: The Iron Curtain divides Europe, Ronald Reagan is our new president, Kurt Russell is a big movie star, the prime rate is 20% and the NCUA has just issued its official guidance – IRPS 81-7 – on how credit unions can engage in sale-leaseback transactions to generate profit and raise capital from their owned operating real estate.

Fast forward to 2021, and everything’s changed – except IRPS 81-7.

Banks embraced sale-leasebacks (SLs) beginning in the 1970s, far sooner and more broadly than their more institutionally conservative credit union competitors, an irony given the greater financial benefits credit unions can realize from SLs because of their tax-exempt status.  Nevertheless, recent changes in tax and accounting rules, historically low interest rates, large amounts of available capital focused on commercial real estate and the widespread disruptions caused by COVID-19 have combined to spark serious interest from credit unions in the benefits of disciplined financial management of their owned real estate.

SLs allow credit unions to sell owned operating facilities at market values often far in excess of their depreciated balance sheet carrying cost, recognizing the gain tax-free and (under recent accounting changes) entirely in the year of sale, boosting their earnings and capital, and freeing substantial cash proceeds for member loans and investments in technology and ancillary CUSO business lines. While reaping the financial benefits of the sale, the credit union retains seamless occupancy of the facilities for an agreed long-term period at net rents that are kept affordable by the current extremely low cost of the mortgage debt that finances 80% or more of the typical SL transaction.

In the past year, several companies focused solely on SLs for credit unions have entered the market, including CU Real Estate Solutions LLC and CU Capital Management LLC. In addition, full-service commercial real estate brokers such as Cushman & Wakefield have assisted credit unions in bringing pre-packaged SLs to market. While it may take time for SLs to become widely accepted as a preferred non-deposit capital source for credit unions, interest margin compression and earnings/capital stress from COVID and CECL-related loan loss allowance growth will of necessity cause credit unions to review their capital planning options, and SLs will become prominent in that limited financial toolbox.

Hence the need for the NCUA to revisit its nearly half-century old guidance on sale-leasebacks – guidance that while fundamentally sound, would benefit from a fresh review in light of its growing practical relevance. Here are some suggestions:

1. The background has changed. IRPS 81-7 by its terms was prompted by industry conditions quite different from those today. The introduction to the guidance describes credit unions starved for deposits and desperate for money to fund loans, suggesting that some institutions were engaging in dubious SLs as a last resort. Obviously, today there’s no shortage of deposits or lending capacity, and credit unions engaging in SLs are doing so not from desperation but to more effectively manage the financial aspects of their operations. Accordingly, the “Background” section should be updated to reflect today’s very different industry landscape and to shift the regulatory subtext from questionable transactions structured to generate deposit-chasing one-time special dividends, to prudently designed transactions boosting capital and supporting enhanced lending and internal investments. In other words, SLs today are not about saving failing institutions but strengthening sound ones, and should be approached and regulated as such.

2. Role of appraisals. IRPS 81-7 requires appraisals of both the sale and lease aspects of an SL, and goes into some detail reviewing the various methodologies behind appraisals. While independent appraisals obviously are a necessary part of due diligence and negotiation of the terms of an SL, the NCUA guidance should be updated to clarify the precise role of appraisals. For example, because SLs are at their core a financing device, there is a relationship between the purchase price paid to the seller/tenant and the net fixed rent charged by the buyer/landlord; that relationship (often called the “cap rate”) varies by transaction and is based upon the rate of return required by the buyer. So long as the minimum required cap rate is maintained, SL transactions can in practice be executed across a range of sale prices and corresponding net rents, depending on the needs and preferences of the seller-credit union. The NCUA’s guidance on SLs should recognize that reality and permit otherwise properly structured SLs to reflect negotiated prices and rents above (or below) appraised values, so long as that variance is expressly acknowledged and explained by the credit union as part of its board approval of the entire transaction.

3. Cash versus buyer note. IRPS 81-7 spends considerable time:

• Cautioning credit unions against a mismatch between the duration of the credit union’s leaseback of its sold locations versus the promissory note offered by the buyer to purchase the properties;
• Citing accounting requirements for a buyer minimum down payment of 15% or 20%;
• Warning against below-market interest rates on any buyer note; and
• Prohibiting liens on the sold property senior to that of the selling credit union.

While these concerns are understandable where an SL involves the credit union selling other than for all-cash, the realities of today’s institutional SL market make all-cash transactions the norm, and so the NCUA should consider whether it wishes to allow SLs on terms other than all-cash, and if so whether seller-financed transactions should require prior review by the NCUA to ascertain why the credit union is willing to accept a buyer note for part of the sale price – this is particularly true where the buyer is partly owned by officers and/or directors of the selling credit union, so that a conflict of interest is present. One obvious revision here would be to simply prohibit seller financing, at least where any credit union director, officer or their immediate family members are affiliated with the buyer.

4. Multiple bids. IRPS 81-7 states that multiple bids are desirable because they offer the selling credit union more options, but the NCUA does not mandate the solicitation of multiple offers.  So long as an SL is structured based upon an independent appraisal, and any material deviation from appraised values is specifically justified by credit union management in obtaining board approval, there should be no legal requirement for multiple offers. Still, since multiple investors now are readily available to a credit union considering an SL, it behooves management to encourage multiple offers absent compelling considerations to the contrary, such as the need for a prompt closing or discreet sale process, and perhaps the NCUA should mandate that management specifically explain to the credit union’s board an absence of multiple offers, or at least an effort to solicit them.

5. Related party transactions. IRPS 81-7 states that an SL “should not be connected with any credit union officials, employees or their relatives, nor should any credit union officials, employees, or their relatives derive monetary benefits from the transaction.” Unfortunately, in apparent conflict with this injunction, NCUA Rule 701.36, its “fixed assets” regulation, which in legal effect stands above IRPS 81-7, allows directors, committee members, senior management and family members to hold a maximum of 10% ownership in the landlord of a federal credit union, and informal guidance from the NCUA suggests the 10% ownership limit is not an aggregate but an individual cap, potentially allowing majority or even entire ownership of the buyer-landlord in a sale-leaseback by management of the seller-credit union. From a governance/policy perspective, it seems wise to entirely prohibit credit union management from being on both sides of an SL transaction, but whatever the NCUA’s views on the matter, the relationship between IRPS 81-7 and Rule 701.36(c) requires clarification, including whether the 10% ownership cap in fact applies to all credit union officials and senior managers as a group, or only to each individual separately.

6. Accounting treatment. IRPS 81-7 refers to several accounting rules for SLs that no longer are in effect, and as part of a general updating, its guidance should be revised to reflect current accounting treatment. The most significant accounting changes are: Allowing the profit from an SL to be fully recognized in the year of sale rather than being amortized over the initial lease term, and bringing the leaseback onto the seller-tenant’s balance sheet, with a liability equal to the estimated present value of the entire fixed rent obligation and an asset equal to the estimated “right of use” of the leased premises for the corresponding lease period.

NCUA 81-7 in general provides sound and useful guidance for federally-insured credit unions considering a sale-leaseback of its owned operating real estate, but it is a creature of its long-distant time, and would benefit from an overhaul to reflect current industry conditions, changed accounting rules and especially a consideration of the risks posed by allowing credit union officials and management to participate in the ownership of the buyer/landlord of the properties.  Whether the NCUA can do anything to revive Kurt Russell’s career is less certain.

Steven Eimert is a Boston-based attorney who has for more than 30 years represented credit unions nationwide in a variety of matters, including regulatory compliance, governance, CUSO business lines and executive compensation. He is a Co-founder and General Counsel of CU Real Estate Solutions LLC, which arranges and invests in sale-leasebacks of credit union-owned operating facilities.