Off-balance-sheet financing: Synthetic leases

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

The lessee/corporate user is treated as the owner of the leased property, which enables it to realize appreciation in the value of the property, take depreciation on the property for tax purposes, and characterize rental payments as payments of interest and principal. The Internal Revenue Service [hereinafter the Service] treats the transaction as a conditional sale, qualifying the transaction for the favorable tax benefits associated with depreciation.4 Under certain conditions specified by the Service,5 and assuming it is the intention of the parties to do so, the tax benefits of owning the leased property that accrue to the lessee may be retained by the lessor or a special purpose entity [hereinafter SPE] acting as the lessor. However, a synthetic lease transaction is seldom structured in this fashion.

Another benefit of a synthetic lease to the lessee/corporate user is that it may not trigger financial covenants in bank loan documents that otherwise limit the incurrence of indebtedness by the lessee/corporate user.

IV. FUNDING AND PRICING

A synthetic leasing transaction, although nominally secured by real property assets, is underwritten on the basis of a guaranteed minimum revenue stream and the financial strength and credit rating of the lessee or a guarantor. The transaction, which usually is treated by the parties as an unsecured corporate credit loan, is easily securitizable and, thus, is attractive to public and private funding sources. A bank, or other capital source, provides the funding for the real estate acquisition and the construction of the improvements. The improvements are typically single-user facilities (e.g., a factory, power plant, office building, food service operation, high-tech or bio-tech facility, warehouse, retail building, studio, or special purpose facility) that are subsequently leased and used by a corporate user. In the simplest form of a synthetic leasing transaction, the capital source directly acquires the real estate chosen by the corporate user and leases the real estate to the corporate user. Generally, in a lending institution financed synthetic lease, the lessee/corporate user pays a rental equivalent to interestonly payments based on either a spread over the London Inter-Bank Offered Rate [hereinafter LIBOR] or similar index, or a spread that is Treasury based, instead of a spread over the lending institution's prime or base commercial rate. The spread is determined by the credit rating and financial strength of the lessee/corporate user. If the lessee/corporate user does not maintain an investment grade credit rating, then additional collateral such as a bank letter of credit, a surety bond, or a first deficiency guarantee may be provided to ensure repayment to the lessor and the lenders.6

A fixed-rate rental equivalent, usually higher than the rate obtained through floating-rate financing, may be obtained by using an interest rate swap arrangement. In an uncollateralized, floating-rate, synthetic lease transaction involving a creditworthy lessee/corporate user, the financing rate is usually priced at approximately 40 to 150 basis points above LIBOR, while collateral financing is generally available at a rate that is less than 40 basis points above LIBOR. Fixed-rate financing, accomplished using an interest-rate swap at a minimal cost, has been available recently at a slightly higher rate of seven to eight percent for ten-year synthetic leases.'