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ynthetic leasing by its very nature is two-faced, an adjective most corporations are scrambling to avoid in today’s scandal-plagued environment. A corporate user gets to be the owner of an asset for income tax purposes and gets to treat it as an operating lease for financial reporting purposes. What could be better? The rent is expensed, neither the ownership nor the debt used to finance it have to be reported, and yet the depreciation write-off and long-term appreciation of the asset continue unabated. Because of its multiple attractions, the practice has been equally welcomed by both privately held and publicly held companies. Some estimates place their total value at US$300-500 billion, across a whole spectrum of industries.
But alas, the bloom is off the rose, if it was ever flowering in the first place. After issuing a Proposed Interpretation in June 2002, the Financial Accounting Standards Board will very shortly issue an official ruling on the practice. If the schedule under the Interpretation is followed, companies would have to conform to new guidelines at the beginning of their first fiscal period after March 15, 2003, but not many are sitting around waiting for it.
In response to a November snapshot survey by Site Selection of corporate real estate professionals belonging to the Industrial Asset Management Council, one said,
We are a very conservative corporation which never participated in synthetic leases because of the possibility that some day, at a time not of our choosing, the game could be called.
Another said that less than one percent of the company’s portfolio was tied up in synthetic leases, but added,
Our CFO has stated that we will not engage in any further off-balance sheet financing.
Most people think that the accounting profession is going to do away with it,
speculates Art Greenberg, senior managing director for Julien J. Studley in Washington, D.C.
I suspect Wall Street in general will look at financial engineering as a negative, not a positive, for the intermediate term. Companies that are viewed as being too cute for their own good are going to get punished. People want to see conservative, clean accounting.
Some speculate that synthetic leasing has become entrenched enough, and attracted little enough negative attention, that it will survive renewed scrutiny. But companies may be abandoning it purely to avoid the dreaded
perception of impropriety.
The current perception is that anything ‘off-balance’ or ‘synthetic’ must equate to illegal, which is not always the case,
write Nina Desrocher and Ed Lubieniecki of Grubb & Ellis, Los Angeles, in their analysis.
In the recent past, companies that announced their investigation of synthetic leasing alternatives, such as Krispy Kreme, watched their stock plummet as public investors signaled their distaste and outright rejection of the notion.
You have some pharmaceutical companies doing these, and they’re so insignificant they’re not material,
says Greenberg.
But everyone on Wall Street is focused on it. You have a company with a billion dollars cash in the bank, and if they have $100 million worth of these and they have no other debt, then quite frankly, who cares?
One corporate real estate professional says that about three percent of his company’s portfolio is still tied up in synthetic leases today, as opposed to six percent in 1997, and comments,
Off balance sheet financing is out of favor in this post-Enron world. Synthetic leasing is ‘out.’
His corporation’s preferred method is now outright purchase. Another commented that
synthetic leases have never been considered an attractive financial alternative by our CFO.
Faced with that need to purchase, some might opt instead for a sale-leaseback transaction, which may flood the market. Greenberg says some of those strong pharma companies will have no problem adding such assets to the balance sheet when the FASB order comes down, but others might have no more fancy dancing at their disposal.
They might have a $100-million synthetic lease facility and the asset’s only worth $70 million and it’s single-B credit in Silicon Valley,
says Greenberg.
They have a problem. They don’t want to take a $30-million write-down and write a $30-million check. I think there are going to be some banks that are going to suffer losses.
The practice truly came into vogue in lockstep with the New Economy, as the fast growers saw it for what it was: a quick, convenient way to secure less-costly financing, and one that benefits both the lender (less residual risk) and the borrower (off-balance sheet accounting). Coming back onto the balance sheet will throw some of them off-balance. But not all.
My company always felt that synthetic leasing was not appropriate since it diluted shareholder value and that it did not adequately report our asset base,
says David Hirsch, director of property management for Masco Corp.
In addition, we always believed that our asset base was useful for supporting direct borrowing and not monetizing the base itself.
The FASB is aiming to bring
non-substantive
entities onto balance sheets. What constitutes
substance
is at the crux of the problem, just as it has been for another controversial corporate practice: offshore incorporation.
Some believe they have come up with a structure to get around the change in the rules,
says Greenberg.
They’re talking about putting a bunch of these into one entity, so it’s a substantive leasing company. But my gut reaction is FASB will plug that loophole before the rule is issued.
One thing that the FASB has made clear is that a third party’s residual equity investment must be at least 10 percent in order to be considered substantive, higher if that party does not have the ability to obtain financing independent of the SPE’s primary beneficiary. But Greenberg points out something else.
The FASB also will require that the equity be at risk first, not last. Right now the tenant guarantees the first dollar of loss. On that $100-million asset that sells for $90 million, the tenant writes that check. The FASB will require the equity to be truly at risk. That equity will have a whole different complexion because it’s not just at risk of the guarantee, but a true risk.
The total result of these changes for certain corporate real estate is summed up in the conclusion to an analysis early in 2002 by KPMG Consulting (now BearingPoint):
Nonfinancial assets such as real estate would be recorded at historical cost upon consolidation … The income statement going forward would not reflect the rent expense. Instead the company will record depreciation expense for the building and interest expense on the debt.
In other words, it’s going to cost you. That has some panicking, but Greenberg attributes some of the panic in the air to a misunderstanding of what accounting really is: an art and a science that’s every bit as complex as law … with a similar range of gray-area interpretation.
We live in a very complex society, and our financings are more complex than anyone ever thought,
says Greenberg.
People create new structures for a variety of true economic reasons and liability reasons, and it’s created the ability to securitize just about everything. But at the same time, it’s created a lot of issues that I’m not sure everyone’s thought through.
Yet the IAMC survey reveals that some have indeed thought it through quite thoroughly, indulging neither in the practice of synthetic leasing nor in the habit of giving its cheerleaders too much credence.
My company has stayed away from synthetic leasing from the very beginning because we have foreseen gray-area SEC and GAAP reporting problems with respect to off-balance sheet financing,
said one survey respondent.
As it turned out, despite being encouraged to do so by real estate consultants and public accounting industry consultants, we stood by this fundamental corporate finance policy.
