The Synthetic Lease
Prof. Ian Giddy, New York University
What is a Synthetic Lease?
A synthetic lease is an operating lease that is structured in a way so that it is not recorded as a liability on the balance sheet. Instead, it is considered to be an expense on the income statement. It allows a company to control real estate and reap the tax benefits of depreciation without being required to show the property as an asset, or its financing as a liability, on the financial statements.
The Advantages of Synthetic Leases
Adapted from an article by Tom Erlandson
in Puget Sound Business Journal (Seattle) - September 14, 1998
A sophisticated method of financing results when a company enters into a synthetic lease agreement with a lending institution which acquires title to the real estate. It's an arrangement that enables the lessee to derive tax, accounting and rent advantages as well as the opportunity to buy the property at a favorable, predetermined rate.
The synthetic lease is especially enticing for publicly owned companies, where shareholders tend to look askance at investments in bricks and mortar rather than in the core business.
That's one of the reasons cash-rich Cisco Systems, a San Jose, Calif.-based provider of networking hardware and software, has taken to synthetic leases with gusto, creating several leases on more than 2.5 million square feet of space valued at more than $600 million.
A synthetic lease is an off-the-balance-sheet lease that allows the company to control the real estate without being required to show the real estate asset on its financial statements. But at the same time, the company derives benefits associated with real estate ownership by depreciating the improvements for tax purposes. In short, the synthetic lease provides the advantages of owning property with the benefits of an operating lease. Structured as triple-net operating leases with typical terms of 5-10 years, rent payments can be either fixed or floating and lessees are able to retain effective control of the leased assets.
"The synthetic lease is an excellent tool for a publicly traded company concerned with the balance sheet ratios of their financial statement and the impact these ratios have on Wall Street," said Rod Petrenchak, senior vice president and regional manager of U.S. Bank's commercial real estate division in Seattle.
The off-the-balance sheet lease provides some significant advantages over a conventional lease.
- Occupancy costs are lower than with a conventional lease. Further, the real estate asset doesn't appear on the tenant's balance sheet and no depreciation is charged against earnings for Securities and Exchange Commission reporting purposes.
- By far the biggest element of uncertainty surrounding the synthetic lease arrangement is what happens at the end of the lease. The company has three options: It can buy the property at the pre-established fixed price, roll over the lease or pay a penalty in the form of a substantial amount of the original cost in supplemental rent to get out of the lease.
Clearly, the incentives on the lessee's part are to either buy the property at the end of the lease or to refinance.
Problems arise if the company is on shakier financial ground at the end of the lease than it was when the lease was created. Or worse yet, if the real estate market is weaker than it was at the start of the lease, the company will wind up paying a premium whether it re-leases or buys.
Yet another downside risk would be the possibility that the Internal Revenue Service or the Financial Accounting Standards Board would retract the ability to have an operating lease off the balance sheet while at the same time deriving the tax benefits of depreciation.
Clearly, the synthetic lease isn't for everyone. The banks have to buy into the business plan. It isn't the kind of lease that a biotech or software firm just emerging from the home garage has the kind of leverage to pull off.
In fact, it helps if the company is already public because in some cases the banks have been known to ask for collateral in the form of marketable securities equal to the loan.
Syn thetic Leases in a Post-Enron World
Adapted from "Some real changes ahead in rules for synthetic leases" by Gene Sachs & Cathy
Sweeney, in Washington Business Journal - May 12, 2003 http://washington.bizjournals.com/washington/stories/2003/05/12/focus13.htm l
The Enron debacle has caused regulators to take a closer look at corporate off-balance-sheet transactions, including a real estate transaction known as a "synthetic lease."
Synthetic leases became popular in the earnings-driven corporate environment of the 1990s, when many companies used them to increase their liquidity and literally fund their growth.
In a synthetic-lease, a corporation finds a lender who uses an independent leasing entity to finance new construction or the purchase of an existing single-tenant building. The leasing entity holds title to the building and leases it back to the corporation through short-term financing, requiring periodic interest-only payments and a potential balloon purchase payment at the end of the term.
On its tax returns, the company deducts interest payments and property depreciation as expenses. However, for accounting purposes, the interest payments are considered rent payments -- thus the property and debt are kept off the balance sheet.
Synthetic leases provide two major benefits:
- Reduced rental rates compared with current market conditions. Because synthetic-lease rents are based on the interest rate on the debt, usually tied to the London Interbank Offered Rate (LIBOR), companies with synthetic leases have rental rates 40 to 60 percent below market rates.
- Off-balance sheet classification of the assets and liabilities. Because companies do not have to report the assets and liabilities on their balance sheet, they show improved performance measures.
Although synthetic leasing remains a legitimate financial structure, the rules governing it have changed significantly.
Early this year, the Financial Accounting Standards Board (FASB) issued Financial Interpretations (FIN) 45 and 46, and corporations must take immediate steps to comply with the new rules by June 15.
Currently, U.S. corporations are adding billions of dollars worth of real estate to their balance sheets or restructuring their leases to meet the new guidelines.
The synthetic rules
In Jan. 2003 the FASB issued FIN 46, "Consolidation of Variable Interest Entities." Although mostly affecting areas other than real estate, FIN 46 does have a significant impact on synthetic leases.
By June 15 2003, corporations had to fully consolidate assets and liabilities covered by FIN 46 in their financial statements.
FIN 46 classifies counter parties to agreements as either Voting Interest Entities or Variable Interest Entities.
A Voting Interest Entity is one that is currently consolidated into another entity's financial statements. In a synthetic-lease transaction, this entity is typically the lender.
A Variable Interest Entity (VIE) acts as a facilitator to a transaction on behalf of another party. In a synthetic lease, the lessor (landlord) may be a VIE.
An entity is considered a VIE if it does not have sufficient equity invested to reasonably support the transaction, or another party bears the majority of the risks and rewards of ownership, or another party controls the actions of the entity even though it does not control the entity's stock.
The party that bears most of the risks and rewards of ownership, or controls the actions of the entity, is considered the "primary beneficiary," the corporate tenant in a synthetic lease.
FIN 46 applies to corporate agreements in which a third-party VIE owns the assets and corresponding liabilities. The guidelines will cause most primary beneficiaries to consolidate the assets and liabilities of an associated VIE.
Many U.S. banks that financed synthetic leases used independent lessor entities, which are likely to be considered VIEs. Thus, their synthetic leases will likely be subject to consolidation by the tenant/primary beneficiary.
FIN 46 does not apply to agreements with Voting Interest Entities. A corporation should not consolidate assets or liabilities of those agreements because they are already reported on the financial statements of another corporation.
Synthetic-lease lessors that are bank leasing companies are generally Voting Interest Entities.
A common provision of synthetic leases calls for the tenant to guarantee a certain minimum value of the property at the end of the lease term.
FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees," addresses the proper accounting of those guarantees. Guarantees entered into after Dec. 31, 2002, are subject to the new rules.
The real options
Corporations with existing or proposed synthetic leases must take appropriate action. They have three broad options:
- Purchase the asset with cash and place it on the balance sheet.
- Remain in the lease or enter into a new lease with that lessor, but only if the lessor is a Voting Interest Entity.
- Replace the synthetic lease with another type -- a conventional real estate lease, a structured finance lease or alternative lease.
Even before the FASB's actions, many companies had begun "unwinding" their synthetic leases. With the stigma associated with off-balance sheet transactions and many banks choosing not to offer synthetic leases, most companies are expected to follow suit.
1. "A synthetic lease qualifies as a lease from an accounting standpoint, but as a loan from a tax standpoint." True or false?
2. If you were an analyst examining a Cisco's liabilities, would you regard its synthetic leases as expenses similar to conventional leases, or as liabilities similar to debt? Why or why not?
3. Do you agree that a synthetic lease can offer a company true savings in its cost of capital? Explain.