The Financial Accounting Standards Board is moving closer to a solid position regarding the consolidation of special purpose entities, and as the revised regulations threaten to completely evaporate synthetic lease activity, many market players are preparing for a deluge of diverted deal flow to swell the banks of the traditional sale/leaseback market.

"We're seeing an increase in potential deal flow involving companies exploring the option of a tried-and-true sale/leaseback to replace or refinance synthetic leases," said Sean Sovak, managing director and chief acquisitions officer at New York-based real estate investment banking firm W.P. Cary & Co. "I think that we'll see more of that toward year end."

The true target of the FASB's increased scrutiny - and the key difference between a synthetic and a true sale/leaseback - is the question of continuing involvement. In a true operating lease, there exists no ongoing relationship between the equity lessor and the lessee other than that evidenced by the lease contract. Synthetics, on the other hand, do not operate at true "arm's length," and many times involve a guaranteed return or purchase option that belies a continuing involvement between the SPE and the lessee.

"It's going to be harder to keep these transactions off balance sheet," said Sovak. "It's going to have to be a tried-and-true off-balance-sheet obligation. Fortunately, the FASB allows for true off-balance-sheet treatment of traditional sale/leaseback and operating leases, but they have to pass the smell test for continuing involvement- synthetic leases today are not."

According to market sources, the volume of synthetic leases done over the past two to four years approaches $50 billion. "All industries, all property types were taking advantage of the synthetic lease," said one market source. "It was a very addictive source of capital. When you have a chance to borrow at 75 to 150 basis points over Libor, how could you not take it?"

Many companies are no doubt reassessing their answer to that question as they find themselves looking to refinance synthetic leases, but will this entire displaced volume hit the sale/leaseback market? Obviously not, according to Sovak. Some of it will go on balance sheet, and some of it will be refinanced with alternative forms of capital such as high-yield bonds and private placements. But a good percentage is expected appear in the sale/leaseback arena.

Sovak expects to see a strong showing of middle market companies - perhaps private, perhaps highly leveraged - that would find it difficult to access bank capital from increasingly stringent senior lenders.

"Historically at W.P. Carey, we've played the fringes of investment grade and below," said Sovak. "Even in the case of what we like to call emerging credits, if we believe in the management team and in the corporate position, we can provide sale/leaseback capital."

There are companies involved with synthetics, of course, which could be stuck without a chair when the music stops. By and large, however, market players see the current situation as a natural correction of an inherently flawed and unfortunately misused instrument.

"It's the regulatory pendulum swinging from one side to the other," Sovak noted. "It's inevitable - you get more and more aggressive on the accounting, eventually it's going to catch up with you. Sale/leasebacks are tried and true - they pass the FASB smell test and they match the letter of the law.

"The old rule of thumb to match a long-term asset with a long-term liability has some validity to it, and some people are relearning that lesson today."

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