Synthetic Leases: A Popular Financing Option for Corporate Real Estate

08/27/2001

Capital markets for funding corporate real estate needs have changed significantly in the past 5 to 10 years, and corporations can now take advantage of new leasing structures to obtain a lower cost of funds, advantageous tax and accounting treatment and greater flexibility and occupancy terms.

Corporations today are increasingly looking at off balance sheet financing options, leveraged leases and synthetic leases to finance the acquisition or construction of new facilities.  These trends in corporate finance are equally important to real estate brokers, developers and lenders, because of their significance in serving the corporate real estate market.

In addition to being used to finance a corporation's headquarters and corporate offices, a synthetic lease can be used  for manufacturing, training, distribution and retail properties.  Equipment may be financed along with real estate in a synthetic lease transaction, or may be financed through a separate synthetic lease transaction, or the equipment may be bought separately from a synthetic lease transaction covering the real estate only.

What is a Synthetic Lease?

A synthetic lease can hardly be called a real estate transaction.  Rather, it is a corporate financing that is poured onto a real estate lease structure.

Tax v. Accounting Treatment.

A synthetic lease is a means of financing corporate real estate or equipment that results in (i) a capital transaction for tax purposes and (ii) an operating lease for accounting purposes.  If the transaction is properly structured, the corporation can depreciate the real estate and deduct the interest (rent) payments, but neither the asset nor the debt appears in the corporation's financial statements.

This accounting treatment is significant because (i) the property will not be counted as part of the asset base in computing the corporation's return on assets, and (ii) the debt does not have to be counted in determining compliance with corporate debt limits.

Structure.

Owner / Lessor.  To structure a synthetic lease, an entity unrelated to the corporate user  (the "lessor") is created to purchase the property and enter into a lease with the corporation.  A facilitator may be engaged by the corporate user to negotiate the transaction.  In that case, an affiliate of the facilitator will usually serve as the lessor.  In most cases, the lender will furnish an affiliate of its leasing subsidiary to serve as lessor.  (Note:  Although there are business reasons to use a special purpose entity ("SPE") as lessor, it is easier to achieve the desired accounting treatment if an entity with other assets is used, to avoid consolidation with the lessee/corporate user.)  Occasionally, a trust is used to serve as lessor.  The property may be raw land or a completed or partially completed building;  the synthetic lease provides for construction or renovation to the corporation's specifications.  Using the corporation's lease (really, its good credit) as security, the lessor obtains financing  (generally non-recourse on its face) to fund 100% of the total cost of the project.  The corporation is fully liable for its lease ("loan") obligations, although in certain circumstances the corporation's "deficiency" liability may be limited to approximately 85% of the total lease obligations.  This limitation of liability is generally applicable only if the corporate user decides to cause the property to be sold to a third party at maturity, and declines to extend the existing synthetic lease or purchase the property outright for its own use.  The limitation of liability is usually not available if the corporation defaults on its lease obligations during the lease term, or decides to cause an early termination of the lease (i.e., a prepayment of the "loan").

From the accounting perspective (i.e. for the accountants to find an operating lease and avoid consolidation), another key structural element is that the owner of the lessor must make and maintain a true equity investment in the lessor (translate, "cash") of at least 3% of the present value of the property.

Rent.  A typical build-to-suit synthetic lease requires that the tenant/corporate user pay as rent the negotiated return/interest rate on the total cost (debt and equity), any principal reduction negotiated by the parties, and (a la triple net) all costs associated with owning, maintaining and managing the real estate during the lease term.  In virtually all cases, the "rent" also includes an environmental indemnity for the lessor and lender (the accounting profession currently is examining how to factor this tenant obligation into the accounting analysis).  This environmental indemnity is generally far more expansive than a tenant's environmental liability to a landlord under a standard lease arrangement.

Purchase Option; Appreciation; Deficiencies.  At the inception of the synthetic lease, the parties commit to a fixed price purchase option that is exercisable by the corporation on expiration of the lease term.  This purchase price is negotiable, but will always at least equal the sum of the total cost (debt and equity) plus the negotiated return/interest on that cost.  On expiration of the lease term, the corporation can purchase the property at the negotiated purchase price, or direct that the property be sold to a third party.  If a "deficiency" would result from the third party sale, the corporation must pay that deficiency up to the maximum guaranteed amount (usually 80% to 87% of the "principal component" of the "loan").  (Note:  It is crucial to obtaining "operating lease" accounting treatment that the total payments made by the lessee are less than 90% of the total cost.)

Any appreciation in value of the project during the lease term generally is paid to the corporation.  If the property declines in value during the lease term, the corporation bears the entire burden of the loss (except in the narrow circumstance in which the corporation's deficiency liability may be limited as described in the preceding paragraph).

Synthetic lease documents frequently also provide that the corporation may "walk away" from the property at the end of the lease term by paying the entire unpaid balance of "principal and accrued interest (rent)" on the gloanh; but, absent unusual circumstances, the size of the payoff amount (i.e., no credit given for residual value) makes this is a very unattractive option for the corporation.

Terms Negotiable; No Definitive Guidelines.  The terms described above are  typical of synthetic leases.  Those terms are  negotiable, based on the corporationfs financial position, bargaining power and specific transactional needs. Although the Financial Accounting Standards Board ("FASB") has issued a few general guidelines applicable to synthetic lease transactions, there are no definitive guidelines from FASB, the IRS or the SEC specifically applicable to synthetic lease transactions.  These transactions must comply with the operating lease criteria set forth in Statement of Financial Accounting Standards ("SFAS") Bulletin No. 13, and avoid consolidation of the lessor/owner with the corporation by complying with EITF 90-15, EITF 96-21, EITF 97-1 and EITF 97-10.  Because these general accounting guidelines do not provide a detailed "safe harbor" for structuring synthetic lease transactions, the corporation's accountants should be involved in structuring the transaction to better assure that, on completion, those accountants will be comfortable treating the lease as an operating lease in the corporation's financial statements.

What Corporations are Good Candidates for Synthetic Lease Facilities?

Typically, synthetic lease facilities are used by rated or investment grade corporations to finance their real estate and equipment.  In some cases, a lender may be willing to make a synthetic lease/loan to a non-rated corporation based on its assets and operating history or the lender's relationship with the corporation's parent or corporate affiliates.  The underlying real estate generally is not given substantial collateral value, perhaps because (i) the total cost frequently exceeds 100% of the appraised value of the property (soft costs, etc.), and (ii) any appreciation in value of the property usually is paid to the corporation and not the lender.  These financing transactions generally are priced and underwritten less as real estate loans and more as corporate credits.

Advantages of a Synthetic Lease.

Synthetic lease financing has the following advantages over traditional real estate loans and other lease financing arrangements that a corporate user typically would consider:

  • The corporation gets the dual tax benefits of (i) deducting the interest (component of the rent) and (ii) depreciating the property.
     
  • The real estate does not appear as an asset on the corporation's books and, therefore, is not subject to "return on assets" tests that might otherwise be applied.
     
  • The financing does not appear as debt on the corporation's books.
     
  • The transaction is priced as a corporate credit, which usually results in a lower interest rate to the corporation than in a "standard" real estate loan.
     
  • At the end of the lease term, the corporation, in most cases, is able to realize the benefits of any increase in value of the property.  If the property has decreased in value, the corporation's "deficiency" liability may be limited to an agreed-upon percentage of the total cost (generally 80% to 87%).

Disadvantages of a Synthetic Lease.

Based on a corporation's specific real estate and financing needs, the following factors common to synthetic lease transactions may be disadvantages for some corporations:

  • The lease term generally will be for a relatively short period (3 - 10 years), although the corporation usually has the option at the end of the lease term to purchase the property or to continue to lease the property by negotiating an extension to the existing synthetic lease or by causing the property to be sold to a new lessor/lender.
     
  • The transaction costs (survey, title insurance, appraisal, accounting and legal costs), usually exceed the transaction costs for an unsecured corporate loan, although the costs may not be significantly greater than those for a leveraged lease.  Obviously, the larger the synthetic lease facility, the lower the ratio of  transaction cost to asset value/debt.  Some corporations negotiate multiple-asset synthetic leases to finance their corporate real estate needs throughout the United States and abroad.
     
  • The corporation must work closely with its accountants throughout the negotiation and documentation of the synthetic lease to assure that the accountants will not require that the asset or the debt be reflected in the corporation's financial statements.  Not all accounting firms recognize synthetic leases, and the criteria applied differs from firm to firm, although the attitude of any particular accounting firm toward a given synthetic lease transaction is likely to turn on (i) relationship issues or (ii) the materiality of the transaction to the financial situation of the user (e.g. risk of shareholder suits), or both.
     
  • Although there currently are no industry-wide formal guidelines, most accountants are unwilling to allow a corporation to transfer existing assets to the lessor in a synthetic lease transaction.  The synthetic lease option generally is available only for the acquisition or construction of new corporate assets.

* Note:  On the other hand, a corporation could enter into a ground lease covering land that it already owns, and then use a synthetic lease for the improvements.  The synthetic lease benefits would only apply for the improvements (i.e. the land remains on the balance sheet).

  • Synthetic leases carry a unique risk because there are no firm accounting, IRS or SEC rules to guarantee that the project will continue to be treated off balance sheet.  At some point, a corporationfs accountants or the SEC may conclude that this treatment is not appropriate, and deny operating lease treatment to synthetic lease structures.  This risk can be partially mitigated by the corporation's negotiating the right to terminate or prepay the synthetic lease if the tax or accounting treatment is changed.

Summary.

Synthetic lease facilities are becoming quite popular in the corporate real estate market.  At a minimum, real estate practitioners should be aware of the requirements and benefits of creating a synthetic lease facility.

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