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Enron effect lingers over synthetic leases

Once a formidable competitor to sale-leaseback transactions, synthetic leases have all but vanished from the playing field years after the Enron scandal highlighted the structure's lack of transparency and sparked changes to accounting rules covering the leases.

The growing acceptance among corporations of the sale-leaseback model coupled with the ongoing credit crisis will fuel the move away from synthetic leases, property experts predict.

“Synthetic leases were less costly [than sale-leasebacks] and used to kill us all the time,” recalls Joseph Cosenza, vice chairman of Chicago-based Inland Real Estate Group. Inland has invested some $3.8 billion in sale-leaseback transactions over the past five years.

Early this decade, companies used synthetic leases to finance an estimated $60 billion in properties, according to a report by Ernst & Young.

Synthetic leases, complex structures that were entered into primarily for tax benefits, generally allowed corporations to set up a special purpose entity, “sell” property to the entity and then lease the property from the entity.

The special purpose entities would finance the sale with bank debt and hold the properties off the corporation's balance sheet. Ultimately, the financing would flow back to the corporation.

But in 2003, the Financial Accounting Standards Board changed synthetic lease regulations, essentially requiring corporations to put the special purpose entities back on their balance sheets. The shift largely resulted from the former Enron's use of the leases to allegedly hide the true financial condition of the company and enrich certain Enron insiders.

Most synthetic leases in Corporate America were completed using five- to seven-year terms, Cosenza says, and those transactions completed just before the rule change are coming due. As a result, companies need to raise cash to pay off the debt or “retire” the synthetic lease.

In fact, Philadelphia-based Pep Boys, an automotive aftermarket retail and service chain, used proceeds in a $77.5 million sale-leaseback transaction last July to retire a synthetic lease, says Ray Arthur, CFO of Pep Boys.

The company paid $116.3 million to buy back 27 stores and two distribution centers out of the lease, which was set to expire Aug. 1. “Synthetic leases are very difficult to do nowadays,” Arthur adds.

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