New reporting standards from the Financial Accounting Standards Board (FASB) will give real estate leases a more meaningful role within corporations, which is expected to impact building owners’ real estate negotiations with tenants and how they manage assets within their portfolios. Among a multitude of scenarios facing occupiers, one results in a potential economic desire for shorter lease terms, which would create more uncertainty for owners. Mike McLain, Transwestern’s chief accounting officer, discusses lease accounting changes and the new variables these changes introduce.
SHORT-TERM LEASES WILL BE REQUESTED BY OCCUPIERS WITH CAPITAL RESERVE REQUIREMENTS AND OTHER BALANCE SHEET CONCERNS
Banking institutions, financial service firms and other enterprises may adopt new leasing strategies since they are required to maintain a certain amount of capital reserves in proportion to their liabilities. Owners can expect some of these types of organizations to seek leases with shorter terms and potentially fewer renewal options. This will introduce some uncertainty for owners and potentially impact how they manage assets, with shorter leases further complicating capital planning, space marketing and asset disposition.
Imagine that based on capital requirements, for each risk-weighted asset on a financial services firm’s balance sheet, such as a lease, a company’s capital reserves must increase 5 percent. In this example, if a firm’s lease obligations total $100 million annually, its capital reserves would increase by 5 percent, or $5 million, to cover that liability. In an environment with shorter lease terms, it will be imperative for owners to maintain the highest level of quality and service at their properties and consider adding the most desirable amenities in their markets to minimize tenant churn.
|Financial Institution Lease Term||Annual Rent||Liability on Balance Sheet||Capital Reserve Requirement Based on 2X Liability||Impact of Choosing 10-Year Versus 3-Year Term|
|3 Years||$1 Million||$3 Million||$6 Million|
|10 Years||$1 Million||$10 Million||$20 Million||Loss of $14 Million Liquidity|
NEGOTIATING LEASE OPTIONS WILL BECOME MORE COMPLICATED
Building owners should know that accounting changes regarding lease extension options will require additional evaluation by occupiers. If a lease offers the occupier a bargain or discounted rate in connection with a possible lease extension at the end of the term, the “economic incentive” could impact how the lease is classified beginning on Day One. For example, consider a tenant signs a 10-year lease with two five-year renewal options that carry an incentive, such as a 95 percent of market rental rate during the extension period. While it is technically a 10-year lease, it could be viewed as a 20-year lease for the company’s accounting purposes if it is considered “reasonably certain” that the options will be exercised. Occupiers will be focused on how to achieve the most beneficial outcome in this new environment.
|Initial Lease Term||1st Renewal Option||2nd Renewal Option||Total Term on Day 1 if Lessee Does Not Have Significant Economic Incentive to Exercise Options||Total Term on Day 1 if Lessee Has Significant Economic Incentive to Exercise Options|
|10 Years||5 Years||5 Years||10 Years||20 Years|
CONSIDERATIONS MAY REQUIRE MORE FLEXIBILITY FROM OWNERS
Under the new regulations, corporate real estate users will have to evaluate whether their leases qualify for the finance or operating lease accounting treatment, both of which will require significant assets and liabilities to appear on their balance sheets. Occupiers may need additional time for lease negotiations and might bring additional advisors into the process as a result. Owners can expect possible delays so are advised to start the lease process as early as possible.
WILL OCCUPIERS CHOOSE TO PURCHASE INSTEAD OF LEASE COMMERCIAL SPACE?
In the years leading up to the FASB change, experts contemplated whether the new guidelines would make it more advantageous to purchase rather that lease commercial space. It’s our contention that buying a building is an economic decision, not one based on accounting, so we do not expect a widespread acquisition movement.
EXPECT SCENARIOS TO VARY BASED ON MATRIX OF CHOICES CONFRONTING OCCUPIERS
The accounting rules must be incorporated by U.S. public companies by 2019, with implementation by private firms following in 2020. While effects of the standards can be discussed in broad strokes, owners must be prepared for myriad potential changes. Staying informed about possible issues will best position owners for conversations with tenants. Ultimately, accounting standards will become one of the many factors occupiers consider when making leasing decisions.