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New Rules Will Change the Game for Commercial Real Estate Leases

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A proposed accounting rule change could substantially alter the way thousands of U.S. businesses treat leased real estate, which could have a seismic impact throughout the U.S. market and beyond.

The proposed change, which could take effect as early as 2017, would prevent companies from listing leases as operating leases -- an off-balance sheet transaction -- and would require them instead to include all leases on their balance sheets in one form or another.

Who’s Changing the Rules?

The proposed change to the more than 30-year-old accounting rules stems from a joint initiative between the Financial Accounting Standards Board, or FASB, and the International Accounting Standards Board, or IASB, the accounting world’s key governing agencies. How businesses track lease expenses has been a major focus of the two organizations, and they began discussing new standards nearly 10 years ago.

Their joint proposal is designed to make companies’ financial reporting more transparent: All companies will be required to include leased assets and liabilities on their balance sheets. The idea is to provide a clearer picture of their leasing activities to investors, lenders, the Securities and Exchange Commission, and the international business community. Proponents of the change contend that it will create uniformity in global accounting standards and make it easier to compare the financial status of various companies.

Essentially, real estate leases will no longer be classified as an “operating” lease or as an “off balance sheet” transaction. All leases would have to be booked as a capital lease and would increase the assets and liabilities.

The good news is the liability is “not” considered debt, which is important for many key ratios that analysts use to evaluate the financial ability of a company. The lease payment will remain the same under current GAAP rules – straight-line average rent of the net rent.

The change would affect millions of lease agreements with which U.S. firms are involved, including financial planning, budgeting and forecasting systems, tax planning and compliance systems, as well as real estate management systems.

Real Estate Fall-Out

The effect on companies could be dramatic. The updated reporting requirements will lower the return on assets (ROA). In addition, the “current” ratio and the “quick” ratio will deteriorate.

The good news is that the company’s credit ratings should not be impacted by the change and will not create problems with existing loan covenants. The new rules would apply to existing leases, regardless of when they were implemented, but would not affect how a lease is treated for income tax purposes.

The changes applies to U.S. companies that follow GAAP. The changes are not as extreme as the international accounting standards. International companies that follow IASB have different rules to follow that will have a greater impact to their financial statements.
Real estate brokers may find that companies will no longer use the impact to the financial statements to determine how they occupy their real estate. Companies may use a form of lease vs. purchase analysis to determine their mode of occupying their space.

The companies most affected by the proposed standards would be corporations that lease a lot of space. Retail and service businesses that lease hundreds of locations can expect a substantial increase in administrative and accounting responsibilities, including data collection and reporting. More importantly, corporations would need to report more assets and liabilities, which would affect financial ratios.

Owners and landlords would also feel the pinch from the rules change. Companies discussing new leases would likely try to negotiate more flexible terms, while businesses currently leasing space are sure to try to renegotiate for shorter lease terms and more renewal options. At the very least, those companies can be expected to monitor renewal dates and termination clauses to a far greater degree than before.

Some of those lessees may seek to reduce the liability they report on balance sheets by opting for a triple net lease. That would enable them to pay a smaller fixed rent plus a pro-rata share of taxes, common area maintenance, insurance and other expenses that were previously included in the fixed rent.

What all this means to owners and landlords is that they may well have to change the way they do business. For starters, they’ll need to develop strategies to address far more demands from lessees during negotiations. The expectation is that many companies would respond to the new reporting requirements with demands to renegotiate and restructure their current leases.

Then, too, landlords would have to work closely with the brokers, accountants, and lawyers representing the companies that lease their space so that they can craft agreements that protect the landlords while enabling the tenant to control their finances.

Financial industry experts say adoption of the proposal is virtually assured. The rules change would significantly shift the playing field for commercial real estate brokers. They can count on new opportunities as more companies respond to the rules change by buying, rather than leasing property. Any time there is a change in the market there is opportunity!

Joseph Larkin, SIOR, CCIM, CIPS, MCR

Joseph Larkin, SIOR, CCIM, CIPS, MCR

Office Specialist
President, First Realty, Inc.
Denver, CO
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