Capital Markets

Virtual Ownership

Synthetic real estate leases may be ready to move from Wall Street to Main.
Ian SpringsteelSeptember 1, 1997

Until recently, off-balance-sheet financing of real estate through so-called synthetic leases was viewed as an escape vehicle from depreciation burdens useful only in isolated conditions. The arrangements were contrived, the legal documents thick, the accounting risky. But several recent developments have conspired to change all that.

Dozens of Silicon Valley companies have penned such deals in the past 36 months, and such blue-chip companies as General Motors, General Electric, Eastman Kodak, and AlliedSignal are now said to be testing the waters. And while the Financial Accounting Standards Board may still redefine the accounting for some lease-holding special-purpose entities as part of its consolidations project, banks and lessees are now creating legal structures to limit that risk.

More significant, the $250 million synthetic lease deal signed in December 1996 by Cisco Systems Inc., which brings its total off-balance-sheet leases to $505 million, is not only one of the biggest synthetics done so far, but also shows that such leases can be much more than an accounting sideshow. Indeed, the San Jose, California-based networking-products giant’s latest deal is an integral piece of the company’s corporate financing strategy.

Filling a Basic Need

Cisco turned to synthetic leases because it needed more space but didn’t like the traditional options. When the company grew to $382 million (in revenues) back in fiscal 1992, management knew it wouldn’t be long before the firm would run out of room. Sure enough, on completion of its most recent fiscal year, ended July 26, Cisco was a $6.4 billion company with almost 11,000 employees.

How much space and where to get it were Cisco’s primary concerns. But David Rogan, treasurer of Cisco, found both standard types of financing — a traditional lease or ownership — unappealing. The first option, leasing existing property or space built to order, carried a price tag of 500 to 600 basis points in annual cash outlays above what the company would pay to own it. Yet ownership — either through a long-term loan or with cash — was also unattractive. Real estate loans were impossible to secure after the collapse of California’s market in the early 1990s; Cisco needed cash for acquisitions and research; and the company didn’t fancy the hit to reported earnings that would result from depreciation of the property.

Best of Both Worlds

Instead, Cisco signed up for three deals in three years for $255 million in lease financing with Sumitomo Bank Leasing and Finance Inc. for several additions on its various sites for a total of about 2 million square feet.

First developed on Wall Street in the late 1980s, the structure allows an investment-grade company like Cisco to obtain 100 percent financing of its property at its corporate borrowing rate and receive the tax benefits of ownership, while avoiding the depreciation associated with straight ownership. Now such leases are widely available from specialized leasing companies.

Synthetic lessees typically reserve the right to buy the property at the end of the lease, extend the lease, or sell the property and take any gain or loss in its value. Minimum deal size is approximately $10 million.

“This is a far better mousetrap than corporations have had in the past, and they are now easier and cheaper to do as the documentation becomes more standardized,” says Todd Anson, a managing partner with Brobeck, Phleger & Harrison LLP, in San Diego, who helped structure Cisco’s latest deal. Typical legal and accounting bills on a synthetic lease run about $50,000 to $100,000 now, he adds. That’s about half what it was a few years ago.

Cisco Systems has helped drive this evolution, most recently signing the $250 million lease deal with Union Bank of Switzerland for the start of a new campus on land purchased from the State of California, in San Jose, with a second-phase option that would add $250 million more in lease financing.

“Off-balance-sheet leases have worked for us because they save us a lot of money and they help us keep our cash available for investment, rather than sinking it into bricks and mortar,” says Rogan. “The accounting and balance-sheet issues aren’t really important to us, but they add to the appeal.”