(This article was originally published in the November/December 2017 issue of BOMA Magazine.
In October 2019, FASB officially delayed implementation of the new lease accounting standards for private companies to December 2020.)
Corporations are looking at real estate through a different lens. New lease accounting standards go into effect in 2019 (now 2020), moving real estate liabilities onto lessees’ balance sheets. While little will change on landlords’ books, the new rules are triggering leasing strategy changes that will spark tenant demands for improved transparency in their lease agreements.
WHAT’S THE BIG DEAL?
Most lease commitments don’t show up on corporate balance sheets today. In fact, more than 85 percent are recorded off the balance sheet, according to the International Accounting Standards Board (IASB). Going forward, any equipment or real estate lease with a term longer than 12 months must be recorded on the balance sheet as a “right-of-use” (ROU) asset with a corresponding lease liability under new rules established by both IASB and the U.S.-based Financial Accounting Standards Board (FASB). In other words, the new standards affect most large companies.
While the standards don’t go into effect until 2019 (now 2020), public company filings will need to include comparable information for 2017 and 2018. Private companies will need to include a one-year look-back. In both cases, lessees must begin to institute changes now to prepare for new reporting processes and collect the necessary leasing data.
The broader fiscal impact of these changes will be a new influence in real estate decision-making. Your tenants’ C-suite executives will be tuning into the implications of real estate decisions more attentively than ever before. The impact will be especially dramatic for retailers, chain restaurants and other sectors that rely heavily on leasing for their operations.
Corporate debt loads will increase by an average of 58 percent once the new rules take effect, according to PwC and Erasmus University research. Rising debt loads elevate a company’s overall financial risk and can set off alarms with investors and shareholders. Loan covenants and key financial ratios, such as debt-to-equity and return on assets, could be affected and potentially force some companies to renegotiate or redraft their corporate debt covenants.
UNDERSTANDING THE FINE PRINT
If tenant questions aren’t rolling in yet about lease agreements and renewals, they will be soon. You should take particular note of several key changes that the new standards will introduce:
- Renewal options will become part of lessees’ reported liability if a company is reasonably certain it will exercise its option to renew.
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Shorter leasing terms will reduce reported liabilities.
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Operating and service contracts will be excluded from balance sheet calculations.
The new reporting requirements will bring greater rigor to how companies record leasing data and the types of information that must be tracked. Lessees will likely have questions about contract language and leasing terms, and they may challenge the status quo as they get compliance-ready.
For instance, your tenants might look to eliminate the standard practice of including several three- or five-year renewal options on a five-year lease. Those options must be included on the balance sheet under the new standards, so doing with-out them will reduce the liabilities to report. The timing of new leases may become another sticking point, since the balance sheet implications begin as soon as a lease commences. Transparency around contract details will be critical.
LEASING STRATEGIES UNDER THE MICROSCOPE
New accounting rules on their own shouldn’t dictate changes to your tenants’ leasing strategies, but they will introduce a new factor to the equation. Leasing decisions will need to take into consideration the broader financial picture of the tenant organization. The pressure is on for lessees to find ways to minimize the balance sheet impact, and the C-suite will be raising new questions about leasing strategies, such as:
- Should we execute more short-term leases? Longer-term leases traditionally have been a win for all parties, providing more stability for investors and owners, and better incentives and prices for tenants. Now, tenants looking for a quick solution to the balance sheet dilemma may be pushing for shorter-term leases, despite the typically higher price tag and reduced negotiating power. Consequently, you may find yourself in a better bargaining position as a result of this shifting tide. Landlords who collaborate with lessees to find effective long-term solutions will be on the winning end.
- Would different lease structures reduce liabilities? Lessees may be interested in considering new lease structures, such as triple net leases, once the new rules take effect. Triple net leases enable lessees to separate out property expenses that would otherwise be included in a fixed rental payment, thereby reducing lease payment liabilities.
- Should we own instead of lease? The new rules will elimi-nate the capital efficiency benefits of leasing, making the financial difference between owning and leasing less significant. While the accounting standards throw a new element into the decision-making process, the fundamentals should continue to drive corporate real estate decisions at many companies. Market dynamics, operational requirements and capital allocation strategies will likely still tip the balance in favor of leasing.
PARTNERING ON SOLUTIONS
Lessees have a challenging road ahead as they prepare for the new standards. The process will require corporate real estate executives to adopt new procedures for decision-making and updating leasing databases, as well as new ways to collaborate with colleagues across their organizations to assess the potential financial impact. Stress levels will be elevated. As lessees start asking questions, it’s important to understand the changes happening inside their organizations.
Addressing tenant concerns head-on and being prepared to negotiate with new potential solutions is key to being a trusted partner in this process. Initiate your own self-assessment to determine answers to the following questions:
- Is there a way to repackage rents to reduce tenants’ reported financial liabilities?
- Can lease options be modified to help tenants improve their financial position?
- How can we improve the transparency of our leasing contracts?
- Can we separate out operating payments from lease payments for tenants who want to distinguish lease and non-lease components in full-service and modified gross lease agreements?
- How can we make it easier for tenants to pinpoint the con-tract details they will need for financial reporting under the new standards?
- How much negotiating power can our organization exert, given current market dynamics and demand for space?
While the accounting standards are established, many companies are still in the early stages of preparing their organizations for compliance. Many are experiencing a great deal of uncertainty around the best leasing strategies to employ. The situation is continuing to evolve and will likely change further as companies begin to better understand the financial impact of their leasing decisions under the new rules. Property professionals who take the time to identify the pain points and offer creative solutions may find themselves in high demand.
ABOUT THE AUTHOR: As JLL’s Global Lease Accounting
Lead, Stephen Miller oversees sales and implementation of
the firm’s lease accounting services and technology tools. Previously,
Miller served as the finance director for one of JLL’s
largest Corporate Solutions accounts, where he led a team
of 11 finance professionals dedicated to planning, technical
accounting and lease accounting for the client’s multi-million square-
foot global property portfolio..
This article was originally published in the November/December 2017 issue of BOMA Magazine.