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Serious Questions About Synthetic Leases

IN THE WAKE OF THE ENRON SCANDAL, anything associated with the term “off-balance sheet” is coming under scrutiny. The Houston energy giant collapsed amid allegations that it hid debt and questionable deals by creating off-balance-sheet entities. Now, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) are considering an overhaul of the rules governing off-balance sheet structures, which potentially can hide debt and inflate reported earnings.

That has focused investor attention on an increasingly popular technique in corporate real estate: the synthetic lease. For tax purposes, companies that use these leases are considered owners of their properties, so they can deduct interest and depreciation expenses. Although companies enjoy some of the advantages of ownership, they are not required to list debt associated with these properties on their balance sheets. That crucial detail makes synthetic leasing suspiciously reminiscent of Enron accounting.

Suddenly, companies such as Kmart Corp. and Charles Schwab were pressed to provide details about synthetic lease deals. And, after coming under criticism for its use of this financing technique, Krispy Kreme Doughnuts Inc. called off plans for a synthetic lease to finance a $35 million manufacturing and distribution plant. The company instead decided to finance the project with a traditional mortgage.

At the same time, however, media goliath AOL Time Warner Inc. is proceeding with a $1 billion synthetic lease provided by Bank of America Corp. to finance its massive headquarters building now under construction in Manhattan's Columbus Circle. The lease also will pay for a production facility in Atlanta.

“We have said that our current plan is to fund the project through a synthetic lease when the core and shell [of the headquarters building] are complete in 2003,” says Tricia Primrose, a spokesperson for AOL Time Warner. “We continue to believe that this structure provides a diversified source of tax advantages and cost-efficient financing that is appropriate for this type of project.”

Amid this turmoil, the future of the synthetic lease is uncertain. “Nobody has said synthetic leases are not usable, but there is a market movement here,” notes Ed Lubieniecki, executive managing director for Grubb & Ellis Consulting Services in Los Angeles. “Basically, the concept of putting assets off the balance sheet is out of favor.”

Some real estate experts tout the sale-leaseback as an alternative to synthetic leases. “We have a diminishing number of synthetic leases, so there is going to be an increasing number of sale-leasebacks,” says Bruce MacDonald, president of Boston-based Net Lease Capital Advisors Inc.

Benefits — And Risks

In a synthetic lease, a lender typically sets up a special-purpose entity (SPE), which borrows money for a company to build a project or purchase an existing property. The SPE (the lessor in the deal) borrows the money, contributes a minimum of 3% equity toward the property and leases it back to the company, which makes rent payments in the form of interest payments. Since the transaction is priced as corporate credit, the company typically pays a low interest rate — a floating rate based on the firm's creditworthiness — without having to add the real estate asset or associated debt to its balance sheet.

However, there are costs for the lessee, as well as benefits. The lessee, for example, assumes the risk on the residual value of the property. If the value falls, the company owes extra money at the end of the lease. If there is a fire or other damage to the building, the risk also resides with the lessee. And a balloon payment is due at the end of the lease based upon the unamortized amount of financing.

Synthetic leases were particularly popular among high-tech firms in the 1990s. “High-tech companies used it as a way to preserve capital,” explains David Stringfield, a managing director for Dallas-based The Staubach Co., which has represented tenants in synthetic lease deals since the mid-1990s. “High-tech firms didn't want real estate to be a drag on earnings, and they were looking for the cheapest way to finance real estate.”

Even when the recession hit in 2001, synthetic leases were still prevalent. In March 2001, Immunex Corp. completed a synthetic lease for its corporate headquarters and main research building in Seattle.

Immunex scrutinized several different financing options at the time. The synthetic lease provided the best flexibility, says John Schroeder, senior manager of corporate communications for Immunex. The company is in the process of being acquired by Thousand Oaks, Calif.-based Amgen Inc. and it's not certain what will happen to the lease after the deal is complete.

What To Do?

Now that synthetic leases have been placed under the microscope, it's becoming more difficult for borrowers to find lenders willing to finance the deals, according to Todd Anson, a principal with San Diego-based Cisterra Partners LLC. He has had no luck arranging a synthetic lease for one of his clients, IDEC Pharmaceuticals Corp., San Diego, which plans to build a $360,000 sq. ft. building as part of a corporate campus.

“Right now, we are sitting tight because it is not possible to consummate a synthetic lease,” he says. “We are on a search for alternative structures of financing.” Anson insists the project won't be delayed, but a different type of financing will be used to finance it. The company is considering a convertible bond, he says.

As an alternative to synthetic leases, most analysts expect potential lessees will turn to sale-leasebacks and are predicting a huge upsurge in those kinds of deals. In a sale-leaseback, a third party owns the real estate and a tenant signs a lease, typically lasting 10 to 20 years, and is responsible for such expenses as taxes and insurance.

Borrowers also have many other options for financing development projects, including on-balance sheet loans, medium-term notes and long-term bonds.

New Regulations?

FASB and the SEC have not issued definitive guidelines applicable to synthetic leases. However, both groups are likely to bolster guidelines later this year. In February, the SEC noted that markets and investors need more timely access to a greater range of important information concerning public companies than what is required by the existing reporting system. Meanwhile, FASB reports that it plans to issue proposed guidance relating to special-purpose entities in the second quarter of this year.

Even if FASB doesn't disallow synthetic leases, new guidelines could make the finance tool far less appealing to investors. Real estate observers agree that FASB and the SEC are likely to enact new disclosure rules. In addition, Lubieniecki believes FASB will increase the minimum lessor ownership position from 3% to as high as 10%.

Gail Gannon, a principal with Ernst & Young Real Estate Advisory Services in San Francisco, says there is a good chance FASB will eliminate the SPE financing vehicle for synthetic leases, which she says would be unfortunate because they have been a “useful tool.” Ernst & Young has arranged about $2 billion in synthetic leases over the past two years.

Steve Bergsman is a Phoenix-based writer.

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