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SCANDALS PROMPT NEW RULES FOR RETAIL REAL ESTATE

By Donna Mitchell

For a time it seemed that the retail property business would escape the fallout from the corporate accounting scandals.

Not anymore.

The Financial Accounting Standards Board is about to roll out new rules governing special purpose entities (SPEs) that will touch on several forms of real estate finance. The industry worries that the new FASB rules will relegate synthetic leases to persona non grata status.

As a result of the recent exposures of questionable corporate accounting methods, 30 percent of real estate executives will either reconsider the use of synthetic leases or stop using them entirely, according to a recent survey by CoreNet Global, Atlanta, an education and networking organization for corporate real estate professionals.

Retail property executives worry that credit-tenant and net leases could be dragged into the conflict, saying that the rules are too heavy-handed and, in the wake of the Enron scandal, amount to a case of guilt by association.

“In the net lease business, SPEs are created for absolutely different reasons,” said Ethan Nessen, principal of CRIC Capital, Boston, a joint venture of CRIC and Prudential Real Estate Investors, Newark, N.J. “There have been no issues of companies falling apart.”

A synthetic lease is structured so that a property is not recorded as a liability on the retailer’s balance sheet, but as an expense on its income statement. In the retail property industry, the accounting maneuver is usually applied to stand-alone stores.

Typically, a retailer strikes an agreement with a lender, usually a bank, to secure a piece of property. The retailer creates an SPE and transfers the property into it. The lender usually finances 97 percent of the property’s value over a three- to seven-year term. The retailer may bring in another investor — the developer, perhaps — to invest the remaining 3 percent. During the lease term, the retailer pays the interest portion of the financing and a small amount of the principal.

But the tenant never has to disclose the property on its balance sheet; instead it just includes a brief footnote acknowledging the SPE. Yet for tax purposes, the retailer depreciates the property, and deducts interest and property taxes, explained Cynthia C. Shelton, vice president of business development at Orlando, Fla.-based Commercial Net Lease Realty Services.

“They get to have their cake and eat it,” said Allen O’Brien, a managing director at Atlanta-based Netfunding.com, an Internet-based interchange for real estate finance. “But that will come to a screeching halt.”

Attractive interest rate pricing based on good corporate credit has helped spur such arrangements. With up to $9 billion in new deals each year, the synthetic lease market has between $100 billion and $120 billion in outstanding financing, noted Jack Murray, a vice president at First American Title Insurance Co., Chicago.

If FASB has its way, the entity with the controlling financial interest in the SPE will have to include the vehicle in its financial statements. Investors in the SPE could face a minimum outlay of 10 percent, up from the current 3 percent, according to Murray. “That will make [SPEs] less attractive and more expensive to do,” he said.

Cynthia C. Shelton

Lost business is already palpable among banks, some say, but several institutions contacted for this story declined to comment or did not return calls.

Some industry players are turning the proposed regulations into business opportunities. FASB wants corporations to form SPEs into substantive operating entities (SOEs) — units with employees and enough equity to support their own operations, and to account for them on their balance sheets. Commercial Net Lease is considering whether to structure such an entity and then use it to secure some synthetic lease properties.

“One of the things we’re looking at is whether we can form an entity that would qualify to be an SOE,” said David Cobb, Commercial Net Lease executive vice president and chief investment officer.

Netfunding.com is considering teaming up with an investment bank to open a $500 million fund, tentatively called Commercial Real Estate Solutions, to buy properties in existing synthetic lease SPEs and eventually securitize the assets, O’Brien said.

Many retailers are responding by cleaning house. Synthetic leases could stink up a corporation’s books, especially now that the market is more hostile to anything perceived to be funny accounting.

Dollar General, a Goodlettsville, Tenn., discount retailer, in June replaced synthetic leases on about 400 of its stores, plus other real estate, with a revolving credit facility from a group of banks. Some of the $450 million in financing was used to refinance the company’s existing bank facilities.

Minneapolis-based electronics chain Best Buy has dropped synthetic leases from its menu of finance instruments altogether. “There was a decision, coming from the accounting department, that we will not do synthetic leases,” said Jim McManus, a Best Buy spokesman.

Krispy Kreme Doughnuts had no idea when it decided to launch its first $35 million synthetic lease transaction in April 2001 that it would stir up a hornet’s nest in the capital markets. The company structured a deal with Wachovia Bank, Winston-Salem, N.C. To reassure investors that there was nothing to hide, Krispy Kreme attached a copy of the lease document to the Securities and Exchange Commission filing and discussed the matter in subsequent quarterly conference calls.

“We wanted to make sure it was fully disclosed in a post-Enron environment,” said Randy Casstevens, CFO of Winston-Salem-based Krispy Kreme. For all the company’s effort, media reports hinted that the synthetic lease was another example of misleading corporate accounting, and investors walloped the stock, which fell 10 percent.

“It was unfortunate timing,” Casstevens said, recalling that he’d been promoted to CFO only four days before the brouhaha. “But that is the way things happen.”

The proposed FASB rules might make business slightly more troublesome for the credit-tenant lease market, especially for specialty lenders. A typical credit-tenant lease arrangement involves a developer as the borrower/owner, a tenant with a BBB or better corporate bond rating, and a lender. The lender usually requires that the borrower be an SPE, said Paul McDowell, CEO of Capital Lease Funding, a New York City-based specialty lender. There is a chance that the FASB proposals would require the lender to consolidate the vehicle onto its balance sheet, he added.

A lender may thus have to record more assets and debts on its books, bloating a balance sheet that it would prefer to keep lean. Capital Lease has made $2.5 billion in loans, but its assets and liabilities don’t come close to that figure.

The credit-tenant lease market should, theoretically, fill any financing vacuum created by the demise of synthetic leases, McDowell said. “However, the way the regulations are drafted, there could be significant negative impacts as well,” he said. “There is a problem, but the cure is worse than the disease.”

FASB is set to enforce the new rules after it issues its final interpretation. After March 15, 2003, companies with existing SPEs would have to make them conform to the new standards. FASB said its objective is “not to restrict the use of SPEs, but to improve financial reporting by [the] enterprises involved.”

To some, the damage is already done.

“We aren’t going to become a defender of synthetic leases,” said Krispy Kreme’s Casstevens. “With the bad publicity that followed the previous [lease attempt], that’s a form of financing we don’t want [our] name associated with.”

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