As mentioned briefly in last week's Private Placement Letter (ASR's sister publication), the Financial Accounting Standards Board hosted a roundtable Monday, Sept. 30 as a forum for industry comment concerning the Board's proposed guidelines for the consolidation of special purpose vehicles. Net lease pro Kyle Gore of Baltimore-based Legg Mason Wood Walker carried the flag for the credit tenant lease camp, emphasizing the distinction between CTLs and synthetic leases, which have been called "financings in disguise" meant to remove real estate related debt from the balance sheet while retaining the tax benefits of ownership.
Given that CTL's typically involve true arms-length operating leases - with no covenants, no debt guarantees, no downgrade triggers, no residual value guarantees and no equity role by the tenant - Gore's primary argument was that they should not be subject to the proposed guidelines at all. While the Board seemed "sympathetic and receptive" to the argument, they reportedly seemed to exude the tacit stance that no structure utilizing an SPE would be completely exempted.
Gore's secondary mission was to demonstrate to the Board that the proposed 10% outside equity requirement for unconsolidated SPEs - up from 3% - should not apply to CTLs or any other situation where it can be actuarially demonstrated that less equity is sufficient.
"The 10% minimum equity guidance provided by the FASB is something that causes a lot of different issues for a lot of industry groups, including people in the CTL business," said Gore. "The nice thing about CTLs - particularly investment-grade CTLs - is that there is abundant data on default rates published by Moody's Investors Service and Standard & Poor's. If you take that data and multiply it by the probable loss of the default - the difference between the loan amount and the underlying go-dark value of the real estate - you come to the conclusion that one or two percent equity is sufficient."
While the final form that the guidelines will take remains nebulous, at the end of the day, according to Gore, representatives from both FASB and the SEC said that it appears the CTL business is in good shape in light of the proposed guidelines, with one FASB member adding "Finally today, someone with whom we agree."
Despite protests to the contrary by synthetic lease professionals earlier this year, the structure seems to be losing its popularity. According to several market participants from both sides of the table, the widespread industry view is that synthetic leases are on their way out. One CTL player spoke of receiving inquiries from people "who've spent their careers doing synthetics" regarding collaborations on future deals, given that the synthetic lease business will inevitably be "transformed."
One source felt that "transformed" is somewhat of a hedge: "I think that the synthetic lease folks have good reason to be terrified," he said. "Synthetics are in real trouble."
Going forward, most market players expect the CTL market to remain robust, despite some FASB-related fence sitting by some potential issuers. "The CTL market has been great so far this year," said one source. "Issuance has been as good as any other year; some folks have been a little hesitant given what's going on with FASB, but given the advanced stage of the [FASB] draft, most investors that are still buying paper are taking into account the potential changes in their structures and documents."
The source added that spreads on CTLs have yet to be affected by any uncertainty surrounding the FASB situation, and in his opinion, rightly so. As long as lenders get their protection, he explained, spreads should remain unchanged. "Theoretically, you're a secured lender, so your recovery is better in a bankruptcy," he noted. "Anecdotally, and luckily we don't have that many examples to look to, CTL investors in companies that have filed for bankruptcy such as Montgomery Ward and Kmart are doing better than the unsecured lenders."
One area where spreads have widened somewhat is in retail CTLs from companies such as Home Depot, Walgreen's and CVS - the bread and butter of the CTL world. This widening is not attributable to FASB concerns, said one market player, but simply because many investors are full on the names, and the rarified demand has pushed spreads wide. Other real estate assets popular with the CTL crowd such as manufacturing facilities and corporate headquarters continue to thrive out of any sector, said one source.
Stephen Jacobson, a principal at Chicago-based William Blair & Co., is bullish on the entire business. "We believe that the CTL business is a growing one," he said. "How the FASB rules will ultimately affect us is unclear at this time, but we remain optimistic. This is the best year we've had since we've been involved in CTLs, which dates back to the early to mid nineties, and we're expecting our strongest fourth quarter ever.
"We have not yet seen an adverse impact regarding FASB concerns," he continued. "It's been business as usual, and we're expecting to finish with a record year."