Synthetic Leases: A "New" Solution to an Old Problem

August 1, 2000 Advisory
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Long used in the equipment-financing arena as a way to secure off
balance sheet financing, the synthetic lease is now recognized as a
viable real estate financing option. 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 property and is
therefore not required to report the property or the corresponding debt
on its financial statements. According to the IRC, however, the same
lessee is deemed to be the owner of the property and is therefore
allowed to use the mortgage interest portion of its rent payments to
reduce its income taxes. The IRC also permits the lessee to benefit from
depreciation.
Getting the Best of Both Worlds
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 three percent 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)); 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 lessees 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 lessors monthly
cashflows (debt service) and provides the source of funds for the
lessors 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; 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 such sale.
Similarly, if the sale results in a loss (i.e., sale price is less than
the lessees 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 at the expiration of the
term of the lease). 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. To obtain
treatment as an operating lease, GAAP requires the following four
conditions to exist:
  • Ownership in the facility must not pass 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 lessees guaranteed
    residual payment under the lease cannot equal or exceed ninety percent
    of the value of the facility at the inception of the lease.
Advantages and Disadvantages
A lessee who has an 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 to a conventional lease
or a two-party transaction involving a development loan. With a
development loan, the monthly payments made by the lessee (borrower) to
the lender 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 lessees rents will usually include interest (at
the lessors higher cost of funds), along with some portion of profit and
principal amortization on the lessors 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 lessees 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
transactions 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 such an
arrangement and the extent to which the arrangement fits into its
overall capital budgeting and financial management scheme.
Conclusion
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, the lessee should understand the risks of
this transaction, including the risk of pegging monthly rental payments
(i.e., debt service on the loan) to a floating index and the risk of
purchasing, re-leasing, or effecting the sale of the property in what
may be a depressed real estate market. Interest rate swaps and residual
value insurance are available to address these issues, but they will add
additional layers of complexity and possibly cost to the transaction.