And particularly for investment-grade credits, synthetic leases can be so much cheaper than sale-leasebacks or outright ownership as to be worth the risk that they can't be rolled over at the term's end. Currently, interest payments on a synthetic lease for even a noninvestment-grade borrower can be as little as 150 basis points over LIBOR (the floating rate typically used to price these deals). That currently works out to roughly 4 percent, whereas interest payments under a sale-leaseback for such a company can run as high as 15 percent, according to Scott Biel, a partner in the San Diego office of Brobeck, Phleger & Harrison.
Such a cost differential, coupled with off-balance-sheet treatment, is "a very attractive choice for us," affirms Jim Kent, vice president and treasurer of Chiron Corp., in Emeryville, California. The biotech company financed a $172 million research facility under a seven-year synthetic lease in 1996, and is about to do another under a similar arrangement worth more than $200 million. Chiron enjoys an investment-grade credit rating and also benefits from a loan guarantee extended by AAA-rated Novartis following Chiron's sale of a minority interest to the Swiss pharmaceuticals maker in 1995. That kind of creditworthiness can make a synthetic lease even less expensive, and Kent reports that Chiron expects to pay well under 4 percent in interest on its newest synthetic.
Financing Mismatch
But critics of synthetic leases say the benefits of such leases aren't great enough to justify their cardinal risk: using short-term financing to support what is normally a long-term asset. This mismatch between assets and liabilities can ultimately force a company to refinance at a much higher cost.
That is what is happening now at companies like SGI and Remec. After selling the real estate financed by synthetic leases, albeit at a profit, they're leasing it back at much higher interest rates and putting the liabilities on the balance sheet. Yet the companies contend that such an outcome is more than acceptable. Remec, for example, is using the cash it freed by unwinding its synthetic lease to fund acquisitions. As Morash points out, "Cash is much more valuable given current economic conditions."
Still, other companies with expiring synthetic leases may be forced to sell at a loss in a sagging market. And as for managing risk, "If you're trying to match assets to liabilities," a synthetic lease "is not the best way to go," says Mike Rotchford, senior managing director of Cushman & Wakefield, a New Yorkbased real estate services firm.
That conclusion is accepted by The Great Atlantic & Pacific Tea Co. (A&P), a supermarket chain based in Montvale, New Jersey. A&P recently sold 19 stores, mostly in the New York City area, through a sale-leaseback with a term in excess of 20 years. And while those stores wouldn't qualify for synthetic leases in any case, because they weren't new, the company has looked at such financing for new properties but decided they aren't as good a choice as a sale-leaseback.
"We're looking for long-term financing at attractive rates," explains treasurer and senior vice president of finance Mitchell Goldstein. And A&P got those rates on its sale-leaseback. While yields on A&P's 20-year bonds were trading in the mid-teens at the time, says Goldstein, "we got 20-year-plus money for less than 10 percent."
Others suggest that individual assets and liabilities needn't match as long as the overall portfolios do. Kent points out that the $1.2 billion in cash that Chiron keeps on the balance sheet helps hedge the risk it assumes through such short-term financing as synthetic leases. Still, many companies are trying to lengthen the duration of their liabilities to take advantage of declining long-term rates — even Chiron saw fit recently to issue a 30-year convertible bond.
Can Real Estate Be Core?
Of course, some companies with lots of cash prefer outright ownership, even though they could qualify for synthetic leases that don't require any cash collateral; their ranks include such giants as Microsoft, Dell, Merck, and Pfizer. "They have so much cash that they'd rather have complete control," says James Koster, a managing director at Staubach Financial Services.
Numerous critics assert that owning real estate is a misallocation of resources, and that companies are better off deploying capital against their core business. However, some finance executives say an asset's ownership is less relevant than its cost when deciding how to allocate capital. From that perspective, Chiron's Kent doesn't buy the argument that synthetic leasing represents a misallocation — indeed, he contends the reverse is true.
What's more, Kent is unconvinced that real estate investment necessarily represents a diversion from one's core competency. In Chiron's case, he notes, the two research facilities it will soon have financed through synthetic leases "are not something you can find on the shelf." In fact, they will help Chiron attract high-caliber scientists, according to Kent. "Research is what we're all about," he says.
In any case, other companies find a diversified asset mix attractive — especially in this environment — and real estate fits neatly into that. Even Cisco Systems, a heavy user of synthetic leases since the mid-1990s, has been buying real estate outright of late.
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