Responding to the need for greater transparency in financial markets in the post-Enron era, a new accounting standard is being presented requiring tenants (both public and private companies) to recognize the current and future value of all leases on their balance sheets. This standard is jointly presented by FASB (Financial Accounting Standards Board) and IASB (International Accounting Standard Board). The proposed standard, if enacted, will be a factor in the real estate decision-making process for all companies. It will have a major impact on financial statements of companies with large lease obligations which are currently considered “Operating Leases”. While this proposed standard applies well beyond the lease of real property, my focus is on its impact to tenants in office leasing. It has been reported that this change will result in between $1 and $2 Trillion being transferred to companies’ Balance Sheets. Some question the timing of this proposed change given the economic conditions and the state of the commercial real estate industry.
All forward thinking tenants should review with their real estate advisor how the proposed standard will impact their real estate strategy. Below is a summary of the current accounting standard, the proposed new standard and its impact on office tenants.
Most office leases today are treated as “Operating Leases” (as opposed to “Capital Leases”) and are not recognized on the balance sheet. Instead, they are recognized annually on a straight-line basis as a rent expense on the income statement. Leases are considered “Capital Leases” by meeting at least 1 of 4 criteria (articulated by FASB) which is tantamount to a financing transaction. Capital Leases are recognized on the Balance Sheet as an asset and liability.
Why the Change?
Think Enron and their infamous off-balancing sheet transactions. Operating Leases are typically a company’s largest off-balance sheet liability. The SEC proclaimed that they need to be fully disclosed to offer a more accurate view of a company’s liabilities. As explained below, the full disclosure is of the entire lease liability as opposed to one year. Laissez-faire critics say that this is unnecessary as most analysts and financial institutions fully account for operating leases by making adjustments to balance sheets. Such an unregulated approach probably isn’t politically palatable today.
What is the proposed rule for tenants?
Replacing the distinction between “Capital Leases” and “Operating Leases”, with a definition of a lease based upon the “right to use” an asset for a period of time in exchange for consideration. All leases will be recognized on the Balance Sheet as: (i) Asset of “Right-of-Use” measured as present value (using tenant’s incremental borrowing rate) of all future lease payments (excluding operating expenses and taxes) plus any initial direct costs (including prepaid rent) incurred by lessee; and (ii) Liability of corresponding “Obligation-to-Pay” measured by the present value (using tenant’s incremental borrowing rate) of all future lease payments (excluding operating expenses and taxes) where the lease payment is divided into amortization and interest expenses. At the beginning of lease the costs are higher than under the current standard exceeding the rent due to higher portion of payment is going toward interest. Consequently, the cash flow is front-end loaded.
In determining the “future lease payments”, a tenant’s estimate is based upon “the longest possible term that is more likely than not to occur.” In making this assessment, a tenant considers the lease terms and options, e.g., options to renew, expand and terminate. This requirement is very controversial as it requires considerable speculation by tenants. Tenants will need a crystal ball to estimate rents for renewal periods where, as with most leases, the renewal rent is based upon “fair market value”.
The value of this Asset and Liability is assessed first at lease commencement and then subsequently updated for each reporting period (which can be very frequent for larger companies).
What is the status of approving & implementing new standard?
The draft new standard (i.e., “Exposure Draft”) was issued in August 2010. There is a public comment period through December 15, 2010. Among the comments, which we support, is that this proposed standard should be limited to publicly-traded companies. Mid 2011 the standard should be published and finalized. The anticipated implementation timing is 2012 or 2013
To avoid a delay in implementing these standards, there is no grandfathering period. Also they likely require restating leases for the past 2 years. For more information on the status, please visit the FASB website – http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011123
What does this mean to Tenants?
Tenants with considerable lease obligations will be most affected and that you can see relate to certain industries. Consumer-related sectors have the large percentage of lease payments as a percentage of liabilities of S&P 500 companies based upon a study by Goldman Sachs Global Markets Institute. Below is quick overview of points for tenants to consider:
- Tenants may favor shorter term leases without renewal and expansion rights. Short term leases will hamper landlords in financing construction of tenant improvements and especially of any new development.
- Good news is that there is no direct impact to cash flow.
- For larger properties, the corporate user may be more inclined to own versus lease.
- Increase EBITA (Earnings Before Interest, Taxes, Depreciation & Amortization) since rent expense is removed from Operating Expenses.
- Highly-leverage tenants may run afoul of debt covenants.
- Increased administrative burden for reporting and updating financial statements.
- Disclosures of lease obligations, particularly by public companies where such information will be in the public domain, could hamper future lease negotiations. It may also run afoul of common lease restrictions against disclosing lease terms.