SYNTHETIC LEASING MID-2002 UPDATE
Prepared
by:
Jeffrey S. Weil, MCR.h,
CCIM, SIOR
Senior Vice President
Colliers International
1850 Mt. Diablo
Blvd., Suite 200
Walnut Creek, CA 94596
Ph. 925.279.5590
Fax 925.279.0450
jweil@colliersparrish.com
www.officetimes.com
Once the darling of high-tech corporations
as an innovative way to occupy costs and control property at low occupancy
costs, the current fallout from ENRON-type of 'smoke and mirror' financial
arrangements has caused many corporations to think twice before jumping on the
Synthetic Lease bandwagon.
Synthetic leasing allowed the lease to be put in the 'off-balance-sheet financing' category. Large credit-worthy corporations were able to have the benefits of property occupancy, control, and purchase options while usually being able to secure much lower rental rates due to lower financing terms. Silicon Valley BUSINESS iNK April 19, 2002 defined synthetic leasing as follows:
"These leases allow large companies with strong credit to obtain most of the benefits of owning a property while recording it as a lease.
This benefits the company's earning per share since the property is not recorded on the balance sheet and no depreciation is charged against earnings.
The company reports the transaction as a lease for financial reporting purposes, but it is considered a loan for tax purposes.
Here's how it works. Three parties are involved: The large company (tenant), the lender and a third party that will technically own the property. The lender makes a loan to the third party (lessor) to buy the property and that entity leases the property at a low interest rate to the tenant. The tenant's rent is the interest on the property loan.
The third party lessor can be owned or set up by the bank or another entity. Often a special purpose entity (SPE) is formed by the bank or another entity specifically to own the property. The tenant pays interest on the property loan to the third party in the form of rent.
The tenant generally secures 85 percent of the loan. It is securing its own financing.
These leases are generally five to seven years long, although at any time the tenant has the option to purchase the property outright for the market rate at the time the lease was initially signed. At the end of the lease the tenant can also refinance or sell the property to a third party.
One reason it's attractive to tenants because of tying up capital in a property purchase, they can use it for other projects."
As reported in the San Francisco Chronicle (8/16/02), "Crushed by big losses and falling revenue, Internet software Inktomi may have to pay $114 million for the Foster City headquarters it now leases. The company is being forced to buy the building for failing to satisfy the terms of its lease. The agreement, known as a synthetic lease and popular among technology companies, requires Inktomi to maintain a minimum level of profitability, when in fact it has hemorrhaged cash... Synthetic leases are attractive because they allow companies to keep real estate debt and depreciation off their financial statements. Because of the complicated financial arrangement involving a company and a partnering lender, rents can be 30 percent to 50 percent lower than they would otherwise be. So even if Inktomi were allowed to sell the Bayside building and then lease it back under a conventional lease, the rent would likely be higher than what the company had been paying under the synthetic lease."
This may be a double-whammy, as just when a company needs to cut expenses to the bone to slow down its cash burn rate, now its real estate costs skyrocket if the synthetic lease needs to be unraveled. Add to this the much lower credit rating of a firm with pennies on the dollar (Inktomi shares were $241 per share in March 2000 and now trade at about 42 cents) and even a sale leaseback will be economically penalizing due to the underlying tenant credit issues.
The Financial Accounting Standards Board (FASB) establishes standards for financial accounting and reporting in the United States. FASB creates the Generally Accepted Accounting Principles (GAAP) which are enforced by the U.S. Securities and Exchange Commission. This quarter FASB plans to issue a recommendation draft for changing the standards for special purpose entities including SPE's involved in synthetic leasing.
As an example of the benefits corporations have received utilizing synthetic leasing, in the San Francisco Business Times March 22, 2002, "They allow companies to obtain 97 percent financing for new facilities - but keep that debt off their balance sheet by using a limited partnership. Companies then lease their facility from the LP they created... The synthetic lease preserves the company's cash position, and could cost them less than 4 percent in interest expense."
In Real Estate Forum April 2002, "The
FASB is working on the interpretation and is expected to release a draft this
month. These new rules will affect most companies that report to
shareholders and lenders under generally accepted accounting principles.
These changes will be effective for new leases done after the release of the
final interpretation, which is expected before the end of the third
quarter. The proposed changes will be applied to all synthetic leases for
years beginning after Dec. 15, 2002. If the new rules are adopted,
calendar-year companies will be required to put all synthetic leases (not just
the new ones) on their balance sheet as of Jan. 1, 2003 unless they are
significantly restructured."