Goodbye, operating leases: part 2
The impact on the commercial real estate market would be substantial and will have a significant impact on commercial tenants and landlords. David Nebiker, Managing Partner of ProTenant (a commercial real estate firm that focuses on assisting Denver and regional companies to strategize, develop, and implement long-term, comprehensive facility solutions) added “this proposed change not only effects the tenants and landlords, but brokers as it increases the complexity of lease agreements and provides a strong impetus for tenants to execute shorter term leases.”
The shorter term leases create financing issues for property owners as lenders and investors prefer longer term leases to secure their investment. Therefore, landlords should secure financing for purchase or refinance prior to the implementation of this regulation, as financing will be considerably more difficult the future.
This accounting change will increase the administrative burden on companies and the leasing premium for single tenant buildings will effectively be eliminated. John McAslan an Associate at ProTenant added “the impact of this proposed change will have a significant impact on leasing behavior. Lessors of single tenant buildings will ask themselves why not just own the building, if I have to record it on my financial statements anyway?”
Under the proposed rules, tenants would have to capitalize the present value of virtually all “likely” lease obligations on the corporate balance sheets. FASB views leasing essentially as a form of financing in which the landlord is letting a tenant use a capital asset, in exchange for a lease payment that includes the principal and interest, similar to a mortgage.
David Nebiker said “the regulators have missed the point of why most businesses lease and that is for flexibility as their workforce expands and contracts, as location needs change, and businesses would rather invest their cash in producing revenue growth, rather than owning real estate.”
The proposed accounting changes will also impact landlords, especially business that are publically traded or have public debt with audited financial statements. Mall owners and trusts will required to perform analysis for each tenant located in their buildings or malls, analyzing the terms of occupancy and contingent lease rates.
Proactive landlords, tenants and brokers need to familiarize themselves with the proposed standards that could take effect in 2013 and begin to negotiate leases accordingly.
The end result of this proposed lease accounting change is a greater compliance burden for the lessee as all leases will have a deferred tax component, will be carried on the balance sheet, will require periodic reassessment and may require more detailed financial statement disclosure.
Therefore, lessors need to know how to structure and sell transactions that will be desirable to lessees in the future. Many lessees will realize that the new rules take away the off balance sheet benefits FASB 13 afforded them in the past, and will determine leasing to be a less beneficial option. They may also see the new standards as being more cumbersome and complicated to account for and disclose. Finally, it will become a challenge for every lessor and commercial real estate broker to find a new approach for marketing commercial real estate leases that make them more attractive than owning.
However, this proposed accounting change to FAS 13 could potentially stimulate a lack luster commercial real estate market in 2011 and 2012 as businesses decided to purchase property rather than deal with the administrative issues of leasing in 2013 and beyond.
In conclusion, it is recommended that landlords and tenants begin preparing for this change by reviewing their leases with their commercial real estate broker and discussing the financial ramifications with their CFO, outside accountant and tax accountant to avoid potential financial surprises if/when the accounting changes are adopted.
Both David Nebiker and John McAslan of ProTenant indicated their entire corporate team are continually educating themselves and advising their clients about these potential changes on a pro-active basis.
Definition of Capital and Operating Leases:
The basic concept of lease accounting is that some leases are merely rentals, whereas others are effectively purchases. As an example, if a company rents office space for a year, the space is worth nearly as much at the end of the year as when the lease started; the company is simply using it for a short period of time, and this is an example of an operating lease.
However, if a company leases a computer for five years, and at the end of the lease the computer is nearly worthless. The lessor (the company who receives the lease payments) anticipates this, and charges the lessee (the company who uses the asset) a lease payment that will recover all of the lease’s costs, including a profit. This transaction is called a capital lease, however it is essentially a purchase with a loan, as such an asset and liability must be recorded on the lessee’s financial statements. Essentially, the capital lease payments are considered repayments of a loan; depreciation and interest expense, rather than lease expense, are then recorded on the income statement.
Operating leases do not normally affect a company’s balance sheet. There is, however, one exception. If a lease has scheduled changes in the lease payment (for instance, a planned increase for inflation, or a lease holiday for the first six months), the rent expense is to be recognized on an equal basis over the life of the lease. The difference between the lease expense recognized and the lease actually paid is considered a deferred liability (for the lessee, if the leases are increasing) or asset (if decreasing).
Whether capital or operating, the future minimum lease commitments must also be disclosed as a footnote in the financial statements. The lease commitment must be broken out by year for the first five years, and then all remaining rents are combined.
A lease is capital if any one of the following four tests is met:
1) The lease conveys ownership to the lessee at the end of the lease term;
2) The lessee has an option to purchase the asset at a bargain price at the end of the lease term
3) The term of the lease is 75% or more of the economic life of the asset.
4) The present value of the rents, using the lessee’s incremental borrowing rate, is 90% or more of the fair market value of the asset.
Each of these criteria, and their components, are described in more detail in FAS 13 (codified as section L10 of the FASB Current Text or ASC 840 of the Codification).