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Maximizing profits with a synthetic lease The Appraisal Journal; Chicago; Jan 2000; Thomas A Dorsey; Abstract: From a real-estate perspective, the words "synthetic lease" might be understood to be a form of agreement for occupancy or use that is in some way artificial and contrived. In fact, it is very real and can be a means of controlling property interests at lower cost than would be achieved by purchasing the asset or signing a conventional lease. The synthetic lease is becoming increasingly popular among corporate chief financial officers. Properly designed, it can meet the requirements of an operating lease while qualifying under tax regulations as a capital lease. The synthetic lease is an agreement structured to appear as an operating lease for income- reporting purposes, and as a capital lease or a loan for taxreporting purposes.1 Nearly everyone is talking about it. "Just as the sale leaseback was the talk of the town in the 80s, the term 'synthetic lease' now may be tripping off the tongues of your CFO and her fellow bean counters."2 Synthetic leases are being used by a wide assortment of businesses as a vehicle that provides exceptional flexibility to corporations that must sort through the wide array of alternative structures to control real estate.3 Leaders in the accounting profession suggest that a synthetic lease produces at least five benefits to a corporate user: enhanced financial ratios, retention of tax benefits, transaction economics, financing flexibility, and realization of future appreciation.4 In today's regulatory and tax environment, synthetic leases are a valuable tool for investors and users of real estate. Asset managers and appraisers alike must have an acceptable level of familiarity with the mechanics and benefits of this popular ownership vehicle. Definitions "Synthetic" means artificial, Imitation. According to The Dictionary of Real Estate Appraisal,4 "lease" means "a written document in which the rights to use and occupy land or structures are transferred by the owner to another for a specified period of time in return for a specified rent."5 Synthetic leases are not easy to understand. To the uninitiated, they may seem too good to be true. Although synthetic leases have been used for a number of years in equipment leasing, they have gained popularity in the real estate arena only recently.6 With these transactions, the objective is to maximize profit through asset control, although the degree of control that results is equivalent to ownership. In fact, for tax purposes, it is assumed to be ownership. In order to appreciate the benefits and the risks, let us look at the differences between a capital lease and an operating lease. Capital Leases and Operating Leases The Financial Accounting Standards Board (FASB) states, "Capital leases are treated as the acquisition of assets and the incurrence of obligations by the lessee. Operating leases are treated as current operating expenses."7 Capital leases are agreements that transfer the risks of ownership to the tenant without transferring the title and under the conditions in which the tenant acts in most respects as the "owner" of the property. Conditions that require capital lease accounting include a bargain purchase option (i.e., at a price lower than market value); an automatic transfer of title at the expiration of the lease; a lease term that extends for 75% or more of the useful life of the asset; or a lease agreement where the present value of the lease payments is equal to or greater than 90% of the fair market value of the property. Most real estate leases are operating leases. For accounting and tax purposes, the operating rent payment is recognized as an expense. The balance sheet does not include the value of the asset or the lease liability. Under a capital lease, the property is treated as an owned asset. It is included on the balance sheet as an asset with a corresponding liability. Both interest and depreciation are recognized as expenses. A synthetic lease is a financing transaction that is structured to qualify under FASB guidelines as an operating lease, while being categorized by Internal Revenue Service (IRS) guidelines as a capital lease. This definition seems to be a contrariety and is sometimes perceived to be a loophole in the tax law, but it is consistent with longstanding positions of FASB and the IRS. In order not to be treated as a capital lease for accounting purposes, the agreement is designed to ensure that it does not meet the four conditions of a capital lease. At the same time, the agreement is designed to provide such a high degree of ownership control by the tenant that the IRS views the transaction as a conditional sale and requires that it be treated as a capitalized lease. Under a synthetic lease, the tenant recognizes the rent payment as an expense for Generally Accepted Accounting Principles (or book) reporting purposes. There is no asset or liability recorded on the balance sheet. For tax purposes, the agreement is a conditional sale, allowing the tenant to recognize both interest and depreciation expenses. Regulations Several regulations of the FASB apply to synthetic leases. The two most definitive are Statements 13 and 98. Statement No. 13, "Accounting for Leases," was issued in November 1976. Statement No. 98 was issued in May 1988, and focuses on "Sale Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Definition of the Lease Term, and Initial Direct Costs of Direct Financing Leases." FAS 98 is just one of the modifications or expansions to FAS 13. Several additional statements have been made since 1976.8 Both FAS 13 and FAS 98 remain in effect today. FASB'S publication, Accounting for Leases, a codification as of October 1, 1998,9 is a comprehensive source of information on this subject. The 450-page volume includes a CD-ROM for easy access to the information. The regulations and requirements presume some familiarity with accounting principles. Although this information is a good library resource for non-accountants, professionals such as analysts, appraisers, and brokers who do not specialize in this area would best serve themselves and their clients by partnering with a certified public accountant or other qualified professional in matters requiring interpretation of accounting regulations. As with government prerogatives, the requirements of bodies such as the FASB and the Appraisal Standards Board of The Appraisal Foundation influence the value of real estate.10 In this instance, the ability to create a synthetic lease adds value11 to the asset by adding after-tax cash flow and enhancing the owner's financial ratios (e.g., with the result of freeing capital to be invested in core business needs). Benefits The bottom-line impact of a synthetic lease is high. When compared with the costs of a conventional lease, the rental payment under a synthetic lease can easily be one third less. One executive suggests that the synthetic lease "provides all the control benefits of ownership and the advantage of keeping that real estate off the books at a significantly lower cost (typically 35%-50% less) than a traditional lease."12 An article in a health care industry publication stated: [B]ecause the lessee controls the appreciation of the property and is liable for depreciation, the IRS sees a synthetic lease as a conditional sale, with the lessee entitled to the tax benefits of ownership. So, for accounting purposes the property is owned by the lessor, and for tax purposes the property is owned by the lessee.13 A synthetic lease is an off-balance sheet financing mechanism. For tax purposes, it is treated as a capital lease. But for financial accounting purposes, a synthetic lease is presented as an operating lease (see figure 1): For tax purposes, the taxpayer has some combination of deductions for rent, depreciation, and interest. Generally, the taxpayer desires deductions that reduce taxable income and, hence, current tax payments. The operating lease typically provides less of a benefit in this respect, while the synthetic lease provides the same deductions as the ownership option or a capital lease. When it comes to financial reporting, the opposite is more often true. Maximizing profits is the objective, and the operating lease can be more attractive for this purpose. The synthetic lease is treated as an operating lease. Under a synthetic lease structure, the "tenant" realizes the best result for both tax and GAAP purposes. Operating results are enhanced, and the resulting tax liability is reduced. Mechanics Setting up a synthetic lease is not easy. Although the concept is not difficult, the structure is complex, and the time and expense required do not compare favorably with other transaction types. Generally, synthetic lease treatment will not apply to assets that have been owned in the past by the prospective tenant. To the asset manager, this removes all owned and sale- leaseback properties from consideration. However, properties that are currently leased and properties that are about to be developed are candidates. Once a property has been identified, there are three roles to be filled: the tenant, the landlord, and the lender. The tenant agrees to lease the property. The landlord (and nominal owner) finances the property based on the tenant's commitment and corporate credit. The lender provides the funds necessary for the prospective landlord to acquire and/ or develop the property. To this point, the transaction is not any different from agreements that are completed virtually every day. This transaction, however, is structured so that the tenant is effectively both the purchaser and the borrower. Assume that ABC Corp. requires a new warehouse, and the property identified to serve its needs is available for $10 million. The first step is to locate an investor who will accept title to the property and serve as landlord. That investor is referred to as a special purpose entity (SPE). Next, ABC Corp. and the SPE must find a tender who is willing to lend nearly all the funds needed to acquire the asset. The SPE must invest a minimum of 3%,14 or $300,000, leaving $9.7 million required of the lender. ABC's rent payment is the sum of the yield required by the SPE and the payments due to the lender (generally, interest only). The lease and loan terms are coterminous, and are set so as not to meet the applicable tests for capital lease. At the expiration of the lease, ABC Corp. has three options: (1) purchase the property at its original cost (assuming no amortization of the debt), (2) sell the property, or (3) extend the lease. In the event of a sale, any excess proceeds would accrue to ABC Corp. If a loss is incurred on the sale, in most cases the tenant would reimburse the SPE for the entire loss, using a contingent rent payment (a residual value guaranty).15 Decision Process According to a Latin proverb, "No gain is so certain as that which proceeds from the economical use of what you already have." Some questions can help decide whether a synthetic lease transaction is appropriate: 1. Are you prepared to make a long-term commitment to the property? 2. Do you want to have a level of control that is equivalent to ownership? 3. Would you be willing to own the asset? 4. Is your credit rating better than the prospective landlord's (e.g., the landlord under an operating or capital lease)? If the answer to the questions is an unqualified 11 yes," then a synthetic lease should be considered. Tenants under a synthetic lease must demonstrate a level of commitment equivalent to ownership, and the credit rating and tax requirements must be such that they make the lease both feasible and beneficial. The "synthetic" structure is a lease without being an actual lease, a loan without being an actual loan, and a purchase without being an actual putchase. In the example, ABC Corp. might be considered to be the borrower (via a residual value guaranty), the owner, or the tenant. The Future Accounting regulations and tax laws are certain to change tomorrow, next week, or next year, but no one knows to what extent those changes will affect the synthetic lease. As long as this tool is available, it can be a creative and viable means of reducing expenses, and when expense is reduced, the potential for income is enhanced. The future is a guess. Opportunities in the present are based on what we currently know and what is forecasted. The synthetic lease is a vehicle that allows users to realize greater profits now and in the future, while retaining the control and flexibility necessary to compete in a fast-moving marketplace. Today's corporations can manage future expenses by employing synthetic leases. Unless regulations change, appraisers should expect to see more of these transactions. [Footnotes] 1. For tax purposes, a synthetic lease is treated in a manner similar to a financing or a capital lease. 2. Theresa Walsh Giarusso, "Synthetic, But Not Fake," Facilities Design & Management (December 1998): 36-38. 3. Steve Bergsman, "Synthetic Leases: Not just for High-Tech Companies Anymore," Corporate Finance (Spring 1996): 42-43; Kurt W. Rosene, "Deal Structures: Ownership vs. Sale Leaseback vs. Synthetic Leases vs. REIT " Corporate Real Estate Executive (January/February 1999): 29-31. 4. Michael L. Evans, Synthetic Real Estate: Corporate America Goes Off Balance Sheet. E & Y Kenneth Leventhal Real Estate Group, San Francisco, California, 1999. www.careyleggett.com/art2.html. 5. Appraisal Institute, The Dictionary of Real Estate Appraisal, 3d ed. (Chicago, Illinois: Appraisal Institute, 1993), 203-204. 6. Frank A. St. Claire, The Who, What, Why, How and When of Synthetic Leases. Strasburger and Price LLP, Dallas, Texas, 1998. www.strasburger.com/pubs/synthetic.htm. 7. Financial Accounting Standards Board, Statement No. 13, "Accounting for Leases," November 1976. 8. See FASB publications FIN 19, EITF 90-15, and EITF 96-21. ("FIN" refers to FASB Interpretations, and "EITF" refers to the Emerging Issues Task Force.) 9. This publication is available through FASB's Order Department at (800) 748-0659. 10. Thomas A. Dorsey, "The Influence of Government Regulations on Market Value," Valuation Insights and Perspectives (First Quarter 1998): 16-21. 11. This is not market value since it includes user-specific finance and tax assumptions. 12. Craig Lund, president of San Jose, California-based Lund Financial Corporation, as quoted in Dan Emerson, "Buy or Lease or Something in Between," Plants Sites & Parks (February/March 1999); 47-50. www.bizsites.com/PastPres/FM99/taxes.html. 13. Kathleen Vickery, "Synthetic Leases Offer Genuine Benefits," American Health Care Association (May 1998): 1-3. www.ahca.org/news/provider/ pv9805fn.htm. 14. EITF 90-15 and EITF 96-21, 15. FIN 19. Thomas A. Dorsey, MAI, SRA, is a senior vice president at First Union National Bank, Charlotte, North Carolina. He is a real estate appraiser, broker, and general contractor. Mr. Dorsey earned his MBA at Florida Atlantic University, Boca Raton, Florida, and his BA at Case Western Reserve University, Cleveland, Ohio. He has written numerous articles for Appraisal Institute publications, and was the winner of the Appraisal Institute's Robert L. Foreman Essay Competition in 1997. Contact: firstname.lastname@example.org.
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