Synthetic leasing: too good to be ignored

In the early 1990s, in response to the collapse of the real estate capital markets, there was a tidal wave of synthetic lease capital flow from equipment financing to real estate. This flood of activity, which began with the Fortune 500, has also captured the attention of numerous fast-growing, high-tech companies that have found the product to be especially beneficial.

The synthetic lease is the best of both worlds for a tenant seeking to finance the construction or acquisition of facilities regardless of whether the product type is office, warehouse, manufacturing, distribution, retail, research & development, special purpose, studio, etc.

A special purpose entity (SPE) is created to book a loan -- the proceeds of which are used to purchase or finance the construction or acquisition of the subject real estate. A short-term lease is then entered into between the lessee and the SPE -- at the end of which the lessee must make a balloon payment to essentially repay nearly all of the project cost.

Many believe that this product is too good to be true because the tenant achieves off-balance-sheet treatment for the asset being financed, together with the retention of tax benefits of ownership. The Internal Revenue Service (IRS), as well as the Bankruptcy Courts, look at substance over form when concluding that these are merely financing transactions and that the lessee is actually the beneficial owner through a conditional sale. The IRS deems that all the risks, rewards and responsibilities for the asset reside with the lessee.

The opposite is true for Generally Accepted Accounting Principles (GAAP) purposes as the form over substance argument prevails and the financing is treated as an operating lease. The product is specifically designed to fail the four tests contained in Statement of Financial Accounting Standards (SFAS) #13, resulting in the lease qualifying as an operating lease. And pursuant to Emerging Issues Task Force (EITF) 90-15, the fact that the SPE owner of record has made a 3% equity investment that is deemed to be "substantive" and it remains "at risk" throughout the lease term obviates the need for the lessee to consolidate the assets, liabilities and cashflows of the SPE.

A recent concern revolves around a recent EITF Exposure Draft targeted at synthetic leases and calling into question the "shell-like" nature of many SPEs that have been created to "own" these assets. If a new accounting guideline is adopted on this subject, as expected later this year, the disparate synthetic lease ownership interests will likely be consolidated into new entities in order to side-step any new rulings.

How is the financing structured?

In addition to the 3% project equity, the balance of the project cost is financed with debt, typically comprised of two tranches: the "A" tranche, equal to 85% of project cost, and the "B" tranche, equal to 12% of project cost. The interest-only financing can float over LIBOR or can be fixed by using an interest rate swap.

The lease is absolutely triple net with the tenant taking full responsibility for operating and managing the asset. The lease looks like a medium-term, revolving credit arrangement rather than a typical lease, with all protections in place as would be the case in a normal commercial loan to a high credit company. If the lessee does not maintain an investment-grade credit, then necessary collateral is provided giving the lender comfort that obligations will be repaid.

What are the benefits to the lessee?

Anyone contemplating a significant relocation finds the benefits associated with the product to be extremely compelling:

* The tenant receives the same tax benefits from depreciation as would an owner.

* The tenant enjoys 100% of the property's appreciation.

* The annual loan constant for a synthetic lease financing is approximately 200-300 basis points less than conventional financing since the project is LIBOR-or Treasury-based as opposed to prime-rate based.

* It is also less expensive than sale/leaseback financing, because risk-based real estate costs are avoided.

* The lessee avoids depreciation for financial accounting purposes improving reported earnings, return on equity, return on assets and shareholders' value.

* Off-balance-sheet financing avoids the need to report an asset or liability on the balance sheet, improving debt to equity ratios.

* Profit potential to the developer is limited.

* All project costs can be financed (real property, land, personal property and all soft costs).

What are the risks and limitations?

The biggest issue is the perceived risk that the lessee bears upon lease termination. At lease termination, if the lessee wishes to continue to utilize the property, it can roll the financing over or purchase the asset at an amount equaling the original project cost. If the facility has no further utility to the firm, the tenant can "walk" from the lease after making a contingent minimum rental payment penalty, which is capped at an amount that makes the stipulated minimum payments required under the lease equal to 89.9% of original project cost.

A lease by any other name...

The most visible domestic banks in the synthetic lease arena include: NationsBank, which is one of the most aggressive; Chemical Bank; Bank of America; and Citibank. Foreign banks -- including Union Bank of Switzerland, International Bank of Japan, Bank of Tokyo, Bank of Montreal, ABN Amro Bank and Canadian Imperial Bank -- have all had great success in penetrating this fast growing capital market area. A number of investment banks, most notably Merrill Lynch, have also been extremely successful.

Don't be fooled by the dozen or so different names that arrangers of this type of financing use to differentiate their product: synthetic lease, master lease program, phantom lease, transparent lease, lease/loan, ABC lease, full benefits lease, asset defeasance program, tax ownership operating lease, tax retention operating lease and/or off-balance-sheet loan. The products are essentially identical.

The synthetic lease contains too many benefits to be ignored, and we expect that, for the balance of the 1990s, synthetic leasing will be a highly competitive source of real estate capital. Notwithstanding this, new forms of real estate capital are now appearing, which may offer other ways for the solid credit tenant to "have its cake and eat it too."

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