News and Information

New option for big players: 'rent to own'

San Jose, Calif., February 25, 2000 -- Lund Financial Corp. has completed financial advisory services on two new building projects for Provo, Utah-based Novell Inc., announced Craig T. Lund, principal of Lund Financial. The projects are valued at $272 million.

What if there were a lease that would give your company all the benefits of ownership, be up to 50 percent less expensive than constructing your own headquarters, and guarantee you the option of purchasing the building at the market price as of the date the lease was signed? Sound too good to be true? It's not. Synthetic leasing, recognized by the Internal Revenue Service and the Financial Accounting Standards Board, is a growing practice among established Silicon Valley companies.

"A synthetic lease is the lowest possible cost of occupancy to a qualified, publicly traded corporation," says Craig Lund, president of Lund Financial Corp. in San Jose. "Qualified" is a key word. It takes a cash-rich tenant with a great record to swing a synthetic lease. Although contracts are structured on a case-by-case basis, most tenants must have revenue of $200 million a year for it to be feasible, says Mr. Lund, who's widely considered the valley's granddaddy of synthetic leasing.

How it works

A synthetic lease involves a tenant, a lender and a third party that will own the property. That third party may be owned by a bank, a bank leasing company or some other entity. Sometimes, it is a company formed specifically for the purpose of holding title to the property.

The tenant gets control of the building and the right to buy it at the end of the lease term--at the market price as of the date the lease was originally signed. In addition, the tenant gets to depreciate the property for tax purposes.

But for financial reporting purposes, which affect the tenant's stock price, a synthetic lease is recorded as an operating lease; therefore, the tenant does not have to record asset, liability or depreciation expenses. The Financial Accounting Standards Board, a national association that governs accounting practices, has an Emerging Issues Task Force that deals with questions of interpretation. That task force has addressed synthetic leasing in at least four publications, which "obviously suggests there's a recognition of those kinds of transactions," says John Hertz, a practice fellow at FASB.

"The goal of the synthetic lease is to get the asset and the debt off your balance sheet and, at the same time, have as much control and retain as many of the benefits of ownership as you can," he says.

Catching on locally

While about two dozen of Mr. Phillips' clients have considered synthetic leases, none of them has ever signed one. "The benefit that they would realize of having off-balance-sheet [financing] wasn't worth the hassle," he says, citing higher fees and extensive paper work as part of the reason.

But Mr. Lund has represented many companies in synthetic lease deals, including Cisco Systems, Novell Inc., Lam Research Corp., Network Appliance Inc. and KLA-Tencor Corp. Novell financed campuses in both San Jose and Utah in 1998 totaling $272 million through synthetic leasing. In San Jose, Novell is occupying two-thirds of its building at First Street and Guadalupe Parkway and subleasing the rest. And Network Appliance, which is building a new 360,000 square foot campus in Sunnyvale, is looking to expand that to 500,000 square feet. The firm used synthetic lease financing for the first 360,000 square feet and is considering it for the rest.

Banks like it

Historically, says Ms. Suhr, tech companies have not gone to banks to fund their growth because they have been able to raise plenty of cash through the equity markets. But synthetic leasing opens new doors for banks to do business with those companies. San Jose-based Comerica California does three or four synthetic leases a year, and the number is growing. These are big deals, averaging $50 million to $60 million.

Comerica typically handles these transactions in conjunction with other banks. It's a bit of risk because the bank provides 100 percent of the financing in a synthetic lease, compared with 70 to 80 percent in a more traditional real estate deal, Ms. Suhr says. Still, synthetic leasing is gaining popularity, she says. Mr. Lund concurs. He figures that by the end of January, he already had more synthetic leasing business ready to go than he handled in all of 1999.

Mr. Lund is setting up synthetic leases for companies nationwide; he's already closed deals in Oregon, Illinois, Utah and Minnesota and has one pending in Massachusetts. And he hopes to do them all over the world. Still, while there are many benefits to synthetic leasing, there are some downsides. The greatest risk for tenants may be they bear most of the risks that go along with real estate ownership; for instance, if a property is sold during the lease term for less than the loan balance, the tenant must pay the difference.

Other considerations: If the loan carries a floating interest rate, occupancy cost will increase with the loan rate; the fees are higher than for conventional leasing; and because it's a fairly new type of financing, FASB is still fine-tuning the rules. "There are a lot of pitfalls along the way to structuring these transactions," says FASB's Mr. Hertz. "You need to deal with people that have expertise in the area. It's very easy to overlook something."