Synthetic Leases under Fire: Corporations Seek Alternatives. (Financial Management)
Pollert, William R., Glickman, Edwin J., Strategic Finance
Continuing skepticism about the quality and complexity of corporate America's financial statements is wreaking havoc on the equity markets and investor confidence. Any hint of accounting manipulation of operating results by a corporation, regardless of whether the results are based on generally accepted accounting principles (GAAP), is being highlighted in the media and usually results in a precipitous drop in share price. To deal with the "financial credibility crisis" that has permeated Wall Street as the result of the Enron, Tyco, Adelphia, Arthur Andersen, and WorldCom debacles, to name a few, the financial community, government agencies, and the accounting profession are working to refine GAAP accounting and financial reporting standards to provide investors with a clear, accurate picture of a company's true financial condition.
Partly as a result of the abuses at Enron and partly due to seemingly inconsistent and confusing accounting treatment, off-balance-sheet financing structures are coming under intense scrutiny. Not surprisingly, synthetic leases and how they are accounted for under tax and GAAP are front and center in this debate. To deal with this issue, the Financial Accounting Standards Board (FASB) is expected to issue new regulations soon, the effect of which could spell the death knell for synthetic leases, creating a sea change in the way corporate real estate is owned and financed.
WHAT IS A SYNTHETIC LEASE?
Synthetic lease financing came into its own in the mid-1990s as companies sought to retain control of their real estate assets while financing them off balance sheet. Though this type of financing is complicated and expensive to structure, well over $100 billion of synthetic lease financing has been used by a wide variety of corporations ranging from Fortune 100 industrial giants to high-tech start-ups.
In a typical synthetic lease, a subsidiary of a commercial bank holds legal ownership of a property with a nominal 3% equity investment. The bank provides itself an interest-only loan equal to 97% of the purchase price of the property, with a term of five to seven years. The 3% band of equity is the minimum the FASB requires to achieve off-balance-sheet treatment. Under this structure, the property is then leased back to the corporate tenant under a bond lease at a net rent equal to debt service payments and an agreed-upon return on the 3% equity. The interest rate is generally LIBOR based, resulting in a relatively low net rent reflecting the interest-only, relatively short-term nature of the underlying debt. (LIBOR is London Inter Bank Offer Rate, the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London. It's a standard financial index used in U.S. capital markets to set the cost of various variable-rate loans.)
A bank's willingness to provide both the equity and debt for a synthetic lease reflects the provisions in the lease that require the tenant to (1) pay off the loan at maturity, (2) refinance the transaction at the expiration of the term (at the pleasure of the bank), or (3) cause the property to be sold to a third party and make up any shortfall between the capital invested in the property (both debt and equity) and the proceeds of the sale. While a "third party" theoretically owns the property under a synthetic lease structure, the economic reality is that the corporate tenant is "on the hook" for almost all of the invested capital in a synthetic lease structure.
From an accounting and reporting standpoint, synthetic lease financing offers corporations the "best of all worlds." According to existing GAAP, corporate tenants can treat a synthetic lease as an off-balance-sheet operating lease, yet, for tax purposes, they can treat the property as owned by the corporation (reflecting the tax standard that the corporation has the "benefits and burdens of ownership"), enabling the tenant to take depreciation deductions that lower reported taxable income and thereby increase income for GAAP reporting purposes. …