VideoWhen Silicon Graphics Inc. announced that it had sold part of its northern California headquarters in December 2000 to Goldman Sachs for $276 million, one building alone accounted for $160 million. That was $50 million more than SGI had paid for the four-building complex less than four years earlier.
The gain couldn't have come at a better time. Like so many other technology companies, the maker of high-performance computing products had been under pressure to divest noncore assets and improve performance, so owning its headquarters was no longer desirable. "A large portion of our capital was tied up in real estate," says Jeff Zellmer, CFO of SGI.
What's more, SGI had financed the complex through an arrangement known as a synthetic lease. Under GAAP, the term of such a lease can usually run no longer than seven years for the property to be excluded from the borrower's balance sheet, as SGI's complex was. While in theory synthetic leases can be rolled over into new ones when the term is up, in practice the lenders have to be willing to go along. They may not be willing if they're worried about a company's ability to pay. That's because the financing is extended against a company's corporate credit, instead of the underlying property.
And if lenders (typically banks) are willing to roll over a synthetic lease, they may charge so much that it may not be worthwhile. In SGI's case, says Michael Hirahara, vice president of facilities and services, the cost of rolling over its synthetic lease would have been "exorbitant."
In fact, Silicon Graphics might have had to sell the building even if it didn't want to. That's because a synthetic lease leaves the so-called residual value risk — the liability for the value of the property at the end of the term — in the hands of the borrower. At that point, if the borrower and lender can't agree on a rollover, the borrower must either buy the property or arrange for a third party to do so. Perversely, that prospect is likely to face a company at exactly the worst time: If the operating difficulties that make a lender wary of rolling over a lease are shared by other companies — because of an economic downturn, say — the result may be falling demand for the property.
So perhaps SGI found Goldman Sachs in the nick of time. Given SGI's belief that real estate values were at their peak, "it made sense to monetize the asset," says Hirahara. "The timing was good."
But other high-tech companies that financed new property through synthetic leases may not be so lucky. Experts say that with corporate real estate in Silicon Valley and other high-tech havens losing value as local companies struggle to sustain earnings, more and more firms that took out synthetic leases to finance construction in the mid-1990s now find themselves facing what some see as a double whammy — a need to sell property as its value falls. And that underscores the risks that finance executives face when seeking the rewards of this type of financing, which by definition is limited to new properties.
Statistics on real estate financing are hard to come by, so it's difficult to compare winners to losers. Others besides SGI have recently unwound synthetic leases at a profit. Remec Inc., a defense and commercial telecom equipment supplier, managed to unwind a synthetic lease it used to build its San Diego headquarters some two years ago for $26 million, which amounted to a gain of 50 percent on its investment, according to CFO David Morash. Other companies that have recently unwound synthetic leases include Sipex, a manufacturer of integrated circuits headquartered in Billerica, Massachusetts; Provo, Utah-based software maker Novell; Minneapolis-based medical-device maker Medtronic; and Irving, Texas-based paper-products maker Kimberly-Clark.
Still, experts say a number of companies with synthetic leases aren't doing so well. According to Maureen Kelly, a vice president at Dallas-based real estate brokerage firm Staubach Financial Services, one of its clients has seen a $70 million data center financed two years ago through a synthetic lease lose half its value.
"Banks are retrenching," says Jon Tomasson, a principal at Cardinal Capital Partners in New York, "so the chickens" — expiring synthetic leases — "are coming home to roost." And while the need to wind down synthetic leases at a loss may be limited at present to the high-tech industry, financiers warn that such problems could spread if the economic downturn persists.
Synthetic Benefits
Not that the hope of unwinding a lease at a profit is the only, or even a primary, motive for synthetic leases. These arrangements allow companies to move real estate liabilities off the balance sheet, as with a conventional operating lease, yet claim tax benefits associated with ownership — namely, deductions for interest payments and depreciation of the property's value. (Some experts think this duality amounts to a loophole in GAAP, and they speculate that sooner or later, the Financial Accounting Standards Board will close it up.)
Moving real estate liabilities off the balance sheet reduces a company's leverage, of course, although credit analysts routinely add back the effects of leases. Indeed, analysts and academics alike decry such off-balance-sheet financing as largely cosmetic. Still, consultants and CFOs continue to cite the lessened impact on the financial statements as a rationale for leasing.
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