Victor Sr.

Monday, 22 July 2002 10:08

Bricks of gold

They don't appear on balance sheets, yet they deliver the tax benefits of ownership. They're called synthetic leases, and their positive impact on corporate profitability can be dramatic.

The market for synthetic lease structures is growing almost exponentially. In fact, in the past three years, one West Coast law firm alone has been involved in deals worth more than $3 billion, for a total of 7 million square feet.

There are a number of reasons for this almost-explosive growth, not the least of which are changes in corporate strategies and tightening real estate markets.

In an era marked by downsizing, restructuring, reengineering, and a zealous search for increased profits, real estate occupancy costs have become a prime target for cutting expenses and enhancing bottom lines.

Corporations have reduced the space-per-person allotment; created virtual offices where employees, supported by computers and telecommunications, work from their homes and other sites; and allotted desks and offices on a temporary, as-need basis.

Still, they continue to search for other sources of cost-savings. And with office markets reaching saturation points and rental rates soaring, constructing their own facilities has become the solution of choice for many companies. Once committed to that route, they then seek the most advantageous way to structure the financing.

For many, synthetic leases are the hands-down winner. Users can now be counted in just about every American industry, and interest is spreading to Europe and Asia.


A definition

A synthetic lease is off-balance-sheet financing. It gives the user the benefits of a capital transaction for tax purposes and an operating lease for accounting purposes.

In simplest terms, a typical transaction works like this: A corporation needs a new facility (office or industrial building, theater, hospital, etc.). A capital source or lessor buys the real estate from the developer and leases it to the corporate user, who may buy the property at a predetermined price when the lease expires.

Looks simple, but it isn't. The lease must meet critical accounting guidelines if it is to deliver its intended advantages. Among these are:

n Stronger balance sheets. Balance sheets show neither the leased property nor the associated liability, which results in better financial ratios. Lease payments are reported as current expense.

n Tax benefits. Users are considered owners for federal income tax purposes, which entitles them to take depreciation and to deduct the interest portion of the lease payment.

n Total control. Users control all the functions of ownership, including potential gain or loss, operational control, and responsibility for expenses.

n Multiple financing opportunities. Commercial paper, private placements, banks and other funding sources are readily available.

n Lower occupancy costs. Corporations that qualify for synthetic leases typically realize substantial long-term savings or find that they can afford a higher-quality property than would be possible with traditional financing. They can normally borrow at the corporate finance rate, which is lower than the higher interest rates typical of real estate financing.


History

Synthetic leases were first introduced in the late 1980s but remained relatively unknown until the past few years. Initially, each was virtually one-of-a-kind. Increased popularity has led to more standardized accounting and documentation and, consequently, to lower fees.

Today's typical users are large corporations with solid credit ratings, but it seems likely that smaller, financially sound companies will follow the trend.

A synthetic lease is limited to new construction or properties to be constructed. It can't be used if a corporation already owns the property.


Caution

In spite of glowing reports, synthetic leases are not without certain risks apart from those inherent in any real estate venture. Because this less-traditional financing is complicated and not yet widely used, many real estate and financial professionals don't know all the ins and outs.

And if a deal violates any of the very strict accounting criteria, it won't fly. So you would want to consult only experienced real estate, legal, and accounting professionals who are experts in synthetic leasing and who can also help you determine whether it will support your company's business strategies and objectives.

Victor S. Voinovich Sr. is president of The Victor S. Voinovich Company, a Cleveland-based commercial real estate firm that represents tenants and buyers exclusively. The Victor S. Voinovich Company is a member of ITRA, the International Tenant Representative Alliance. ITRA members are located in all major markets throughout North America.

Monday, 22 July 2002 10:03

Specialized expertise

Do you remember the software revolution that began to take hold in the 1980s? Until that time, computers were big, powerful tools that the majority of businesses and industries found difficult to use effectively. Manufacturers, focused on production, didn't design with the needs of end users in mind-to a large extent because those needs weren't defined. And customers, or potential end users, didn't know enough about the hardware to know what was possible.

Into this budding impasse came software designers, who set about to rectify the situation. With a basic understanding of hardware and its capabilities, they delved into business processes and operations and began to develop programs that made computers more responsive and, therefore, more attractive to the marketplace.

Where do exclusive tenant and buyer representatives fit into this picture?

Real estate developers and building owners understand the ins and outs of property, and their goals are to maximize the returns on their investments. They don't take the time to understand how real estate can enhance an occupant's productivity and profitability, and to a greater extent, they expect tenants and buyers to make their operations fit into what a property has to offer.

Tenants and buyers, on the other hand, understand their operations but lack the skills and experience to communicate their requirements or to convince building owners and managers to do what's necessary to meet them. This is where real estate professionals who represent tenants and buyers exclusively can streamline the process. They ask the right questions, make observations with a practiced eye and involve other consultants as necessary to pinpoint what a space must provide to serve their clients. At the same time, they know what's happening on the other side of the fence-most have personal experience in that arena-thus, they're sensitive to what may or may not be possible.

In build-to-suit situations, exclusive tenant/buyer representatives can play a critical role, helping users outline their requirements and translating those requirements into locations, materials and layouts that developers can live with. Interestingly enough, developers ultimately benefit from this process as well. Many build on spec, trying to anticipate the needs of various users. The degree of risk in this course depends on the stage of the real estate cycle, but that risk will be mitigated at any stage when the specific needs of potential users are grasped early on.

This is very much like the influence software designers can exert on hardware manufacturers; i.e., interpreting the needs of the end user to the benefit of all parties. Even in today's tight markets, sophisticated landlords are beginning to seek the opinions of tenant/buyer representatives, knowing that they can speak authoritatively to what features will enhance the appeal of the property.

Technology-computers and all their siblings-has forever changed the way business is done, both directly and indirectly. In terms of real estate needs, technology demands virtually total flexibility. Movable walls and easy access to floors and ceilings are just the beginning. Buildings, themselves, must be "user-friendly." Lighting, both natural and artificial, heating and air conditioning systems, elevators, fire safety, and security must all reflect the latest technology in ways that satisfy the constantly changing needs of business.

All of this has become part of the expanding role of tenant/buyer representatives. Sought initially for the uncompromising stance that eliminates the conflicts of interest built into full-service real estate firms, they are now singled out as much for their broad knowledge of business and real estate and their wide-ranging skills.

Enlightened business owners and managers consult regularly with their tenant/buyer representatives to assure that facilities continue to serve their goals and to take whatever corrective steps might be necessary in a timely manner. Enlightened landlords, who might once have scorned them as adversaries, realize that tenant/buyer representatives play a substantive role in creating strong, amicable tenant-landlord and buyer-seller relationships.

Victor S. Voinovich Sr. is president of The Victor S. Voinovich Company, a Cleveland-based commercial real estate firm that represents tenants and buyers exclusively.