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Synthetic Hype

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Written by Stan Wendzel MBA, CPA, LEED AP   
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Synthetic Hype
Another Synthetic Lease Benefit
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By now most of us have heard and read numerous articles about synthetic leases. We also know synthetic lease transactions are relatively commonplace for financing corporate build-to-suits and acquisitions, and that they are widely accepted by corporate real estate executives, financial institutions, and accounting firms. But is the synthetic lease a panacea for the corporate executive faced with a leasing decision? Are they the perfect solution for keeping real estate assets oil the company balance sheet? Are there any drawbacks to a synthetic lease? Before entering into a synthetic lease, the corporate tenant should know the potential shortcomings of a synthetic lease as well as when and when not to use one.

 

A Quick Review in Case You Forgot


A synthetic lease has two main components, which qualify it as such. First, the lease is treated as an operating lease for Generally Accepted Accounting Principles (GAAP). Simply put, the lease does not show up on the company balance sheet and therefore it benefits certain key financial ratios such as return on assets, debt to equity, return on equity, and interest coverage. Instead, the lease is recorded as an expense as incurred on the company's income Statement. Second, for Internal Revenue Service (IRS) purposes the lease must transfer all lax benefits associated with ownership of the leased asset to the lessee. The lessee deducts depreciation and interest expense in lieu of the rent expense under a typical lease. Why is this type of transaction so unique and why does is warrant a special name? Because, the lessee has figured out a way to be viewed as the owner of the property for tax purposes but a mere lessee when it comes to financial reporting. In the process, the lessee gets the best of both worlds. The lessee achieves his/her objective of getting the assets off the books and gels tax benefits to boot.

Let's Avoid Too Much Technical Stuff


The IRS rules that govern when a lessee is required to capitalize a lease as an asset on its balance- sheet are very different from the GAAP rules. Knowing this, it was only a matter of time before a few bean counters like myself got together to figure out how lo achieve the preferred outcome under both sets of rules. Essentially, the IRS test relates to transferring all or most of the risks and rewards of ownership to the lessee. If this is done, the lessee is generally viewed as the owner for tax purposes. For GAAP, it gets a little more complicated. Outside accountants had to make sure the lease avoided the four lease capitalization tests under Statement of Financial Accounting Standards (SFAS) 13, and met the minimum equity tests of the Emerging Issues Task Force (EITF) 90-15. The accountants also had to avoid the issues associated with the lessee's involvement in asset construction under EITF 97-10, follow the safe harbor guidance available under EITFs 96-21 and 97-1, and avoid sale-lease-back accounting all together (SFAS 98). Once the accountants figured all this out they had what we now call a synthetic lease.

Lower Lease Rates and More


We have covered the enhanced financial ratios and tax benefits, but perhaps the biggest benefit of a synthetic lease is the low lease rate. The typical synthetic lease rate-is at least 30 percent less than that of a traditional lease. This low lease rate is attributed to a number of factors. First, the capital providers of synthetic leases, typically banks, provide financing based on the credit of the lessee rather than providing a loan on real estate. The capital providers also require strict debt covenants that effectively allow them to monitor the lessee's financial condition and trigger higher lease payments or even repayment of the synthetic lease if the covenants are violated. This improved lending position translates into lower interest rates for the borrower. In fact, for investment-grade corporations, a synthetic lease will typically run two to three percent less than a traditional real estate mortgage loan. In addition to the lower cost of funds, most synthetic leases are structured with no debt principal amortization over the lease term in order to meet the accounting requirements. Consequently, if the synthetic lease interest rate is 6.5 percent, the lease rate (or lease constant) is 6.5 percent of total project costs (including financing points and fees). Even considering the balloon balance, which is the responsibility of the lessee, the savings can be dramatic compared with those of a typical real estate lease. For example, a recent synthetic lease transaction I worked on was priced at LIBOR plus 75 basis points. The resulting lease constant was around 6.0 percent. A typical real estate lease for this same tenant would have required a lease constant of 9.25 percent or more, plus have rent escalations during the lease term. The total savings under this scenario were approximately 39 percent over the five-year lease term for the corporate lessee. Further, an after-tax analysis of this transaction reflected even greater savings.



 

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