Capital Markets

Double Whammy

As real estate markets sag, companies with synthetic leases could face a costly dilemma.
Ronald FinkJanuary 1, 2002

When 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.

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.

Ultimately, a company’s approach to real estate will depend on two issues, asserts Koster. One is a company’s financial condition. Until recently, for example, Lucent and Nortel Networks preferred to own their real estate. “They were among those companies that believed that was the only way of being sure you have complete control of your home,” says Koster. Yet after falling on hard times, both of these companies have chosen to sell some of their major operating facilities and lease them back.

The other issue is the type of asset involved, says Koster. As A&P’s Goldstein puts it, the question here is, “How well does it hold its value?”

Both concerns seem a lot more pressing today than they did only a year ago.

Lease or Buy?

Real estate finance alternatives.
Source: Staubach Financial Services

  Ownership Traditional Real Estate Lease Long-term Credit Lease Synthetic Lease
Financing Funded through corporate capital Arranged for by purchaser

Debt provided by a traditional real estate mortgage lender or pension fund

Typically 75% debt and 25% capital Bond markets utilized such as CMBS or private payments

Pricing primarily based on corporate credit of lessee Bank debt

Interest-only payments with balloon at end of term

Pricing based on corporate credit of lessee Terms Permanent 8- to 25-year lease 15- to 25-year lease 3- to 7-year financing Accounting Treatment  Asset and  liability on balance sheet

  Operating lease treatment

Rent expense Operating lease treatment

Rent expense Operating lease treatment

Rent expense Tax   Rent expense deduction Rent expense deduction Treated as owned asset

Depreciation and interest deduction

On or Off?

The conundrum of what off-balance-sheet treatment of assets and liabilities is worth comes quickly to the fore when discussing the merits of synthetic leases.

High-performance-computing company Silicon Graphics Inc., for instance, dismisses the importance of such treatment now that it has unwound a synthetic lease on its Mountain View, California, headquarters campus in favor of a sale-leaseback, the liability for which still needn’t be put on its balance sheet. For the most part, credit analysts ignored the off-balance-sheet treatment of such financing, says a spokeswoman. The same holds true at Chiron Corp., which is about to do a second synthetic lease, according to treasurer Jim Kent. “Balance-sheet treatment is not at all a key factor,” he says.

But consultants say off-balance-sheet treatment is a big reason companies opt to finance such real estate through synthetic leases. The biggest accounting advantage of any kind of lease over outright ownership lies in not having to write off depreciation of the asset against earnings. Granted, many analysts consider such a boost from a synthetic lease to be artificial (since companies effectively own the asset) and will strip it out of their estimates. But James Koster, a managing director of Staubach Financial Services in Dallas, says companies “still get some value for it,” while Mitchell Goldstein, treasurer and senior vice president of finance at A&P, insists the value is largely ephemeral or, as he puts it, “a bit of optics.”

In any case, such treatment isn’t automatic under U.S. GAAP. In fact, Statement of Financial Accounting Standards No. 13 requires that a lease fail all of the following four tests to be treated as an operating lease instead of a capital lease, and thus qualify for off-balance-sheet treatment:

1. The lease transfers ownership of the property to the tenant by the end of the lease term.

2. The lease contains an option to purchase the leased property at a bargain price.

3. The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.

4. The present value of rental and other minimum lease payments equals or exceeds 90 percent of the fair value of the leased property.

Even if their leases fail these tests, companies may eventually have no choice but to include them on their balance sheets if the Financial Accounting Standards Board accepts the reasoning of the International Accounting Standards Board. Since the IASB makes no distinction between operating and capital leases, such financing must be included on balance sheets by companies reporting under International Accounting Standards. And while any such treatment under U.S. GAAP would be a long way off, FASB has said that it would take the IASB’s position on leasing into account as it helps resolve differences between the two accounting regimes.