Off-Balance-Sheet Corporate Finance with Synthetic Leases: Shortcomings and How to Avoid Them with Synthetic Debt
Graff, Richard A., The Journal of Real Estate Research
Synthetic leases provide corporations with off-balance-sheet finance for acquisition of tangible assets. The financings are less efficient for financial planning purposes than conventional onbalance-sheet debt. The inefficiencies can be avoided by replacing synthetic leases with synthetic debt. Synthetic debt finance transforms lease obligations into the investment equivalent of senior corporate debt. The distinguishing features of synthetic debt are: (1) synthetic debt represents a fixed-rate off-balance-sheet fixed-income obligation with the same default risk as on-balance-sheet debt; and (2) in default synthetic debt provides the financier with immediate recourse against the obligor comparable or superior in recovery protection to conventional senior debt.
Occasionally a gimmick appears in corporate finance that appears to have significant shortcomings, yet that manages to develop a following among financial executives. An idea of this type currently popular with publicly traded corporations is the synthetic lease, a specialized instrument used primarily for the debt finance of corporate real estate acquisitions.1
The sole innovation provided by synthetic leases is the movement of mortgage debt off the corporate balance sheet.2 Although synthetic leases differ functionally from conventional mortgages in their effect on corporate financial accounting, they do not possess any other feature that cannot be replicated at less expense by conventional on-balance-sheet financial products.
Previous articles have examined the financial and tax accounting features of synthetic leases, mechanics of the synthetic lease structure, and other synthetic lease benefits suggested by synthetic lease vendors (e.g., Holmes, 1996; and Hodge, 1998). In addition, articles by corporate real estate professionals have discussed synthetic lease applications in corporate real estate finance (e.g., Bloomfield, 1997; and Levine, 1999). However, with the exception of Bloomfield, the articles do not discuss the impact of the synthetic lease structure on financial risk or compare the financial risk with other real estate finance alternatives. In particular, previous articles fail to consider the economic implications of synthetic lease constraints that do not apply to conventional on-balance-sheet mortgage debt.
The recent flurry of corporate interest in synthetic leases conflicts with current academic thought on the lack of significance of off-balance-sheet debt to corporate borrowers. For example, Brealey and Myers (1996) observes that credit analysts at lending institutions view off-balance-sheet fixed-income obligations as equivalent to on-balance-sheet debt, as do investment analysts at institutional portfolio managers. This suggests that financing with off-balance-sheet debt should neither enhance corporate debt capacity nor benefit stock prices. The widely read tome concludes that off-balance-sheet debt should not have significantly greater appeal to corporate borrowers than on-balance-sheet debt.
The apparent conflict between theory and practice suggests that the accounting benefit accompanying synthetic leases may create opportunities in corporate financial management not apparent immediately from the standard academic analysis. For example, real-world corporate bond default covenants may not restrict incremental off-balance-sheet borrowing as much as incremental onbalance-sheet borrowing. Alternatively, the primary appeal of off-balance-sheet debt may represent an agency cost to the corporation3
Agency costs frequently are probabilistic in nature. In general, the ultimate extent of the impact on corporate finances is dependent on future economic events, although the corresponding impact on stock price can be more immediate. Accordingly, it is instructive to examine incremental financial risk and constraints incurred by synthetic lease finance in return for the accounting benefit. …