When Creative Leases Are a Red Flag


By Amey Stone A number of large-scale bankruptcies, not to mention the Enron debacle, have made investors realize the importance of scrutinizing a company's financing activities. So here's something to watch for in 2003: references to "sale-leaseback transactions." These are deals where companies raise cash by selling corporate real estate, then sign a long-term lease to continue using it. Expect to find a lot more of them.

Sale-leasebacks, as well as their cousin, "net leases" -- in which a company finances a new location by finding third parties to buy the property and then leasing it from them -- are expected to surge next year. That's partly because companies with weak credit ratings are finding it hard to get conventional financing and are increasingly turning to real estate as a source of cash. Plus, even solid companies with strong credit ratings are looking for ways to raise cash to retire debt and improve their financial ratios.

The factor most likely to spur such deals, however, is a set of new rules from the Financial Accounting Standards Board that's due out in January. Crafted after the Enron implosion to force most off-balance-sheet financing back onto the books, these rules are expected to encourage many companies to convert once popular but now discredited "synthetic leases" -- by which companies maintained control of the property while gaining tax benefits -- into more legitimate "true leases," such as sale-leasebacks and net leases. Companies mainly used synthetic leases as a way to keep real estate debt off the balance sheet while reaping all the other benefits of owning real estate.

A DOUBLED MARKET? For the last few years, true leases have been a $6 billion to $8 billion annual market, compared to $15 billion to $18 billion for synthetic leases, estimates Ethan Nessen, a principal at Boston-based CRIC Capital. That activity slowed in the latter half of 2002 as companies waited for the new accounting rules. Nessen thinks about one-third of the synthetic business could potentially switch over to net leases or sale-leasebacks next year. "It's not unrealistic to think those markets could double," he says.

Such lease deals aren't necessarily red flags. They've always been transparent to investors, at least when companies don't cook the books. And fans argue that they allow companies to reallocate precious capital to their core business. "For most companies, that capital can be better deployed in other areas," says James Cate, a managing principal in Atlanta for Newmark Capital Group, which has structured deals in recent years for Bristol-Myers Squibb (BMY), Goodyear (GT), and Tweeter Home Entertainment (TWTR).

Sale-leasebacks were once considered "cash of last resort"

In fact, many of the biggest names in business -- including Cisco (CSCO), Microsoft (MSFT), and Wal-Mart (WMT) -- have used one type of leaseback or another in recent years. "The sale-leaseback was traditionally thought of as cash of last resort," says Michael Smith, a real estate attorney in the Chicago office of law firm Foley & Lardner. "But that isn't necessarily the case anymore."

Despite these leases' advantages, investors who seek a complete picture of a company's financial maneuvering should give them close scrutiny. Citigroup (C), for example, sold its New York City headquarters to Boston Properties (BXP) for $1 billion last September, which amounted to a $323 million aftertax gain in its third quarter. That boosted earnings in the quarter by six cents a share and allowed Citi to beat Wall Street forecasts. That in turn supported its scandal-battered stock -- even though several analysts complained it was a one-time gain and should not have been considered part of operating results.

"WHY NOT WAIT?" Lease arrangements also have downsides. They can increase a company's fixed costs, leaving it less flexibility should it need to downsize, says Smith. And companies lose the chance to participate in the appreciation of the real estate, since a sale-leaseback is basically a one-time maneuver.

For investors in a company that's having trouble raising cash, a sale-leaseback may also be a heads-up. "If this is going on while cash flows are declining or revenue is falling, then it could be a warning sign," says John Lonski, senior economist at Moody's Investors Services. He points out that prices of commercial real estate have fallen in the past year as office-building vacancy rates have risen (see BW Online, 12/20/02, "The View from America's Biggest Landlord"). "This might not necessarily be the best of times to liquidate real estate to raise cash," says Lonski. "Why not wait until the market improves?"

In fact, against the backdrop of a weak economy the trend strikes some economists as a tad unsettling. Robert Smith, president of Smith Affiliated Capital in New York, sees sale-leasebacks as another way companies leverage themselves to survive in a business climate that isn't improving. "It's like having your house paid off and then taking a mortgage on it," he says. "How much hocking up can you do?"

APPEALING PLAY. For now, the answer is probably plenty. Even as more companies may be planning to do sale-leasebacks, lots of investors are looking to help them do it. For those with the means -- high-net-worth individuals, some private real estate companies, and off-shore investors -- buying a commercial property and leasing it back offers a decent yield: about 7% for a lessee with a high credit rating, and 10% or more for those with weaker credit.

"It has a lot of appeal to individual investors right now," says Richard Ader, chairman of New York-based U.S. Realty Advisors, a private company that purchases leases. Investors get passive income for an attractive return that's long-lasting and predictable, he points out. Individuals would need a sophisticated financial adviser to even know about such deals, but Ader says he's in discussions with a large financial-services company about a new kind of financial product that would give individuals better access to these deals. (He declined to provide additional information.)

If a lessee goes bankrupt, the court may not uphold the lease

Sale-leasebacks aren't a vehicle for an investor who doesn't want the potential headaches of owning commercial real estate or can't afford to lose his stake. If a company that's leasing a property goes bankrupt, the court may not uphold the lease. And like everything else in real estate, the degree of risk depends on location, location, location. "If you have a remote or a special-purpose facility and the tenant fails, you have an empty building on your hands," says Michael Torres, president of real-estate investment firm Lend Lease Rosen.

The wisest course for most investors would be to confine their interest in sale-leaseback deals to figuring out why a company whose stock they own is doing such a transaction. "If the company is doing it when it's doing well, it could be a very good move," says Moody's Lonski. But with the economy still rocky, investors should also check to see if companies that sell and lease back corporate real estate are doing so to pump up earnings -- or even as a last-ditch effort to raise cash. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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