CORFAC News

In 2010, the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), as part of an international project to standardize financial reporting, issued a proposed set of standards to change how lessors and lessees report lease agreements on their financial statements.  One of the project’s concerns was that many long-term lease obligations, including most commercial real estate leases, are not currently reported as liabilities on the financial statements of lessees even though the agreements often represent long-term financial commitments similar to a debt obligation.  These “Operating Leases” are currently reported only as expenses when due (e.g. on a monthly basis) with no liability being reported related to the future obligation remaining.

There are naturally questions and concerns about how the proposed changes will affect commercial real estate.  Lessors and lessees need to be familiar with the new rules because there may be severe consequences: estimates of $1 trillion in new liabilities to be recorded by companies, of $1 billion to implement the change, and the negative impact on balance sheets could cost thousands of jobs. 

And the rules are still evolving.  On June 13, 2012, the two Boards met to address comments and revisions to the new rules.  For lessees, the meeting primarily dealt with technical accounting and reporting mechanics, leaving the major requirement to record operating leases as liabilities on lessees’ balance sheets intact.  Recording this debt, especially for large retail chains with multiple lease locations, could have a significant impact on financial statements and decision making:

1. Higher debt could reduce a company’s borrowing capacity and increase interest costs.
2. Shorter term leases could become more popular to reduce liabilities to record related to leases.
3. The negative effects on debt to equity ratios could negatively impact companies’ financial strength for investors.

Some companies are already beginning to prepare for this by reducing lease terms and going to multiple one year options.  Walgreens, for example, operates more than 7,500 drugstores in the United States.  They are trying to move away from 25 year guaranteed lease terms and 5 year options to 20 year of guaranteed terms with the option periods in one year increments, which would be exempt from the new rules.

For lessors, however, a big change from the original version has been made.  Investment Property Entities will be allowed to record most leases under the old rules, when the income is due.  (In a related project, the FASB is in the process of developing a new standard that would require Investment Property Entities to record most real estate properties at fair values.)

For investment property entities, even though their accounting procedures will not change, the uncertainty and risk associated with the threat to tenants, especially if shorter term leases is a result, has the potential to:

1. Negatively impact property values and create pressure to increase lease rates.
2. Reduce borrowing and refinancing capacity for investors and increase interest costs.
3. Increased brokerage and tenant improvement costs relative to lease terms.

How do you prepare for a significant change like this?  Be informed.  Talk to your chief financial officer, your outside accountants, tax advisors and legal counsel.  Consider the impact of the new rules on your financial reporting and the resources needed to comply with the standards, initially and on an ongoing basis.  As a tenant, consider what will be the impact as you analyze future leases.  As an investor, consider how you will handle the potential impact if certain tenants start pushing for shorter leases, and consider refinancing before the changes take effect.  Keep monitoring the progress of the rules and provide comments to FASB, either individually or through your associations so that your concerns are heard.

Finally, there could also be changes to and/or delay in the final adoption.  In May, 60 members of Congress wrote a letter to the FASB urging a “careful rethinking” of the proposed rule changes relating to lease accounting and warning of “disastrous consequences”.  In the letter, the Congress members recommend a thorough study of the impact of the new rules. For now, the Boards expect to issue another draft later this year and issue the final draft in 2013 with possible implementation in the 2015.

(Craig Trbovich, CPA is a commercial real estate advisor with Commercial Properties, Inc./CORFAC International, based in Tempe, AZ)