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CDFA Spotlight:
Off-Balance Sheet Financing - Operating and Synthetic Leases
By Stan Provus |
Preface
There are several forms of off-balance sheet financing (OBS). OBS may include a variety of business arrangements such as: investments in the equity of other entities, transfers of financial assets (where there is continuing involvement), certain retirement arrangements, leases, contingent obligations and guarantees, derivatives (like interest rate swaps), and other contractual obligations. Generally, only larger businesses get involved with most of these arrangements, except operating leases.
This article discusses the two types of Off-Balance Sheet (OBS) Financing: operating and synthetic leases. More companies, particularly small companies, acquire new productive equipment through leases than through loans. Of the $850 billion spent by business on productive assets in 2006, $229 billion, or 27 percent, is estimated to have been acquired by American businesses through leasing. Leases are the primary form of financing for many small businesses. A number of port authorities, particularly in Ohio, provide OBS lease financing, particularly for land and buildings.
Eighty percent of U.S. companies lease all or some of their equipment. They lease on an ongoing basis – adding, upgrading, and using the flexibility provided by leasing to have the most effective operation possible. Companies that lease tend to be smaller, growth-oriented, focused on productivity, and more technology-oriented. These are companies long on ideas, short on capital, and in need of flexibility as they grow and change. Companies that lease tend to create more jobs and be the most entrepreneurial and competitive.
This article does not review two types of OBS financing bond issuers transact because they have been the subject of prior CDFA articles. These are the use of operating leases where there is a capital expenditure problem over the $20 million, six-year limit for qualified small issues. David Bovee, VP for Zenith assets in Bellevue, WA, sent us this note: “we routinely consult with companies on using operating leases in order to stay compliant with the capex limitations of the small issue IRB program. This was not (in my experience) quite as frequently used PRIOR to the capex legislative change on 1/1/07. Now, we are attracting larger projects and larger companies where capex is really the limiting factor. The proper use of a FASB13 off balance sheet lease has proven invaluable to helping clients remain within the “box”. Secondly, many issuers or conduit borrowers are undertaking interest rate swaps today, which are also off-balance sheet transactions.
Operating and Synthetic Leases Versus Capital Leases
The accounting for leases under GAAP is based on the view that a lease transaction that transfers substantially all of the benefits and risks of ownership should be accounted for as the acquisition of the asset and the incurrence of an obligation by the tenant. Such a lease is characterized by the tenant as a “capital lease.” This treatment requires that the asset and the obligation associated with it be carried on the balance sheet of the company. In other cases the tenant should account for the lease as an “operating lease.
FASB No. 13 provides that if a particular lease meets any one of the following classification criteria, it is a capital lease:
(1) The lease transfers ownership of the property to the tenant by the end of the lease term.
(2) The lease contains an option to purchase the leased property at a bargain price. The synthetic lease is structured to fail this and the previous criterion by providing a fixed, market-rate purchase price at the end of the lease term, which is not a bargain price and usually is the unamortized principal.
(3) The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property.
(4) The present value of rental and other minimum lease payments equals or exceeds 90% of the fair market value of the leased property.
If none of the four criteria is met, the tenant treats the lease as an operating lease. The effect of characterizing the lease as an operating lease for accounting purposes is that the debt does not appear on the balance sheet (although the lease obligation does appear as a footnote in the financial statements). All lease payments appear on the income statement as currently deductible operating expenses.
Under a synthetic lease, the lessee retains the tax advantages of ownership. Because the transaction places significant benefits, burdens and control of ownership with the corporate user, the user is regarded as the tax owner of the property and is eligible for the accelerated depreciation and interest deductions contained in the lease payments. In other words, the deal is treated as an operating lease for accounting purposes and as a capital lease for federal tax purposes.
Most tenants in synthetic lease transactions are publicly traded corporations, although there may be a growing move toward synthetic leases by companies that are intending to go public as well, if there accountants will sign-off on them. While for-profit companies have been the primary players in the area, nonprofit companies are also beginning to appreciate the benefits of the structure. In nearly all synthetic lease transactions, the tenant is an "investment grade credit" that has been given a favorable credit rating by one of the four nationally known rating services.
The end-user has a specific and identifiable real estate need and is willing to enter into a build-to-suit transaction. The end-user may also need equipment, fixtures or other personal property. The company typically is capable of managing the development of the property, wants to finance as much of the cost of the project as possible, and would like to control the property. It also must be willing to accept a significant portion, if not all, of the on-going and residual risks of ownership.
The Enron collapse changed the popular view about synthetic leasing. The fact that almost every one of the Enron financial vehicles broke one or more of the synthetic leasing rules did not stop members of the accounting profession, financial analysts and securities regulators from taking a hard look at the existing rules with a view toward the development of new rules to achieve greater transparency in financial statements. Enron buried over $10 billion of its debt in Special Purpose Entities (now called Variable Interest Entities), and its balance sheets certainly did not reflect the company’s true economic position. Enron along with other companies fueled legislative and regulatory reforms, including the Sarbanes-Oxley Act of 2002.
New SEC rules will require much more disclosure and discussion of material synthetic leasing arrangements. Pursuant to Section 401(a) of the Sarbanes-Oxley Act of 2002, on January 27, 2003, the SEC promulgated rules requiring (1) disclosure of off-balance-sheet arrangements in registration statements, annual reports, and proxy or information statements that are required to include financial statements for fiscal years ending on or after June 15, 2003, and (2) a table of material contractual obligations in such statements and reports for fiscal years ending on or after December 15, 2003. This means that some companies and their accountants that may have entertained synthetic leases in the past are more cautious now, although other companies may continue to use synthetic leases due to their advantages. It is our understanding that many large accounting firms will no longer sign-off on synthetic leases for their clients.
In some quarters, there is a perception that something is wrong with Off-Balance Sheet financing. Many OBS transactions fully observe SEC disclosure and FASB accounting rules without pushing the envelope, which have been made still more transparent since the Enron debacle. In addition, since Enron, Wall Street analysts, and lenders, among others, will be far more diligent in evaluating a company’s true economic position that may include either operating or synthetic leases.
Special Treatment for Synthetic leases through Governmental Entities
Governmental entities like port authorities, or hypothetically, any Industrial Development Authority, that become involved with providing synthetic leases, unlike for profit lenders, enable a company to keep synthetic leases off their balance sheets under FASB Interpretation No. 46 issued in December of 2003. A company does not have to consolidate a synthetic lease on its consolidated balance sheets when a governmental entity is the other party to the lease.
Why Operating Leases Vs. Loans
Relative to a capital lease or loan, an operating lease can improve the end-user’s return on equity, return on assets, and debt coverage ratios. CDFA Board member and Vice President at GE Capital, David Markovchick has observed that “borrower’s use the operating lease structure (tax-lease) all the time for a variety of reasons, in lieu of commercial debt, but mostly because they can’t use the depreciation ( they have tax credits or loss carry forwards) or to dress up the balance sheet- shows less leverage.”
- The most frequent reason given is the need for equipment flexibility related to either changes in the business or protection against technological obsolescence.
- Cash flow and financial reasons. Leasing permits a close matching of rental payments to the revenue produced by using the equipment. Leasing keeps debt lines open for working capital rather that tied up in capital expenditures.
- Efficiency and convenience. Companies make money by using equipment -- ownership has become incidental depending on business factors. Leasing companies provide a wide range of services related to equipment that can allow a company to focus on its core business -- not managing equipment. Acquisition, disposition, maintenance, and upgrading are just some of the benefits a lease can provide along with the capital itself.
- Stimulating investment and serving growth. Companies are incented to invest in new equipment by the federal and state tax codes. But often the companies cannot use these incentives. Through the use of leasing, however, the benefit of the incentive can be passed through to a company in low rental payments because as the owner of the equipment, the leasing company utilized the depreciation or credit incentive.
Why Synthetic Leases Vs. Loans or Operating Leases
Jerry Arkebauer, Managing Director of Argus Growth Consultants, and the former Vice President of Finance and Strategic Planning at the Toledo-Lucas County Port Authority in Ohio for 18 years, sent us some excellent material on leasing. Jerry has been called the “father of the port financing program” in Ohio. The Toledo-Lucas County Port Authority has completed 17 operating and synthetic lease transactions totaling $542,657,000. Of these, seven were synthetic leases (also called “Government Operating Leases”) and the balance were operating leases.
Port Authorities in Ohio have the ability to own and lease real property and to finance those assets. Jerry believes that port authority ownership through operating and synthetic leases can be a tiebreaker in the competitive world of business attraction. Jerry offers the following table comparing the merits of different financing options, an explanation of risks and a case study.
In Ohio, port authorities view their operating and synthetic lease products as business attraction incentives that other states do not offer. For this reason, some leases are structured with significant interest-only features with balloon payments and the ability to extend leases to amortize the debt. This feature enables companies to use cheaper dollars to purchase facilities because the dollar has depreciated 34% over the past 10 years. In addition, companies benefit from State sales tax savings, since the owner is the port authority. All building materials used to construct a facility for a unit of government in Ohio are exempt from sales taxes, which currently range from 6% to 7.5% depending on the county in which the project is located. About half the cost of constructing a building are materials normally subject to the tax, and half labor which is not subject to the tax.
Finally, in Ohio, leasing deals may benefit from a portion of the financing being provided to qualified companies by the State’s Ohio Enterprise Bond Fund (OEBF) that can borrow at a AA- rating and in Northwest Ohio by the Northwest Ohio Bond Fund, which is rated BBB+. These funds are credit enhanced by the State, port authorities, or lenders. The State may also provide grant funds for certain deals. Because the State is assisting a political subdivision, the State may be more willing to provide credit enhanced participation, since whatever the State does will not set a precedent of what the State will then be asked to do for private companies. The benefit of these financing sources are evident in the Case Study, which shows the Bond Fund rates are much lower than those of the Dana Company bonds, which are the Lease Bonds based on the credit of the company.
Synthetic Lease Case Study: Dana Corporation—Technology Center
In November of 2002, the Toledo-Lucas County Port Authority purchased 30 acres from the City of Toledo and constructed a 183,500 sq. ft. facility. The port authority is provided a synthetic lease facility to the Company for 111/2 years, including an 18-month construction period. The project created or retained 450 jobs at an average family wage salary of $62,500.
Funding Sources
Source | Amount | Balloon | Interest Rate |
State OEBF -Taxable | $10,000,000 | $8,000,000 | 6.10% |
Port Bonds (NWOBF)-Taxable | $7,000,000 | $5,000,000 | 6.18% |
State of Ohio Loan | $3,000,000 | $2,000,000 | 2.0% |
State 629 Grant | $1,000,000 | | |
State 412 Grant | $625,000 | | |
Sales Tax Savings | $625,000 | | |
Dana Lease Bonds | $13,810,000 | $13,810,000 | 10.50% |
Financing Options Comparision
| Loan | Operating Lease | Synthetic (Governmental) Lease |
Owner/Borrower | Company | Port Authority | Company for Federal Tax Purposes and Port Authority for State Tax and Book Purpose |
Term | Maximum of 20 years | 15-20 years | 10 years, with ability to extend 10 more years |
Use of Funds/Costs | Construction, acquisition and equipment | Construction, acquisition and equipment | Construction, acquisition and equipment |
Company Residual Guarantee | N/A | N/A | Up to 90% of the eligible project costs (must meet FASB #13) |
Port Authority Balloon Rate | N/A | 10-25% of borrowed amount | 10-25% of borrowed amount |
Purchase price at end of Lease | N/A | fair market value | Unamortized principal balance |
Subject to accounting review | No | yes | yes |
Company Reserve/Security Deposit | 10% of bond proceeds | as required | as required |
Construction Period | Up to 18 months | Up to 18 months | Up to 18 months |
Funding Option Benefits | · Funds used for construction/permanent financing
· Company controls project during construction/occupancy
· Limited financial covenants
· Facility Company owned
· Long-term, fixed rate financing
· Full amortization of debt
| · Funds used for construction/permanent financing
· State sales tax savings
· Company controls project during construction/occupancy
· Limited financial covenants
· Low cost of funds
· Off-balance sheet for book and tax purposes
· Long term lease at a fixed lease rate
· Options at end of Lease:FMV purchase
Walk away
Re-lease @ FMV
| · Funds used for construction/permanent financing
· State sales tax savings
· Company controls project during construction/occupancy
· Limited, if any, financial covenants
· Low cost of funds
· OBS for Accounting
· Co. takes depreciation for federal tax purposes
· Fixed purchase option to acquire at end of lease
· Co. can extend lease for 20 years and fully amortize the debt at a fixed rate
· Lease payments may be interest only
· Not Required to consolidate under FASB |
Type of Bond | Taxable/Tax Exempt, if qualified | Taxable/Tax Exempt, if qualified | Taxable/Tax Exempt, if qualified |
Risk Factors
The port authorities try to minimize the risks of owning property, particularly environmental, process related, or employee injuries. The ports make sure these risks are the responsibility of the company not the port authority. In addition, with OBS synthetic lease financing there is a 10% “tail” credit risk, meaning a company may not be required to pay back more than 90% of the debt. This means some entity other than the company must accept this risk. In Ohio, ports have accepted the full 10% tail risk and in other cases have shared this risk with the State or sometimes a bank.
Synthetic lease transactions may be structured as almost entirely interest only during the term of the lease. Since a company can only pay 90% of the debt, a large balloon payment may be due at the end of the lease if the company decides not to purchase the facility or extend the lease. For this reason, port authorities will typically extend synthetic lease financing only to BBB rated or better credits.
If a company decides at the end of the lease to vacate the property, it will have paid 90% of the debt. At this point in time, the entity (e.g. port authority) holding the “tail” will assume a first lien position on the facility assets. This mean the facility must be sold for a price at least equal to the 10% “tail” amount. Assuming a buyer can be found, its very likely the facility can be sold for an amount in excess of the “tail” amount, resulting in a profit to the entity taking the “tail” risk.
Operating Lease Case Study: Avery Dennison Project:
(Tim Long, Managing Director of Robert W. Baird and Company, sent us the following case study of an operating lease)
The Avery Dennison Corporation wanted office and research and development facility to serve as the headquarters for Avery’s Roll Materials Worldwide Division Headquarters. The 185,000 square foot buildings included administrative and corporate offices, research labs, support amenities and a conference-training center, located on approximately 15 acres of land in Mentor, Ohio. The project also financed specialized equipment as well as furniture for the new site.
Avery wanted an off balance sheet structure for their headquarters, in which Avery would lease the Project for 10 years and not treat the Headquarters as a capital expenditure. The Port Authority of Cleveland issued $49 million in taxable bonds to finance the project. Avery served as Construction Agent to the Authority managing the construction of the project, and agreed to pay a fixed lease payment to the Port Authority for a term of 10 years. The State of Ohio, though the State R &D Loan program, along with the Port Authority also provided an unsecured portion of debt, allowing the transaction to meet off balance sheet treatment.
The off balance sheet accounting treatment of this project reduced the amount of working capital Avery used for the project. The financing retained 450 jobs in Lake County and will provide approximately 60 new jobs within 3 years.
Nonprofit Operating Lease Case Study
Hospitals and health systems typically select leases over loans when they are financing high-tech equipment that evolves rapidly, such as ultrasound machines. Magnetic resonance equipment, CT and PET scanners and other diagnostic imaging machines also are commonly leased through the equipment manufacturer or an equipment lessor. With a lease, a health system pays for the use of the equipment, not the ownership. So lease payments are much lower than loan payments because they take into account the equipment's residual value. Leases are also off-balance sheet, so they do not add to an institution's debt level - although rating agencies are increasingly looking at financial footnotes to understand an organization's complete indebtedness.
A healthcare equipment lease works much like a car lease: At the end of the three- or five-year term, the user turns over the equipment to the lessor, often in exchange for a new-state-of-the-art version acquired via a new lease. Alternatively, the user can opt to purchase the leased equipment based on its fair-market value at the time. A third option is for the hospital to renew the lease for an additional period (and return, or purchase it, at the end of that second term).
A 20-hospital system in Wisconsin, for one, began making extensive use of equipment leasing about three years ago. Previously, they had been using bond financing for their equipment, but they found that using part of a 20-year bond issue to pay for MR or CT scanners left them paying for equipment at least 15 years past their useful life. Working with GE Commercial Finance Healthcare Financial Services, the system has been leasing about $10 million in clinical and imaging equipment annually. It has found that leases offer three key advantages. They more effectively help it manage technology obsolescence risk, ensuring the system can stay on the technological cutting edge. In addition, operating leases are not carried as liabilities on its balance sheet and they do a much better job of matching revenues from the equipment to the cost of ownership.
Monetizing Assets
Some non-profits, including Evanston Northwestern Healthcare in suburban Chicago and Iowa Health System in Des Moines, in recent years have sold medical office buildings, and then leased them back. Monetizing their real estate assets allowed them to add cash to their balance sheets and reduce their debt-to-capital ratios.
There is growing investor demand, especially from real estate investment trusts (REITs,) for both new and existing medical office buildings. In fact, institutions in need of new buildings will find that REITs and other real state developers often are willing to work with non-profits to finance or invest in such a project.
Just like medical real estate, hospitals may find that sale-leaseback is an effective strategy to monetize equipment assets. These transactions are relatively simple to execute and can free up cash for other needs while improving key financial ratios.
Conclusion
Development finance agencies, including port authorities and industrial development authorities, may find that providing lease financing is a more attractive option for many companies than traditional loans. There are, of course, risks associated with lease financing relative to loans, particularly when they are structured as interest-only transactions with balloon payments. Loans or capital leases structured in a similar manner would bear the same credit risks. Although synthetic leases offer many benefits to companies, in the post Enron era it will be more difficult for companies and their accountants to sign-off on these transactions. Despite this, FASB rules give a clear advantage to governmental entities providing synthetic leases in terms of helping a company keep this debt off-balance sheet.
This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.