Off-balance-sheet financing: Synthetic leases

Real Property, Probate and Trust Journal, Summer 1997 by Murray, John C

John C. Murray

Editors Synopsis: Synthetic leasing is a technique of off-balance-sheet financing that has become popular in recent years as a means of financing real estate acquisition and construction without creating significant new debt on the corporate balance sheet. The user of the real estate retains many aspects of ownership, but the transaction is characterized as an operating lease for financial accounting purposes. This Article examines the background and purpose of synthetic leases, as well as the accounting, legal, title insurance, funding, and pricing concepts applicable to this type of structured financing. This Article also examines the structuring and documentation issues involved and analyzes and discusses the advantages and disadvantages of using a synthetic lease. The Appendix provides an example of a memorandum of lease that could be recorded as part of a synthetic leasing transaction.

"The basic drives of man are few: to get enough food, to find shelter and to keep debt off the balance sheet."'

I. INTRODUCTION

In the past several years many United States and foreign banks, as well as other capital sources, have become increasingly active in offering "offbalance-sheet" financing for corporate real estate acquisition, construction, and expansion. This method of structured financing is attractive to a corporate user of real estate because, if properly structured as a true "synthetic" leasing transaction, the lessee/corporate user will be able to expense the rental payments it makes to the lessor under the synthetic lease, and its balance sheet will not be marred by the appearance of real estate ownership or by the existence of mortgage debt.2 However, the lessee/corporate user will retain all the tax benefits and burdens of ownership, including the ability to depreciate the real estate assets and obtain any appreciation upon a subsequent purchase of the real property from the lessor or upon resale to a third party.

II. WHAT IS IT AND WHO USES IT

Synthetic real estate financing is a method used to provide off-balancesheet financing to a corporate entity for the acquisition and development of a commercial facility or site, with a substantial credit support for debt issued by or through an investor or capital source, usually a bank. Off-balancesheet financing has been used for many years as a source of capital financing for acquiring heavy equipment, especially airplanes, as well as for assets with a shorter economic life, such as automobiles and inventory for retail operations. Recently, off-balance-sheet real estate financing has proliferated in connection with corporate acquisitions and with construction and development of commercial real estate facilities. This recent growth is a result of: (1) the collapse of traditional sources of commercial real estate financing during the real estate recession in the late 1980s and early 1990s; (2) the pressure on corporate entities to show strong debt-to-equity ratios and to increase stock values; (3) the desire of capital investors to diversify into areas other than equipment financing, while avoiding the operating and residual risks associated with traditional real estate transactions; and (4) the issuance of accounting, tax, and legal opinions, regulations, and pronouncements clarifying the circumstances under which real estate transactions qualify for off-balance sheet financing treatment.

Off-balance-sheet real estate financing is most attractive to large, publicly traded, creditworthy corporations and businesses, such as manufacturers, supermarket and drug store chains, food service businesses, computer, transportation, and energy companies, financial institutions, health maintenance operations, and retailers. Major users of commercial real estate seeking medium-term, revolving-credit financing, that have substantial and highly specialized build-out costs, and that seek an opportunity to maximize the value of their companies' stock, are likely to benefit from off-balance-sheet financing. This method of structured financing may also be employed in connection with a number of planned corporate acquisitions by developing a master lease facility for the inclusion of numerous properties, to be brought into the facility as they are identified and acquired or made ready for the construction of improvements.3 However, off-balance-sheet financing is less appropriate for smaller companies and smaller transactions because of the significant structuring, documentation, and compliance expenses.

III. BEST OF BOTH WORLDS

A synthetic lease is characterized as an operating lease for financial accounting purposes. The lessee/corporate user retains the tax benefits and operating control associated with ownership and debt, but, for accounting purposes, does not have to book the lease obligation as a liability or the leased property as an asset. Therefore, the lessee/corporate user's asset ownership and corresponding "mortgage" liability do not appear on the lessee/corporate user's balance sheet. Rental payments are expensed annually on the lessee/corporate user's income statement. Notwithstanding this treatment for accounting purposes, a synthetic lease qualifies as a loan for federal and state income tax, bankruptcy, and commercial purposes.