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Long used in the area of equipment-financing as a way to secure “off balance sheet financing,” the “synthetic lease” is now recognized as a viable real estate financing option for businesses looking for ways to manage their financial statements more effectively. As its name implies, the synthetic lease is a hybrid form of financing, combining the financial reporting advantages of an operating lease with the tax advantages of a loan. The benefits of the synthetic lease arise from its dual treatment with respect to Generally Accepted Accounting Principles (GAAP) and the Internal Revenue Code (IRC). According to GAAP, the lessee in a synthetic lease arrangement is not the owner of the subject property and is therefore not required to report the property or the corresponding debt on its financial statements. In contrast, the IRC views the lessee in the same arrangement as the “owner” of the property, thereby allowing the lessee to use the mortgage interest portion of its rent to reduce its income taxes. The IRC also permits the lessee to benefit from its depreciation.

Unlike a real estate loan, which requires a higher level of developer or owner financing and is structured as a two-party transaction, the synthetic lease typically requires a 3% equity contribution by the lessor/developer and involves three parties: (a) the initial lender(s); (b) the borrower/lessor (usually a special purpose entity (SPE)) created solely for the execution of the synthetic lease transaction; and (c) the lessee. The SPE purchases and develops the property and serves as the landlord of the property for the term of the lease.

The synthetic lease has two essential components, the loan to (or debt issuance by) the SPE and the lease and purchase option from the SPE, which is the bedrock of the arrangement. The initial loan provides the lessor with the funds to acquire and make improvements upon the real property. The funds are usually obtained by way of a loan from a financial institution or a debt issuance made by the SPE. Through this funding vehicle, an SPE with considerable financial backing (typically in the form of a guarantee by the lessee) can use its strength to negotiate favorable terms with the initial lenders.

The lease arrangement provides the basis for the lessor’s monthly cashflows (debt service) and provides the source of funds for the lessor’s repayment of its loan from the permanent lenders. The repayment feature is further insured by way of a purchase option given to the lessee that is exercisable at the expiration of the lease term (maturity of the loan). The purchase option gives the lessee the right to: (a) purchase the property at a predetermined price; (b) renew the lease for an additional term; or (c) refinance the loan. If the property is sold to a third party, the lessee may participate in any capital gains that result from the sale. Similarly, if the sale results in a loss (i.e., the sale price is less than the lessee’s purchase price pursuant to the purchase option), the lessee must pay the deficiency.

To obtain the tax benefits associated with ownership, the lease must contain a purchase option that is based on the Financing Balance (i.e., the unamortized balance of the initial loan). In addition, the taxpayer (lessee) must assume all of the risks and benefits of ownership of the property. The second requirement can usually be met by way of a triple-net lease.

Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 13.07 sets forth the four qualifying criteria that are necessary to demonstrate the existence of a “capital lease”. The term “operating lease” is defined as “all other leases”. Accordingly, an “operating lease” is one that lacks any of the indicia of a “capital lease.” To that end, under an operating lease:

• Ownership in the facility must not revert to the lessee upon expiration of the lease;

• The lease must not contain a “bargain purchase option”;

• The duration of the lease cannot exceed 75 percent of the facility’s estimated economic life; and

• The present value of all lease payments plus the lessee’s guaranteed residual payment under the lease cannot exceed ninety percent of the value of the facility at the inception of the lease.

A lessee who has the opportunity to enter into a synthetic lease transaction should find that the synthetic lease may offer several advantages over a conventional lease. Foremost among the potential benefits of a synthetic lease is the opportunity for the lessee to take advantage of the tax benefits of ownership and simultaneously avoid the consequences of reporting additional debt on its financial statements (i.e., higher leverage ratios and lower profitability ratios).

An added benefit to the lessee is the lower interest expense it will incur in this type of transaction, when compared with a conventional lease or two-party transaction involving a development loan. With a development loan, the monthly payments made by the lessee (borrower) to the lender will usually cover debt service at a higher interest rate and a monthly principal and profit component to the lender. Similarly, with a conventional lease the lessee’s rents will usually include interest (at the lessor’s higher cost of funds) along with some portion of profit and principal amortization on the lessor’s long-term loan. The synthetic lease, however, optimizes the tax treatment of interest expense by calling for rent payments to consist only of interest on the loan over the term of the lease.

Finally, because the lease will usually involve a build-to-suit site, the lessee has the opportunity to participate in the design and development of the improvements, thereby ensuring that the improvements accommodate any special or anticipated needs. An equally important feature of this arrangement is the lessee’s ability to maintain total control of the property and the ways in which the property is used during the term of the lease. These two features make the synthetic lease especially attractive to large pharmaceutical and bio-tech companies that are interested in obtaining additional lab space, companies that desire to expand their manufacturing or warehousing capacity, and businesses whose needs require specially-designed manufacturing or warehousing sites.

Despite its benefits, the synthetic lease has several noteworthy deterrents to its use. First, current accounting rules limit the scope of this transaction’s application, thereby precluding its use in a sale-leaseback arrangement or in connection with properties that have surpassed 75% of their useful lives. Second, the complexity and cost of the transaction (e.g., survey, title insurance, appraisal, and legal fees) make this arrangement attractive to only a limited number of lessees. Finally, because the synthetic lease uses relatively short-term debt to finance a long-term asset, the lessee must consider the practicality of and the extent to which the arrangement fits into its overall capital budgeting and financial management goals.

Because the raison d’être of a synthetic lease transaction is to ensure off balance sheet reporting of the asset and its corresponding debt, it is essential that the company wishing to achieve that end structures the arrangement to avoid the accounting pitfalls that could bring the arrangement within the scope of “reportable transactions” under GAAP. Thus, one of the first steps in creating a synthetic lease is to understand the accounting and tax reporting rules that affect the transaction and consider the implications of these rules for the transaction.

Among the rules that the parties to the transaction must understand are the Financial Accounting Standards Board’s (FASB) Statements of Financial Accounting Standards Nos. 13 and 98 and FASB’s Emerging Issues Task Force’s Abstract, Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions (EITF 90-15). Together, these rules govern such matters as the type of entity that should be used in order to ensure that the parties achieve their desired goals, the type of financing that is necessary when purchasing the real property and financing the development costs, the extent of any interrelationships between the lessor (the SPE) and the lessee, the extent to which each party may be involved in the ownership and development of the property, and the extent to which the lessor is required to hold an equity interest in the lessee.

One of the initial issues that the parties to the synthetic lease arrangement must address is the method by which the project will be financed and the vehicle that will be used to effect the purchase of the underlying real property. It is common practice to create and use a trust whose purpose is to acquire the land directly and develop the property for the benefit of the investors (the beneficiaries of the trust). Project financing may be secured by way of a loan to the trust for the full amount of the project’s costs or a loan to the trust combined with an equity investment made by the beneficiaries of the trust. In the event that the latter method of financing is used, the amount of the equity investment (typically about 3% of the project’s costs) could be used by the trustee to constitute the trust’s 3% equity investment in the lessee for purposes EITF 90-15.

By creating and using a trust, the interested parties can maintain the SPE’s independence and ensure that the property (including the improvements) remain outside of the reach of bankruptcy laws in the event that the SPE later files for or is forced into bankruptcy. The lessor should be aware, however, that if a bankruptcy petition is filed by or against the lessee, a bankruptcy court might recharacterize the synthetic lease as a financing transaction, with a corresponding limitation of rights and remedies. Recharacterization turns on the likelihood that a bankruptcy court, in looking at the structure of the transaction, would deem the lessor to be the lender and the lessee to be the owner of the property, thus treating the arrangement as a disguised mortgage. The potential for recharacterization leaves the lessor vulnerable to the Bankruptcy Code’s differing treatment of lessors versus secured creditors.

In determining whether the synthetic lease is actually a disguised mortgage, the courts will scrutinize the structure of the transaction and the behavior of the parties during the term of the lease. Some of the factors that may be considered are, whether: (i) the rental payments compensate the lessor for the use of the land or for some other purpose, such as ensuring a particular investment return; (ii) the purchase price is related to the fair market value of the property or is the amount necessary to finance the transaction; (iii) the lessee assumed obligations associated with financing the project; and (iv) the lessee may purchase the property at the end of the term of the lease for nominal consideration. Thus, the parties should bear such factors in mind when documenting the transaction and consider adding safeguards to reduce the likelihood that the lease will be recharacterized. Some safeguards that may be considered in case of recharacterization include the use of typical mortgage provisions in the synthetic lease and recordation of the lease or a memorandum of the lease on the land records.

Given the complexities of structuring a synthetic lease transaction and the potential for recharacterization of the transaction, it is no surprise that the parties to the transaction may look to a title insurance policy as a means of mitigating their respective risks, including the risk of recharacterization. From its inception, a synthetic lease has the potential to create more than one insurable interest for the insured. The risk of recharacterization arises form the likelihood that a bankruptcy court would deem the lessor in the synthetic lease transaction to be a lender and the lessee in the transaction to be the owner of the property.

The ways in which title insurers underwrite coverages for synthetic leases continue to evolve and most insurers will work with the parties to provide coverages specifically tailored to such transactions. The proposed insured will need to be aggressive and persuasive in seeking to obtain the coverage that it desires. These transactions are complex by their very nature and the title insurer may be reluctant to assume some of the risks inherent within the transaction. Therefore, the proposed insured should anticipate that the policy, if written, would likely include one or more exceptions that will shield the insurer from uninsurable risks.

One way in which the insured may limit its risk of loss is by the use of specialized endorsements. There are a number of specialized endorsements, including the so-called (a) “Alternative Estates Endorsement”; (b) “Alternative Policies Endorsement”; (c) “Owner’s Policy Conversion to Loan Policy Endorsement”; and (d) “Limited Recharacterization Endorsement”. The availability of some endorsements may vary, depending upon the laws of the state where the subject property is located. Certain states require the state’s regulatory agency’s prior approval of the endorsements before the policy is issued. This requirement may impact the timing of the consummation of the transaction.

The benefits of a synthetic lease to the appropriate lessee can be significant. However, in structuring the arrangement the lessee should assess its long-term financing and profitability reporting needs, and convey to its attorneys and accountants its desire to take advantage of the tax and financial reporting benefits associated with this arrangement. Furthermore, because of the complexities of structuring a synthetic lease, the lessee should plan to work closely with its attorneys and accountants through all phases of the negotiation and formation of the transaction to ensure that its needs will be met as the transaction unfolds. Lastly, management should understand the risks of this transaction, including the risk of recharacterization, the risk of pegging monthly rental payments (i.e., debt service on the loan) to a floating interest rate index, and the risk of purchasing, re-leasing, or effecting the sale of the property in what may be a depressed real estate market. Title insurance, interest rate swaps and “residual value” insurance are available to mitigate some the transaction’s inherent risks; however, use of these measures will add additional layers of cost and complexity to the transaction.

Footnotes

1. See Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 13.05(d), defining “bargain purchase option” as “a provision allowing the lessee, at his option, to purchase the leased property for a price which is sufficiently lower than the expected fair value of the property at the date the option becomes exercisable that exercise of the option appears, at the inception of the lease, to be reasonably assured.” For financial reporting purposes, the Financing Balance is usually deemed as sufficiently large to eliminate any certainty that the lessee will exercise the option.

2. For a sale-leaseback transaction to qualify as an operating lease, Statement of Financial Accounting Standards No. 98.11 requires that the seller/lessee transfer all of the risks and benefits of ownership to the buyer/lessor. Because this rule contravenes the IRS’s requirement that the lessee assume all of the risks and benefits of ownership in order to realize the tax benefits derived from its payment of mortgage interest, the sale-leaseback transaction cannot be used as the basis for a synthetic lease.

3. It should be noted that at the time of the trust’s creation, there must be a trust res that will serves as the basis for the trust’s creation and will be managed by the trustee. Accordingly, issues related to the procurement of funds that will constitute the initial res of the trust and the issues attendant to financing the project will likely need to be addressed prior to the establishment of the trust. See Goytizolo v. Moore, 27 Conn.App. 22, 25 (articulating the elements necessary for the establishment of a trust) “A trust requires three basic elements: (1) a trust res; (2) a fiduciary relationship between a trustee and a beneficiary requiring the trustee to deal with the trust res for the benefit of the beneficiary; and (3) the manifestation of an intent to create a trust.”

4. See e.g., In re Signal Hill-Liberia Ave. Ltd. Partnership, 189 B.R. 648, 651 (E.D. Va. 1995) (distinguishing between legal title and equitable and holding that when a debtor owns property in the capacity of a trustee, the corpus of the trust is not part of the debtor’s estate in a bankruptcy case.)