C-Suite Advisory February 2003

The silence punctuating the real estate community is the reaction to FASB finalizing its revision of rules impacting special purpose entities and synthetic leases. After a year of development and review, the final regulations, entitled FASB Interpretation #46, Consolidation of Variable Interest Entities Interpretation of ARB #51, are out, bringing to a close the saga of special purpose entities synthetic leases and the disaster created by the Enron scandal.

The regulators’ intent was not aimed at restricting the use of SPEs (and by default, synthetic leases), but rather to clarify the reporting requirements surrounding their use. Major changes in the new regulations include:

* Changing the name “special purpose entity” to “variable purpose entity” (whew!);

* Requiring the consolidation (off-the-book treatment of synthetic leases to become on-the-book treatment) for those entities receiving a majority of their risk or benefits from variable purpose entities;

* Disclosure of any variable-purpose entities, even if the risk or benefit is not accrued to the holding company; and

* In the future, ownership participation, previously pegged at 3%, will be increased to 10%.

From a timing perspective, new entities created in 2003 will be subject to reporting requirements effective immediately. For existing entities, e.g., the majority of previously issued synthetic leases, companies have until June 15, 2003 to consolidate or report existing SPEs and by default, their existing synthetic leases.

So, what is the impact on existing synthetic leases–now and in the future? Companies with existing synthetic leases or other VPEs will need to consolidate; convert to another structure (most likely sale-leaseback); or disclose.

Many companies who utilized synthetic leases, e.g., high-tech companies bent on growth without balance sheet encumbrances, have already had to deal with these assets due to deteriorating business conditions. Many of the remaining companies with synthetic leases will simply consolidate, move them onto the balance sheet and be done with it. Company explanations will cite recent accounting-treatment revisions to lessen negative reactions. Other companies will convert to a sale-leaseback structure–a more costly alternative. Despite early predictions of severe negative impacts, in fact, the worst may be past. Disclosures have already been made by most companies with existing synthetic leases in the period since Enron erupted. As a result, there will probably be little impact from disclosures of consolidation in the future resulting from the new regulations.

The Future of Synthetic Leases

From a real estate perspective, synthetic leases were financial vehicles built for high growth companies looking to leverage their capital position and manage balance-sheet treatment. But in the current economic climate, there is no or very little growth activity in the marketplace. The 10% participation requirement, coupled with low interest rates, further erodes the financial benefits that synthetic leases once offered.

Today, most corporate real estate professionals are interested in optimizing their portfolios, nudging growth forward and controlling costs. They are not likely to be interested in creative financing through balance-sheet management.

The result, in short, is that synthetic leases are largely dead–the wrong product for today’s economic conditions. FASB’s goal to preserve SPEs while increasing their reporting requirements has been met. SPEs’ name has been changed to protect the innocent. In the next few months, those companies with existing synthetic leases will continue to take a hard look at whether certain assets should remain a part of their portfolio, be disposed of, be consolidated and moved onto the balance sheet or simply be converted into a traditional sale-leaseback.

I’m betting that when the marketplace does return and growth becomes of paramount concern, synthetic leases will rise from the ashes, re-branded and re-launched under some new name, all thanks to some bright structured finance professional. “Phoenix Leases” anyone?

Ed Lubieniecki is national director of Grubb & Ellis Consulting Services Co.