Double Whammy

As real estate markets sag, companies with synthetic leases could face a costly dilemma.

When Silicon Graphics Inc. announced that it had sold part of its northern California headquarters in December 2000 to Goldman Sachs for $276 million, one building alone accounted for $160 million. That was $50 million more than SGI had paid for the four-building complex less than four years earlier.

The gain couldn’t have come at a better time. Like so many other technology companies, the maker of high-performance computing products had been under pressure to divest noncore assets and improve performance, so owning its headquarters was no longer desirable. “A large portion of our capital was tied up in real estate,” says Jeff Zellmer, CFO of SGI.

What’s more, SGI had financed the complex through an arrangement known as a synthetic lease. Under GAAP, the term of such a lease can usually run no longer than seven years for the property to be excluded from the borrower’s balance sheet, as SGI’s complex was. While in theory synthetic leases can be rolled over into new ones when the term is up, in practice the lenders have to be willing to go along. They may not be willing if they’re worried about a company’s ability to pay. That’s because the financing is extended against a company’s corporate credit, instead of the underlying property.

And if lenders (typically banks) are willing to roll over a synthetic lease, they may charge so much that it may not be worthwhile. In SGI’s case, says Michael Hirahara, vice president of facilities and services, the cost of rolling over its synthetic lease would have been “exorbitant.”

In fact, Silicon Graphics might have had to sell the building even if it didn’t want to. That’s because a synthetic lease leaves the so-called residual value risk — the liability for the value of the property at the end of the term — in the hands of the borrower. At that point, if the borrower and lender can’t agree on a rollover, the borrower must either buy the property or arrange for a third party to do so. Perversely, that prospect is likely to face a company at exactly the worst time: If the operating difficulties that make a lender wary of rolling over a lease are shared by other companies — because of an economic downturn, say — the result may be falling demand for the property.

So perhaps SGI found Goldman Sachs in the nick of time. Given SGI’s belief that real estate values were at their peak, “it made sense to monetize the asset,” says Hirahara. “The timing was good.”

But other high-tech companies that financed new property through synthetic leases may not be so lucky. Experts say that with corporate real estate in Silicon Valley and other high-tech havens losing value as local companies struggle to sustain earnings, more and more firms that took out synthetic leases to finance construction in the mid-1990s now find themselves facing what some see as a double whammy — a need to sell property as its value falls. And that underscores the risks that finance executives face when seeking the rewards of this type of financing, which by definition is limited to new properties.


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