Property Values

High-end computing supplier Silicon Graphics Inc. faces the same set of problems these days roiling most erstwhile high-tech darlings: mounting losses, a pummeled stock price and an increasingly unappetizing balance sheet. Not surprisingly, the Mountain View, Calif.-based company–making a mark recently with its animation technology contributions to box office hits Monsters Inc. and The Lord of the Rings–spends almost as much time these days developing new ways to cut costs and improve its return on equity as it does making computer-generated effects.

Of course, the first cuts involved the standard spinoffs and selloffs. But SGI also found unexpected, underperforming assets just sitting around taking up square footage, so to speak: the seven Silicon Valley office buildings housing the company's operational headquarters. "Apart from providing the physical space for the company, it wasn't bringing in anything," explains Michael Hirahara, SGI's vice president of facilities. "We wanted to monetize these assets."

So SGI brought in Cushman & Wakefield Inc.'s Michael Rotchford, senior managing director for structured finance, who helped put together a deal that allowed SGI to sell the seven office buildings for $276 million, lease back six and take the assets off its balance sheet–a big advantage to any company concerned with improving performance as measured by ROE. The most lengthy of these leases–one for four of the buildings–ends in 12 years, with subsequent options to renew and rents starting below market before escalating.

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SGI is hardly alone. Thanks to low interest rates and high, but declining, property values, many companies–particularly victims of the high-tech implosion–are deciding to morph from landlord to tenant. Because most of these deals are private, no firm numbers are available on the scope of sale/leaseback activity. Real-estate experts, however, confirm a dramatic spike, and anecdotal evidence shows the biggest players getting their feet wet. Besides SGI, telecom giants Nortel Networks Corp. and Lucent Tech

nologies Inc. have also recently disposed of huge chunks of property only to subsequently lease back smaller pieces.

"We feel it is best for the company and shareholders to not have significant capital tied up in real estate," says SGI CFO Jeff Zellmer. Even though actual cash flow turns negative in the face of the lease payments themselves, monthly lease expenses are offset by the recognition of the gain from the sale spread over the life of the lease, he notes.

Additionally, sale/leasebacks can pay off tremendously as far as costs of capital, says C&W's Rotchford, who also recently did deals for CIBC and Phillips Lighting. Because the "arbitrage" versus the cost of obtaining funds through other sources amounts to as much as a couple of percentage points, Rotchford explains that these deals enable a company rated below investment grade to tap into funding at an estimated all-in cost of 200 to 250 basis points over Treasurys or near the current spread demanded by investors in triple-B-rated paper.

But while the benefit of this "arbitrage" is demonstrably greater in the case of lower-rated companies, the more solid corporate citizens can also realize savings using this approach if they involve partners such as real-estate investment trusts (REITs), which generally have more conservative investment rules prohibiting forays below investment grade. With this, "you have an arbitrage play, and you have a conservative investment play," notes Craig Linden, director of investment sales at D.G. Hart Associates, a New York-based real estate brokerage and property-management firm.

Admittedly, after the Enron debacle, the four-word phrase "off the balance sheet" raises as many eyebrows as stock prices. But that's why, as Rotchford asserts, you follow the letter and spirit of the applicable Financial Accounting Standards Board rules–mainly, FAS 13. This rule, affecting all sale/leaseback deals, imposes four tests necessary for off-balance-sheet accounting treatment:

o The deal can't transfer ownership of the property

to the tenant by the end of the lease;

o The lease cannot contain a bargain purchase option;

o Its term can't be longer than 75% of the useful

remaining economic life of the property; and

o The present value of the minimum lease payment

can't exceed 90% of the fair value of the property.

FAS 98, which imposes a second set of restrictions on sale/leasebacks of facilities already owned and included on balance sheets, prohibits any type of purchase option at the end of the term as constituting "continuing involvement."

So when do sale/leasebacks make sense? Brian Scott, senior vice president of the capital markets group at Chicago-based real-estate firm Jones Lang LaSalle Inc., says he has identified some factors to be considered in making such a decision and assigned point-weightings to each. Scott helped Whirlpool Corp. design a decision-making matrix so the appliance manufacturer could determine the optimum ownership structure for a planned warehouse. (Whirlpool won Treasury & Risk Management 's silver Alexander Hamilton Award for this project in October 2001.)

Besides dollars-and-cents measurements such as EPS, ROI and ROE, the Excel-based model matrix developed by Jones Lang LaSalle and Whirlpool's treasury, real estate, tax and accounting units analyzes such "qualitative" factors as whether the asset is "core or non-core," the length of any commitments and how binding these commitments are and the corporation's needs for flexibility and liquidity.

In addition to Whirlpool, Jones Lang LaSalle has structured sale/leasebacks over the past two years for Newport Beach, Calif.-based construction and engineering company Fluor Corp., IBM Corp. and Engelhard Corp., an Iselin, N.J.-based industrial-materials company. "It's absolutely a growing trend," Scott says. "More and more companies are focused on taking equity out of real estate, and making a real-estate investment is not their expertise."

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