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By Mike Yungerman-Vice President of Real Estate Development

Opus Development Corporation

At the end of the summer, the Financial Accounting Standards Board (FASB) proposed significant changes to how companies record real estate leases on their balance sheets. The new requirements essentially eliminate “off-balance sheet” financing or operating leases, which the majority of leases are classified as, and mandate that all leases be capitalized using the present value of the minimum lease payments. This change is significant and calls for real estate professionals to consider the effect that leases – existing and future – will have on the financial statements of tenants and how this regulation will affect the real estate markets where we do business.

The purpose of this accounting change is to coordinate standards with the International Accounting Standards Board (IASB), the entity that sets the standards for all of Europe and other countries and to create transparency by including lease obligations on the balance sheets. FASB is accepting public comments on the proposed changes until Dec. 15, 2010, and is expected to make a final decision by mid-2011, implementing new rules as soon as 2013. Once the rules are in effect, existing leases will not be grandfathered and public companies will be required to restate their financial results for the prior two years.

Effects on Tenants

The proposed changes will have the most impact to the balance sheets of tenants who have a substantial number of operating leases. Simply stated, the change will no longer allow a company to recognize rent as an expense on their income statement; the rent obligation will be classified as a liability or “right-of-use” similar to how a mortgage interest payment is recorded on the balance sheet. The change also will require tenants to capitalize all “likely” liability obligations such as purchase options and/or lease extensions, driving up the present value booked. For example, a five-year lease with a five-year renewal option will be booked as a 10-year lease commitment. The immediate impact will be a reduction in a company’s earnings that could trigger multiple issues:

1. Businesses may become non-compliant with loan covenants and would need to notify lenders or re-negotiate new covenants entirely;
2. Changes in net income could affect tenant credit ratings; and
3. Costs to administer the accounting of all leases will become more cumbersome.

Ultimately, the decision making process will become longer. Real estate decisions will have a greater impact to a company’s balance sheet, which will force more than the real estate department to be involved in all real estate commitments. It is likely that input from accounting and finance departments will play a major role in any decision.

Effects on Landlords: Short-Term Lease Requests

The most significant potential change for landlords is that tenants will shift to requesting short-term leases. Short lease terms could create financing issues for some landlords, as investors prefer longer term leases for security purposes. Shorter leases also could negatively impact the value of the property from investors’ perspectives. For long-term holders of real estate, short term tenants typically mean added costs to asset management because marketing and re-leasing efforts are cycled more often.

Overall Market Impact

For two primary reasons, most businesses lease space. First, to allow for flexibility as their businesses expand and contract and to utilize the capital otherwise spent on owning real estate to invest in operational growth. Since the new rules will take away the benefits of “off balance sheet financing” afforded to businesses in the past, tenants could determine that leasing space is a less beneficial option compared to owning real estate. While a higher ownership demand would initially stimulate market activity, in the long run tenants will remain in spaces for longer periods of time reducing overall demand. Landlords and real estate brokers will need to find ways to make leasing their buildings more attractive to tenants than owning.

It is impossible to predict exactly how these changes will impact the way companies make their real estate decisions or what the overall impact to the market will be, but we can ask ourselves questions that will certainly arise:

• What effect will shorter term leases have on rental rates?
• What effect will short term leases have on a landlord’s willingness to fund tenant improvements?
• What will the effect be on exit cap rates?
• Will increased user/owner demand translate to more build-to-suits?

It is important for landlords, tenants, and real estate advisors to prepare for these changes by understanding and reviewing the consequences with the proper financial advisors to avoid conflicts when the rules are adopted.

Mike Yungerman is the vice president of real estate development for Opus Development Corporation in Chicago and is reachable at mike.yungerman@opus-group.com.

Tags | Accounting, Commercial Real Estate, FASB, Opus

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