Synthetic or "off-balance sheet" leases continue to gain popularity with public technology companies in the market for new or expanded facilities. Sophisticated California public companies have used this form of leasing for the past few years, successfully combining the advantages of owning property with the benefits of leasing. The structuring of these deals as corporate financing, not traditional real estate loans, creates a significant added benefit --improved earnings per share and return on assets.
The synthetic lease transaction structures a facilities lease to optimize a corporation's control of its facility, while preserving tax advantages such as depreciation and achieving substantially lower financing rates.
This method of alternative financing should be considered by any public company that is contemplating acquiring facilities through property acquisition or a build-to-suit lease. Additionally, a public company that currently leases its facilities in an above-market single-tenant lease may also take advantage of this structure to buy its way out of an unfavorable lease.
The synthetic lease is a relatively new structure for an old problem. Only a handful of law firms and accounting firms have been involved in structuring these transactions and fewer yet have had the transactions they have structured satisfactorily reviewed by the SEC.
Consider the following comparison of traditional leases, traditional ownership and off-balance sheet leasing.
Traditional Lease
A traditional lease has a number of disadvantages:
- the corporation does not control its facility;
- the occupancy cost is high, because the rent typically contains a return on the developer's investment and the facility is financed at higher, real property-secured interest rates; and
- the tenant corporation generally cannot depreciate costs.
Traditional Ownership
Similarly, ownership of corporate facilities typically has disadvantages:
- the asset appears on the company's balance sheet; and
- the occupancy cost is relatively expensive due to the high interest rate applicable to real estate-secured loans and other costs associated with acquisition.
Off-Balance Sheet Lease
In contrast, the off-balance sheet lease allows the corporation to control the real estate, without being required to show the real estate asset on its financial statements. This improves the corporation's earnings per share and return on assets, a powerful result in our corporate culture.
At the same time, the corporation is able to achieve tax benefits associated with ownership of facilities by depreciating the improvements for tax purposes. In addition, the corporation obtains funds at the lower corporate finance rate, rather than the higher real property loan rate.
Typical Off-balance Sheet Structure
In a typical off-balance sheet transaction, a lender makes a loan to a captive leasing company created by the lender. This loan rate is usually at a more favorable corporate financing rate, and not the higher real property loan rate charged in the open market. The captive leasing company then acquires the property.
The leasing company then leases land and improvements to the tenant entity and the tenant pays rent in the amount of interest on the loan.
Typically, the tenant pledges security (generally liquid assets) in an amount sufficient to secure the loan. The lease then calls for mandatory purchase of the facility by the tenant at end of lease term, with an optional purchase at any time for the balance of the loan amount.
Benefits for Public Companies
Off-balance sheet leases typically result in the following benefits for public companies:
- Lower occupancy costs due to a lower corporate finance rate based on LIBOR + x%, not prime + x%, resulting in significant improvement in the rate over real property loan rates.
- Higher earnings per share and return on assets through operating lease accounting. Further, the real estate asset does not appear on the tenant's balance sheet and no depreciation is charged against earnings for SEC reporting purposes.
- The structure allows improvements to be depreciated for tax purposes thus providing the benefit of a tax shelter.
- The company controls the real estate for all functional purposes.
- The transaction provides for 100 percent financing of acquisition costs, rather than the lower loan-to-value ratio required in traditional real estate financing.