Jeffrey Perrone is a partner with Deloitte & Touche’s (www.deloitte.com) New England tax practice in Boston and is the leader of the firm’s real estate practice for the region.
The Enron mess, which has already had a major impact in the boardroom and in the capital markets, is threatening to spill over into the real estate industry by closing the door on the widely used corporate strategy of synthetic leasing. Under current accounting practices, a corporation can use a synthetic lease to finance the construction or purchase of a facility without reporting it as an asset and related debt on its balance sheet. Such an arrangement, however, typically requires the corporation to create a special-purpose entity to hold actual title to the property – the very sort of off-book maneuvering that regulators, shaken by Enron’s questionable use of SPEs to hide its massive debts, are targeting for reform.
The Financial Accounting Standards Board, upon the urging of the Securities and Exchange Commission, is currently working on an interpretation of the rules relating to SPEs. These new rules will impact most public and private companies that report to shareholders and lenders under generally accepted accounting principles, commonly known as “GAAP.” These changes will be effective for new leases prepared after the release of the document, which is expected to occur this summer. In addition, the changes will be applied retroactively to all synthetic leases for years beginning after Dec. 15, 2002. This means that calendar year companies will probably need to put their synthetic leases on their balance sheet as of Jan. 1, 2003, unless they are significantly restructured.
Constructing Assets
Specifically, the changes for leases using SPEs will generally require the lessee to include an asset held by an SPE on its books along with the debt used to construct the asset. In order for this general rule not to apply, the SPE will have to have 10 percent equity in place at all times during the lease. Currently, synthetic leases use only 3 percent equity. Perhaps more importantly, even if the equity of the lessor entity is increased to 10 percent, the SPE will still need to be put on the lessee’s books if the lessee provides a residual-value guarantee or similar arrangement. These types of guarantees are really the backbone of the synthetic-lease structure. They provide credit enhancement to the lender, reducing the cost of funds and also allowing the lender to underwrite the transaction based on the credit of the company as opposed to a real estate deal with a short-term lease.
This accounting change will have major consequences for corporations that use synthetic leases. Under current rules, synthetic leases allow companies to finance the entire cost of new buildings at short-term interest rates with leases that usually range from five to seven years. A typical “build-to-suit” would require a longer-term lease and higher interest rates, due to the real estate risk borne by the lessor. In addition, companies that previously relied on synthetic leases to keep both assets and liabilities off their books may find themselves suddenly saddled with numbers in both columns that may affect their financial viability. The addition of a substantial asset to a company’s balance sheet will reduce its return on assets, hurting its rating with analysts who use this ratio to measure performance. The technology industry, which relies heavily on synthetic leases to begin with and benchmarks performance significantly by return on assets, will be especially hard hit by such a move. And on the other side of the balance sheet, converting lease obligations to debts might cause many companies to default on their debt covenants, spooking current lenders and bond holders, while at the same time making their balance sheets less appealing to new sources of capital.
Certainly, if these changes go through – and the smart money is saying that they will – corporations, lenders and the real estate capital markets will be scrambling in the next three quarters to re-engineer corporate balance sheets for this major change in GAAP.
If the economy begins to recover, perhaps the only noticeable impact will be long days for chief financial officers and big fees for lawyers and bankers. If the economy continues to stagnate however, the changes could spell trouble for big synthetic-lease users, especially in the retail and technology industries whose numbers are already under a lot of pressure.
In considering these regulatory changes, the FASB doubtlessly thinks it is protecting the interests of the public. And there’s much to be said for reining in the ability of corporations to mislead investors, whether through SPEs or any other accounting loophole. However, by eliminating synthetic leases as opposed to requiring more disclosure, the FASB may have unintentionally put many companies that have incorporated synthetic leases into their overall financial planning in a bind. It would be unfortunate and ironic if the reaction to Enron’s abuses causes more corporate failures.
