|Emerging Trends in Corporate Real Estate Finance:
Leveraged and Synthetic Leases
by Joe Corcoran
Go to Glossary of Terms
Capital markets for funding real estate have changed significantly in the past 5-10 years, and corporations can now take advantage of sophisticated financing instruments to obtain a lower cost of funds, advantageous tax and accounting treatment and greater flexibility in occupancy terms. Today corporations are increasingly looking at "off-balance sheet" options, notably leveraged leases and synthetic leases, to finance the acquisition or construction of new facilities.
Facility and real estate managers do not need a complete understanding of all the tax, finance and legal issues that are involved in these techniques. However, in order to safeguard the company's long-term facility interests they do need to "raise the level of their game" and gather a more comprehensive understanding of the issues in play. This article will describe leveraged and synthetic leases and discuss why they are attractive to corporations. It will also review some of the constraints these techniques can impose on near-term and long term facility planning and how these effects might be mitigated.
Lease Types and their Benefits
If a company can utilize a building reasonably well for ten years or more, ownership is generally more cost-effective than leasing. Ownership provides the company with interest and depreciation tax benefits. Overall ownership cost is not encumbered by a landlord/investor's administrative burden or profit margin. Using its corporate credit, a company can usually place debt on a property at a lower interest rate than is available to commercial real estate companies or investors. Finally, at the end of the holding period the building's residual value accrues to the corporate owner.
Alternately, a company can acquire an interest in real estate through a capital lease or an operating lease. The lessee in a capital lease a) must reflect the subject property as an asset and a corresponding liability on company financial statements, and b) is generally deemed to be the owner for tax purposes and may be able to depreciate the property and deduct interest payments. The lessee in an traditional operating lease is not treated as the owner for tax or financial reporting purposes, and can expense all rent payments.
Despite the cost advantages over time of ownership, there are many reasons a company might prefer to acquire an interest in real estate through a lease, particularly an operating lease.
Companies often prefer an operating lease because it allows them to avoid reporting building related assets and liabilities on their balance sheets. Reducing reported assets and liabilities can enhance key financial performance ratios; notably return on assets, return on equity, and debt coverage ratios. If it can improve these ratios a company can appear to its investors and analysts to be "doing more with less", and it may be rewarded with a better valuation of its stock. On this comprehensive basis, alternatives to building ownership may create value even though they carry a slight cost premium.
There are other reasons a company may prefer an operating lease. As a capital budgeting issue, for example, a company may decide to allocate capital to core operations, not real estate. A bias toward operating leases may even be created when compensation incentives offered to senior management overemphasize improving a company's return on assets.
To keep real estate assets off their balance sheets yet enjoy the cost and control advantages of ownership, companies are turning to non-conventional techniques like leveraged and synthetic leases to finance buildings. Most of the lawyers and financial experts consulted for this article related that synthetic leases seem to be emerging as the preferred mechanism.
Leveraged and synthetic leases can initially be confusing even to fairly sophisticated real estate managers. The following descriptions and diagrams define these two mechanisms and clarify their differences.
Compared with conventional real estate financing, a leveraged lease combines a small component of third-party equity (10%-12%) with a large component of third-party debt (88%- 90%). By committing to a long term lease, typically 15-20 years, a company can effectively use its corporate credit to finance the project, as lenders would consider the company's lease a credit obligation comparable to corporate bonds.
As illustrated in the accompanying Leveraged Lease Diagram, the property is effectively owned by a tax-sensitive investor (an investor interested in depreciation write-offs) through a Single Purpose Entity (SPE), and leased to the company/lessee. A lender, looking to the company's long-term lease, provides the SPE with up to 90% financing, with the investor contributing the remaining 10% as equity.
For its return on equity, the investor/lessor looks primarily to the tax benefit of interest and depreciation deductions, and the resale of the property at the end of the long-term lease. The 10% equity investment typically does not earn a significant current return from lease payments, so these are almost entirely dedicated to servicing the debt. This efficiency, combined with the fact that lease payments only have to service 90% of the project's original cost, often result in an "all-in" implicit lease rate that is comparable to a direct corporate obligation.
Although the corporation enjoys a low rental rate that is fixed for the duration of the leveraged lease, it does not directly enjoy the tax benefits of ownership nor does it capture any residual value or appreciation in the project. Additionally, the 15-20 year lease commitment can reduce the company's flexibility. This condition can be compounded if the lessee is capped in terms of the tenant improvements it is allowed to make (as these may cloud ownership).
Leveraged leases are attractive to corporations because of their lower cost relative to conventional leases, and because they are considered operating leases rather than a capital leases when properly structured.
Leveraged Lease Diagram
Unlike a leveraged lease, which is an operating lease for both financial accounting and federal tax purposes, a properly structured synthetic lease is an operating lease for financial accounting purposes and a financing transaction for federal tax purposes. As the subject of an operating lease, the building does not have to be identified as an asset nor the lease obligations as debt on the company's financial statements. As the owner for federal tax purposes, the company/lessee is entitled to interest deductions and tax depreciation (including component depreciation).
(To borrow from an old Saturday Night Live skit, it's a dessert topping and a floor wax! Tastes great... and look at that shine!)
The transaction mechanics are illustrated in the accompanying Synthetic Lease Diagram. A Single Purpose Entity (SPE/lessor) is created to purchase the property and enter into a lease, generally 3-7 years, with the corporation. Using the corporation's lease as security the lessor borrows non-recourse debt to fund property acquisition (and development in the case of a Build-to-Suit). The SPE/lessor typically borrows 97% and contributes 3% as equity.
At the inception of the synthetic lease the corporate lessee commits to a fixed-price purchase option (FPO) with the lessor. The FPO is based on a market rate purchase price, but is in no case less than the project cost plus the lender's return. The corporate lessee also gives the lender a payment guarantee, insuring that when property is sold at the end of the lease the company will make a termination payment equal to any shortfall between the loan amount and sale proceeds. The termination payment is typically capped at 80%-90% of the original loan. The corporate lessee is thereby effectively insuring the lender from the first dollar of loss up to 80%-90% of the loan (said differently, as long as the company honors its payment guarantee the property would have to sell at just 10%-20% of the original loan amount for any of the lender's investment or return to be to lost).
If all goes well during the lease term, the corporate lessee can typically select one of the following alternatives at the end of the lease.
Synthetic Lease Diagram
For federal tax purposes, the true owner in a lease transaction is not necessarily established by who has title and who pays rent, but rather by determining which party possesses the significant burdens and benefits of ownership. A synthetic lease places these with the corporate user/lessee, primarily because of the FPO and the termination payment. If the property appreciates the corporate lessee can exercise the FPO and realize the appreciation. If the property suffers a loss in value, the corporate lessee bears the burden through the termination payment provided to the lender.
For financial accounting and reporting purposes, a synthetic lease is an operating lease (and off the balance sheet) because it fails the four determining criteria outlined in FASB 13 (Accounting for Leases). The criteria, and parenthetically why they are failed, are listed.
The company/lessee generally pays its own attorneys and accountants, as well as all transaction costs of the lessor/SPE and the lender (including accounting, legal and trustee fees). Synthetic lease documentation for real estate is complex. In addition to standard charges for appraisal, title fees, etc., the company must also indemnify all parties from tax liability, third party claims and environmental claims. The company will also want to involve its auditors during documentation to insure that they will treat the transaction as a synthetic lease in the company's financial statements.
Net cost advantages (credit-driven interest rates and ownership tax benefits) should be understood, as transaction costs can be high when compared to conventional alternatives. Because of this, synthetic leases tend to be more beneficial in larger transactions, where front- end documentation costs are a smaller proportion of the project's overall cost.
Synthetic leases carry unique risk in that they are the subject of ongoing reviews by FASB, EITF and the SEC. Questions have been raised about whether an operating lease classification is appropriate for synthetic lease structures. At some future time these groups may conclude it is not appropriate, and deny operating lease treatment to synthetic lease structures.
Implications for Facility Management: Lessons Learned
Real estate and facility managers, finance and tax accountants and legal counsel must work as a team all the way through negotiations.
Facility and real estate managers are usually very involved in the selection of properties for acquisition. Once a suitable property has been identified, however, corporate departments without facility responsibilities, including tax, treasury and legal, are often brought in to structure the financial transaction.
The nature and complexity of leveraged and synthetic leases often lead to protracted and technical negotiations. As reviews begin to address areas like tax indemnification and yield maintenance provisions, real estate and facility mangers may become less involved.
Without the continued input of building professionals there is some danger the negotiating team will lose sight of the primary reason for the acquisition company operations need a footprint of space for a defined period of time and may need flexibility with regard to the way they use the space. Without these objectives being constantly reinforced negotiations may focus on the optimization of legal, tax and accounting objectives.
Facility managers can add value to the negotiating process by understanding the objectives of other corporate team members, and make known their own concerns when issues are being negotiated that bear on facility planning and management.
While many commitments asked of the company cannot be avoided, some may be negotiable.
Leveraged and synthetic leases, as hybrids of real estate finance and corporate finance, are typically encumbered with the underwriting provisions of both. As with most corporate debt, the lender will require the company to disclose closely-held financial information and provide ongoing performance guarantees; such as maintaining certain liquidity ratios and quarterly profitability measures. In addition to these corporate guarantees, the lender will still borrow from traditional real estate underwriting and will include real estate-related provisions, covenants and defaults--even though it is looking to the financial strength of the company and not the underlying value of the property.
Kristin Markham, Vice President with The Staubach Company, notes that negotiating teams with experience in corporate finance and real estate can often gain some relief for the company from unnecessarily rigid real estate provisions in a synthetic lease. These include conditions regulating occupancy, ability to sublease or vacate, or excessive construction documentation in the case of a Build-to-Suit.
Allocate enough time for the corporation to become comfortable with and execute these kinds of transactions.
In terms of project scheduling, it can be disastrous to have identified a building, allocated time for a conventional real estate transaction, planned necessary building improvements and operational relocations (all before existing leases expire)--and then have the transaction delayed while the company a) decides what financial strategy to use, b) selects a financial partner, and c) struggles with issues like its covetousness of internal information and the risks of indemnifying everyone against everything.
The time it takes to execute one of these transactions--once all the parties are identified and the property selected--is becoming shorter as corporations, lenders and the legal community all gain experience with these techniques (8-12 weeks is typical unless the transaction involves a large portfolio and multiple lenders).
A company can lose time, and even miss opportunities, if it waits until it has identified the property before it researches and selects a financial strategy. If a company has enough foresight, it may even be able to select a financial partner on a competitive bid basis before a property is identified (the partner will be looking first to the financial strength of the corporate guarantor, not the underlying value of whatever property is selected).
Anticipate operational changes that may require capital improvements to the facility during the term of the agreement.
Some leveraged and synthetic leases cap the amount of lessee-owned improvements that can be made to a building, as the value of these modifications over time can cloud the issue of building ownership (which in turn can have serious tax and accounting implications). Clearly, this is more of an issue on longer leases, but a lot can happen in 3-7 years as well.
The burden is on facility planners to look ahead at how operations might change, and provide for those changes during negotiations.
Being a lessee in a Synthetic or leveraged lease can complicate unrelated real estate issues for a company.
As an example, many community and state redevelopment rules are worded so benefits flow to owners and developers.
John Dettbarn, with TRW/IS&S, relates that when part of the company's operations were relocating to an existing 280,000 SF facility in Allen, Texas the company's position as lessee in a long-term credit lease complicated the negotiation of certain relocation incentives. Inasmuch as TRW was "driving the deal" and a coveted corporate presence, it was difficult to endeavor to be a lessee and also receive relocation incentives.
In order to contribute effectively to corporate deliberations and negotiations of these financing mechanisms, understand the language of real estate and finance.
To this end, an abbreviated Glossary of Real Estate Terms for 1995 and Beyond is provided courtesy of Haynes & Boone, L.L.P., a law firm with offices in Dallas, Houston, Austin, Fort Worth, San Antonio, Washington D.C. and Mexico City. The complete glossary is available from the firm (contact Ann Saegert, a partner in the Dallas office, at 214-651-5000).
Asset Backed Security
A term used to describe security collateralized by non-mortgage assets.
A property transaction structured as a lease, but where substantially all benefits and burdens of ownership pass to the tenant. For accounting purposes, the tenant is treated as the owner of the property.
The broad market used for raising capital, and usually referring to private placements and public offerings.
A determination of a yield or rate of return based on actual cash flow rather than nominal principal or interest.
Unsecured corporate debt obligations that typically have a maturity of nine months or less.
Insurance, cash reserve funds, guarantees, letters of credit or other mechanisms that enhance the probability of timely payment of principal and interest on a debt security, such as one backed by a pool of mortgage loans.
An unsecured debt instrument backed only by the general credit standing and earning capacity of its user.
Deposits made in a bank or bank branch that is not located in the country in whose currency the deposit is denominated. Dollars deposited in a London bank are Eurodollars; German marks deposited in a London bank are Euromarks.
In the Money
In connection with an option, swap or other derivative, a situation where the exercise price is favorable compared to the current market price.
Interest Rate Cap
A transaction in which one party pays another party (in consideration for a premium payment) periodic amounts of the same currency based on the excess, if any, of a specified floating rate that is reset periodically over a specified rate.
Interest Rate Collar
A combination of an Interest Rate Cap and an Interest Rate Floor. One party transfers to another party the risk of movements in a specified interest rate or price above an agreed maximum and below an agreed minimum.
Interest Rate Floor
A transaction in which one party pays another party (in consideration for a premium payment) periodic amounts of the same currency based on the excess, if any, of a specified rate over a specified floating rate.
A lease arrangement involving debt; often referred to as "off balance sheet financing" for the tenant, who does not have to carry the debt as an obligation on its books.
A financial market that brings together investment capital and short-term money instruments (those maturing within a year), such as Treasury bills, notes, commercial paper, etc.
Out of the Money
A put option with a strike price that is below the current market price of the underlying security or a call option with a strike price that is above the current market price of the underlying security.
The market in which an original mortgage is created by extending funds directly to a borrower (versus the secondary market, where existing mortgages are bought and sold).
Principal or Principal Transaction
Principal used as a verb refers to committing capital to a transaction, e.g., to Principal the Whole Loan by taking it into position. Used as a noun to describe a transaction in which capital is committed, e.g., to commit to fund a borrower in a Principal Transaction. Contrast with Best Efforts.
RAP (Regulatory Accounting Principles)
The accounting principles required by regulation, which can vary from the generally accepted accounting principles promulgated by FASB.
Measures of creditworthiness assigned to securities by Rating Agencies. On fixed income securities, ratings are typically assigned in descending order as to quality as follows: Investment Grade: Triple-A, Double-A, Single-A and Triple-B; Non-Investment Grade: Double-B and below
Formerly, a real estate investment trust only/ but today it means an entity (either a corporation or a business trust) that invests principally in real estate and real estate interest/ which can, unlike an ordinary business corporation, by meeting certain requirements of the Internal Revenue Code (including distributing most of its earnings to its owners), avoid federal income taxation on its earning. The earnings are taxed to the owners of the REIT when the distributions are made to them.
A market in which securities currently outstanding are bought and sold.
A type of leveraged lease treated as a capital lease for tax purposes and a true lease for accounting purposes.
True Lease (Operating Lease)
A transaction structured as a lease and treated as a lease on the books of the landlord and tenant. Rent payments are treated as an expense by the tenant.
The analysis of a real estate loan for the purpose of determining the amount of risk involved in making the loan. Basically, it involves review of the borrower's credit, value of the security property, and certain legal documents.
Additional compensation paid by the borrower in conjunction with a prepayment of principal prior to scheduled maturity.
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