Firms Use Synthetic Leases
Despite Widespread Criticism

The widespread use of so-called synthetic leases by companies to purchase and build everything from new campuses to retail stores is coming under increased scrutiny. But that's not stopping a handful of firms from plowing ahead with the controversial financing method.

A synthetic-lease arrangement allows a company to get the tax benefits associated with owning real estate, while keeping the debt associated with it off its balance sheet. Critics say that such leases are an accounting maneuver that hides potential liabilities and can be used to boost earnings per share.

AOL Time Warner Inc., for one, remains committed to financing the construction of its new Manhattan headquarters at the site of the old New York Coliseum and a new production facility in Atlanta with a $1 billion synthetic lease with Bank of America Corp., according to Michael Colacino of real-estate services firm Julien J. Studley Inc., who worked on the deal for the media giant.

Enron Corp.'s use of off-balance sheet subsidiaries were allegedly used "to conceal lots and lots of debt" and "misdirect people away from understanding" its core business, says Mr. Colacino. In contrast, synthetic leases are "used to finance real estate and equipment that aren't part of the core business of a company." For AOL Time Warner, the synthetic lease is "not a material issue."

A spokeswoman for AOL says a synthetic lease "continues to provide a diversified source of tax advantaged, cost-efficient financing ... our synthetic leases are disclosed in our financial statements, and we believe they are in the best interest of our shareholders."

Cheaper Alternative

In a synthetic-lease deal, a financial institution typically sets up a special-purpose entity that essentially borrows money from the institution to build a facility or purchase an existing one for a company. The special-purpose entity holds the title to the property and leases the property to the respective company. In many cases, the company gets a lower interest rate, which is a floating rate based on the firm's creditworthiness rather than on the value of the real estate, although there are up-front legal and accounting costs. Companies have used synthetic leases to finance equipment purchases as well.

They see them as a cheaper alternative to leasing, purchasing or developing property with traditional loans. For accounting purposes, a company is considered a tenant leasing the property under a synthetic-lease structure. As such, the transaction is treated like a simple operating lease, and the company doesn't have to carry the asset on its balance sheet -- though many companies mention their use in a footnote. That means the company avoids taking depreciation charges against earnings. For tax purposes, the company is considered the owner of the asset. As such, it is entitled to deduct the interest payments and the depreciation of the value of the property.

What's more, typically these lease deals run from three to seven years with options to renew. And that's where potential problems can arise.

Because the leases are short-term, if a company can't renew a synthetic lease because its credit rating has fallen, it may all of a sudden be faced with getting new financing and putting it on its books -- a rude surprise for investors. This might be particularly problematic for companies that are short on cash or have properties whose values have fallen.

"There's nothing wrong with them as a concept," says Gordon DuGan, president of W. P. Carey & Co., a New York-based real-estate investment firm that helps companies get out of synthetic deals, "but synthetic leases have a hidden balloon payment." Given these economic times and the drop in real-estate values in some markets, "you don't want to have to make a payment like that," he says.

Often, these deals lack transparency because the liability a company may have isn't fully divulged. Concern about disclosure prompted an about-face last week by Krispy Kreme Doughnuts Inc., whose previous plan to finance the construction of $35 million manufacturing and distribution plant with a synthetic lease came under fire, touched off by a Forbes magazine story.

The Winston-Salem, N.C., company now says it will finance the facility with a traditional mortgage that will be reflected in its financial statements.

Not Dettered

Other companies, meanwhile, plan to proceed with their plans. In a filing with the Securities and Exchange Commission, Idec Pharmaceuticals Inc. says it plans to develop a new $100 million headquarters campus in the San Diego area and a $300 million to $400 million manufacturing facility in nearby Oceanside, Calif., using "off-balance-sheet lease" arrangements.

Idec Pharmaceuticals Chief Financial Officer Phillip Schneider says that while accountants and lawyers at the San Diego-based biotech company have become "less comfortable" with synthetic leases, "we're still looking at that as an option."

What's more, Mr. Schneider says, "synthetic leases are much lower in cost to the company than a normal lease by about 4%."

Chiron Corp., another biotech company, is proceeding with financing a more than $200 million expansion of its Emeryville, Calif., headquarters, although the deal isn't yet completed, says John Gallagher, a company spokesman.

Mr. Gallagher wouldn't comment on Chiron's reasons for continuing with the synthetic lease deal, but he says the company is "monitoring" reaction to synthetic leases "in light of recent events" involving Enron's off-balance-sheet activity.

Write to Sheila Muto at sheila.muto@wsj.com¹

Updated February 20, 2002