Tenants, Landlords Could Face Dramatic Changes from New Lease Accounting Rules

"Changes in International Accounting Standards Could Transfer Up to $1.3 Trillion Onto U.S. Balance Sheets and Discourage Companies From Signing Longer Leases."

"Northrop Grumman Corp.'s decision in July to relocate its corporate headquarters from Los Angeles to a 14-story, 334,385-square-foot building it acquired in Falls Church, VA, was a huge economic development victory for Fairfax County and the state of Virginia. But the defense contractor's decision to buy rather than lease its headquarters building at 2980 Fairview Park Drive has also drawn renewed attention to a major international proposal that could effectively end off-balance-sheet treatment of leases.

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on Aug. 17 released their long-awaited "exposure draft." The two accounting authorities have proposed requiring companies to record nearly all leases on their balance sheets as a "right of use" asset, and as a corresponding "future lease payment" liability. In a joint statement, the IASB and FASB said the proposals will greatly improve the information available to investors about the financial impact of lease contracts.

Under current International Financial Reporting Standards and U.S. Generally Accepted Accounting Principles (GAAP) guidelines, accounting treatment of real estate, office equipment or other leased assets differs depending on how the lease is classified. "Capital" or "finance" leases are accounted for as a sale and included on the lessee's financial statement. Contracts classified as "operating" leases, however, aren't recorded as assets or liabilities on a lessee's balance sheet. If adopted, the new accounting rules would require almost all leases to be capitalized on a firm's balance sheet.

The boards will accept public comment on the exposure draft through Dec. 15. If the IASB/FASB makes a final decision next year, the new rules will go into effect in 2013. According to some industry estimates, about 70% of the up to $1.3 trillion that would be transferred to U.S. corporate balance sheets under the new guidelines would be real estate leases.

Commercial real estate industry analysts say the proposed rules would have a profound and mostly negative impact on commercial tenants and landlords, with a steep learning curve amid the challenges for their brokers and other service providers. Many believe they will dramatically increase the complexity of lease arrangements and create a powerful incentive for tenants to sign shorter-term leases, while making it more difficult for owners to achieve the long-term leases favored or required by lenders and investors. It would also lead to more companies deciding to own their buildings instead of leasing them.

Mindy Berman, managing director of capital markets for Jones Lang LaSalle, tells CoStar that adoption of the new rules, as proposed, "would result in a huge change in leasing behavior."

"The leasing premium will be really diminished, especially for single-tenant buildings," Berman said. "Given the enormous administrative burden and the complexity of financial reporting that will result, single tenants will be asking the question, 'if it's going to be on my books anyway, shouldn't I own it?'"

Northrop Grumman said yes. Following a lengthy search, the defense and aerospace company announced it would purchase its future headquarters building in Virginia after two decades of occupying leased space in Century City, CA. That set off a round of industry speculation over whether other companies will follow suit in light of the new standards. Gaston Kent, a vice president of finance with Northrop Grumman, told The Wall Street Journal in July that buying the building "just made more sense in light of the [leasing] rules."

Under the proposed rules, tenants would have to capitalize the present value of virtually all "likely" lease obligations on balance sheets. FASB and IASB view leasing essentially as a form of financing in which the landlord is lending a capital asset to the tenant, who in exchange agrees to pay high interest costs up front, much like a mortgage.

Tenants would have to estimate their expected payments for contingent rents such as rates or escalations triggered by changes in a retailer's sales or the consumer price index (CPI). Tenants also would have to project the probability that they might exercise a renewal or termination option and re-assess lease terms and payments each reporting period.

"If you have to report all your future leases as a current liability, that's going to cause tenants to want to shorten their leases. And the problem with shorter leases is that it's harder to finance properties with long-term money," said Norm Miller, vice president of analytics for CoStar Group. "It's hard for an owner to ask a life insurance company for a 10-year loan when all your leases are three years. It's messy trying to estimate lease terms and payments; like trying to forecast the interest rate on a variable rate loan."

The proposed accounting rule changes could also affect lease renewal strategies. While retailers in prime locations likely won't want to forfeit renewal rights, office tenants may opt out of including renewal options in their lease contracts in order to avoid going through the complicated exercise of estimating their lease terms and rent payments, Berman said.

The accounting boards appear to believe that if leases are transferred to balance sheets, virtually all companies would choose to own rather than pay rent, Berman said. In fact, the word "rent" will not appear on financial statements.

Companies in buildings with multiple tenants such as downtown offices, however, often don't want to own their space. Technology, professional services and other companies that emphasize human capital want the flexibility to scale up and scale down according to their level of business activity, Berman said.

"Regulators have missed the point about why companies lease, which is about maintaining occupancy flexibility in location, size and duration, and deploying corporate capital into their business rather than into real estate," Berman said. "In the U.S., we don't have an orientation toward condominium ownership interest because we've got robust capital markets that make real estate relatively accessible compared to other countries."

The proposed standards will affect landlords as well, especially public entities with audited financial statements like real estate investment trusts (REITs). Major mall owners and other trusts will be required to go through the same analysis with every tenant in each of their buildings or malls, evaluating their likely terms of occupancy and contingent rental rates, Berman noted.

"Tenants are really going to get crushed in their overall expense load because they're going to go from a straight-line rent today, to a pattern where expenses run high early in the lease term to low at the end, crossing over at roughly the midway point," she said. "On a 10-year lease, our estimate is that the expense a company will show from real estate is about 20% higher than today."

For example, a retailer with a 5% profit margin whose rent is 6% to 8% of their total expenses will see its expense load increase by 25% to 30% in the early years of a lease, increasing their rental expense to between 7.5% and 10% of total revenues. At a time when retailers are just beginning to recover from the recession, that cuts as much as 2% from that already slender 5% profit margin, Berman said.

The new rules would require companies to constantly re-evaluate their use of space and their lease payment and adjust the initial estimate, and then re-amortize the asset based on the adjustment. One positive impact is that the new standards will force companies to re-evaluate the business case for why they lease versus own, and the changes will prompt communication between an enterprise's accounting and business units.

"There will be a lot of noise about this, but at the end of the day it will come down to an economic negotiation between two commercial parties," Berman said. "They'll probably wind up in the same place as today. But there will be a tug of war, at least until everyone gets used to the new paradigm."

With the changes likely to take effect in 2013, many companies are already beginning to negotiate leases that will commence at that time, and CRE professionals must learn and prepare now, Berman said. "The best thing that landlords, tenants and the brokerage community can do now is become familiar with these standards," she said. "Any prudent tenant should be factoring the change into their decision making today."