They don’t appear on balance sheets, yet they deliver the tax benefits of ownership. They’re called synthetic leases, and their positive impact on corporate profitability can be dramatic.
The market for synthetic lease structures is growing almost exponentially. In fact, in the past three years, one West Coast law firm alone has been involved in deals worth more than $3 billion, for a total of 7 million square feet.
There are a number of reasons for this almost-explosive growth, not the least of which are changes in corporate strategies and tightening real estate markets.
In an era marked by downsizing, restructuring, reengineering, and a zealous search for increased profits, real estate occupancy costs have become a prime target for cutting expenses and enhancing bottom lines.
Corporations have reduced the space-per-person allotment; created virtual offices where employees, supported by computers and telecommunications, work from their homes and other sites; and allotted desks and offices on a temporary, as-need basis.
Still, they continue to search for other sources of cost-savings. And with office markets reaching saturation points and rental rates soaring, constructing their own facilities has become the solution of choice for many companies. Once committed to that route, they then seek the most advantageous way to structure the financing.
For many, synthetic leases are the hands-down winner. Users can now be counted in just about every American industry, and interest is spreading to Europe and Asia.
A definition
A synthetic lease is off-balance-sheet financing. It gives the user the benefits of a capital transaction for tax purposes and an operating lease for accounting purposes.
In simplest terms, a typical transaction works like this: A corporation needs a new facility (office or industrial building, theater, hospital, etc.). A capital source or lessor buys the real estate from the developer and leases it to the corporate user, who may buy the property at a predetermined price when the lease expires.
Looks simple, but it isn’t. The lease must meet critical accounting guidelines if it is to deliver its intended advantages. Among these are:
n Stronger balance sheets. Balance sheets show neither the leased property nor the associated liability, which results in better financial ratios. Lease payments are reported as current expense.
n Tax benefits. Users are considered owners for federal income tax purposes, which entitles them to take depreciation and to deduct the interest portion of the lease payment.
n Total control. Users control all the functions of ownership, including potential gain or loss, operational control, and responsibility for expenses.
n Multiple financing opportunities. Commercial paper, private placements, banks and other funding sources are readily available.
n Lower occupancy costs. Corporations that qualify for synthetic leases typically realize substantial long-term savings or find that they can afford a higher-quality property than would be possible with traditional financing. They can normally borrow at the corporate finance rate, which is lower than the higher interest rates typical of real estate financing.
History
Synthetic leases were first introduced in the late 1980s but remained relatively unknown until the past few years. Initially, each was virtually one-of-a-kind. Increased popularity has led to more standardized accounting and documentation and, consequently, to lower fees.
Today’s typical users are large corporations with solid credit ratings, but it seems likely that smaller, financially sound companies will follow the trend.
A synthetic lease is limited to new construction or properties to be constructed. It can’t be used if a corporation already owns the property.
Caution
In spite of glowing reports, synthetic leases are not without certain risks apart from those inherent in any real estate venture. Because this less-traditional financing is complicated and not yet widely used, many real estate and financial professionals don’t know all the ins and outs.
And if a deal violates any of the very strict accounting criteria, it won’t fly. So you would want to consult only experienced real estate, legal, and accounting professionals who are experts in synthetic leasing and who can also help you determine whether it will support your company’s business strategies and objectives.
Victor S. Voinovich Sr. is president of The Victor S. Voinovich Company, a Cleveland-based commercial real estate firm that represents tenants and buyers exclusively. The Victor S. Voinovich Company is a member of ITRA, the International Tenant Representative Alliance. ITRA members are located in all major markets throughout North America.
