Market Data

Companies Focus on Real Estate Strategies for the New Economy

As new e-businesses emerge and existing companies reinvent themselves by converting current operations to adapt to the new economy, their real estate strategies increasingly focus on off-balance-sheet alternatives. 

Many companies seek to alleviate earnings pressures, improve net asset returns, and leverage ratios, while harvesting real estate gains from corporate assets and reducing the long-term risks associated with corporate property ownership. Some companies believe that the real estate market is at the top of its cycle, and with changing real estate requirements, they see an opportune time to retool their balance sheets.

As a result, companies are putting new twists on well-developed real estate strategies such as synthetic leases, sale-leasebacks, and property swaps for real estate investment trust operating units in umbrella partnership REITs, or UPREITs. Those using these structured transactions include financial services companies such as banks and insurance companies, as well as start-ups that do not want real estate capital requirements or balance-sheet liabilities.

These strategies have prompted companies to reduce operating costs going forward, possibly outsourcing corporate real estate management, improving financing costs, and potentially mitigating regulatory issues.

Synthetic Lease Scenarios
Synthetic leases have become an increasingly cost-efficient option as the cost of financing has risen.

Synthetic leases achieve off-balance-sheet operating lease treatment according to generally accepted accounting principles. At the same time, they provide tax benefits in the form of depreciation through deemed ownership.

To qualify for this treatment, an operating lease cannot transfer real estate ownership to the company at the end of the lease term; contain an option to purchase the real estate at a bargain price; have a non-cancelable term equal to or greater than 75 percent of the estimated economic life of the property; or have a present value of rents that are minimum lease payments equal to or exceeding 90 percent of fair market value of the leased property.

While tax standards are less clear, the criteria for the financing/conditional sale treatment must be met. Accordingly, the Internal Revenue Service considers in each case whether the risks, rewards, and responsibilities of the asset reside with the lessee.

Synthetic leases usually require investment-grade credit for the lessee to make the economics work. To bear the transaction costs, a minimum $10 million property cost is required. Because tax rules are incompatible with certain accounting rules, synthetic leases work for new construction rather than existing real estate.

Currently, synthetic leases are popular for financial services, insurance, retail, and health-care companies. However, companies should study the cost and complexity of this structure carefully to implement it successfully.

Sale-Leaseback Considerations
A well-structured sale-leaseback results in the seller recording the gain on sale as income, while moving the real estate and related debt off balance sheet. In addition, the lease payments are a go-forward expense with no further balance-sheet impact. 

Sale-leaseback accounting has its own GAAP authority. For the asset to be considered off balance sheet, the leaseback must be an operating lease and the structure must meet certain technical requirements of Statement of Financial Accounting Standards 98, SFAS 28, and SFAS 13.

Further, the transaction must be a “normal” leaseback without prohibited involvement by the seller. Leasebacks are considered normal if the property actively is used in the seller's trade or business, subleasing of the property is less than 10 percent of the fair value of the asset sold, and the seller has minimal involvement with the asset. The seller cannot have continuing involvement, which could include supporting property operations, being a general partner in a limited-partner acquisition entity, guaranteeing a return on the buyer's investment, having an obligation or option to re-purchase the property, or having a receivable subject to future subordination.

While complex to structure, sale-leasebacks can be used as a “silver bullet” when companies face non-recurring losses. For example, a company may enter into a sale-leaseback transaction that meets GAAP criteria except that the seller continues to support the property's operations. If the seller realizes a non-recurring loss by quitting the support of property operations and qualifying for sale-leaseback accounting, it may book the deferred gain from the transaction. This may offset the non-recurring loss for financial reporting purposes.

UPREIT Contribution
Under a less-used, more-adventuresome strategy, real estate can be moved off balance sheet through contribution to a partnership entity that receives operating unit shares in a REIT. Effectively, operating unit shares are convertible into REIT shares. Financial statement and tax gain are deferred until the UPREIT units are converted into REIT shares or sold. While financial statement and tax gain are deferred until such disposition, the seller runs the risk of market fluctuations in the REIT's share price — such as when the REIT market declined in late 1998 through 1999.

The UPREIT contribution to a joint venture or partnership cannot constitute a sale. The contributor may not receive monetary consideration. The contributor can retain certain control rights through the partnership agreement but must exercise caution to not require financial statement consolidation of the partnership.

For example, a presumption of control exists if a partner owns more than 50 percent of the venture. A partner can mitigate consolidation by defining protective rights in the partnership agreement as opposed to participating rights. Protective rights include approval over amendments to agreements, pricing related parting transactions, liquidation of the venture, significant capital (sale or refinance) events, or equity sales or purchases by the venture. Participating rights include changes in management or management policies or determining operating and capital expenditure budgets related to the ordinary course of the venture's business.

The non-controlling contributing partner records no gain for tax purposes but reports any loss incurred pursuant to the terms of the transaction. As noted, the deferred gain is realized when the operating units and/or the underlying asset are sold.

Each strategy has risks and rewards as well as technical requirements. Nevertheless, careful planning can reward property owners economically. 

Jack Barthell

Jack Barthell is partner in charge of real estate capital markets at PricewaterhouseCoopers in New York. Contact him at (212) 596-7280 or jack.barthell@us.pwcglobal.com.

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