Thousands of corporations are facing a move they would rather not make — relocating commercial real estate lease liabilities onto corporate balance sheets.
The Financial Accounting Standards Board (FASB) kicked up a storm last August when the organization released a draft of its new lease accounting standards. The intent was to create more transparency for investors in the wake of the financial crisis.
But the proposal sparked an immediate backlash in the corporate arena as 785 companies ranging from Gap Inc. to Wells Fargo & Co. responded with formal comment letters voicing concerns about the burden the “onerous” changes would impose on accounting systems and balance sheets.
“Everyone has to pay attention to this because it will move a lot of money back on the balance sheet,” says Richard Kadzis, spokesperson for Atlanta-based CoreNet Global, an association for corporate real estate professionals with nearly 7,000 members.
Industry estimates value the current volume of operating leases in the U.S. alone at more than $1 trillion, notes Kadzis. For corporations who lease space, the changes will impact their accounting practices and balance sheets, and could trigger existing loan covenants and influence real estate strategies.
For landlords, developers and brokers, it is a waiting game to see how their tenants and clients will react.
The shift of lease liabilities to balance sheets is expected to drive demand for shorter lease terms and encourage more companies to buy and own real estate as opposed to renting facilities.
The wild card for the commercial real estate industry is to what extent companies will alter those real estate decisions.
Buying more time
The good news is that FASB, which is working on the proposal jointly with the International Accounting Standards Board (IASB), has responded to those concerns by modifying some requirements and pushing back the timetable for implementation.
The accounting boards are continuing to work on revisions and hope to release a final standard by the end of this year with an effective date tentatively scheduled for Jan. 1, 2015 at the earliest. That's two years later than originally planned.
“The feedback led them to the conclusion that they needed to slow down a little bit and rethink how aggressive some of the requirements were in the original pronouncement,” says Vivian Mumaw, director of global lease administration at Jones Lang LaSalle in Chicago.
The proposed requirement to include renewal options when accounting for the total value of the net rent obligation has been eliminated.
“Including those renewals as part of the calculation just about doubled the impact on the balance sheet for every client that we did the calculation for,” says Mumaw.
The later implementation date buys companies time to evaluate their real estate portfolios and gauge the impact on their balance sheets.
The bad news is that the new accounting rules still represent a major shift in lease accounting practices that could have a far-reaching impact on businesses and the broader commercial real estate industry.
Shift in strategies?
In the wake of the proposed changes, companies are still coming to terms with the added accounting burden and a bigger debt load that will soon hit balance sheets.
“It is a real game changer because a lot more work will be required of those internal commercial real estate departments and their service providers. The lease implications are significant,” says Kadzis of CoreNet Global.
The new rules would likely not go into effect until January 2015, but companies required to show comparative-year financial statements would need to have the new practices in place two years prior, or by January 2013.
Based on the most recent revisions, the new accounting standard would effectively eliminate all operating leases and require leases to be capitalized on the company's balance sheet.
Essentially, companies would have to report their rent obligations on their balance sheet as a liability — or asset as the case may be — across the entire term of the lease whether that is for two years or 20. Companies also would be required to replace rent payment expense reporting with interest and amortization expense reporting for those leases.
“I think companies will have to retrench to some degree on their real estate strategies and three- to five-year business plans,” says Kadzis.
Real estate supports business growth, productivity, speed to market and all of those things that make companies profitable, emphasizes Kadzis.
“So this is not only a game changer for real estate, it definitely is on the radar screen of most CFOs, especially publicly traded companies,” he adds.
Many industry experts point out that this is an accounting change and does not impact a company's fundamentals, such as cash flow and earnings. In addition, public companies already disclose lease expense information in financial statements.
The difference is that the information is generally located in footnotes, and the new rules would move that information to the forefront on corporate balance sheets.
At a minimum, corporations will require more manpower and more sophisticated technologies to properly manage the job of gathering and reporting the lease data.
Consider that General Electric has a global real estate portfolio that spans some 300 million sq ft., or that Kelly Services Inc. operates some 1,000 individual leases in the U.S. It's easy to see how quickly the new accounting rules can add up to a monumental task.
Impact remains unclear
The trillion-dollar question facing the commercial real estate industry is how significantly the new accounting rules will affect leasing decisions. In a client survey Deloitte conducted last December, 42% of respondents said that the new accounting standards would result in more leases with shorter terms, while 28% indicated it would result in more potential lessees deciding to purchase rather than lease. The survey included 284 respondents.
The fact that the accounting standards boards have already eased some of the requirements will soften the effect on the leasing market, notes Josh Leonard, a partner in the real estate consulting practice at Deloitte Financial Advisory Services in New York. “It will be more than zero, but I don't think it will be overwhelming,” he adds.
“In the companies that we have spoken to, I have not heard any of them say, ‘Okay, that's it. We're buying all of our assets,’ because they have found leasing to be an appropriate financing vehicle for them,” says Mumaw.
That being said, the new accounting requirements will certainly play a factor in corporate real estate decision-making.
Retail at the forefront
Retailers will be the most affected, at least from an administrative perspective, simply due to the large number of leased stores. Will retailers push to negotiate shorter-term leases in order to improve balance sheets?
Yes, some might do just that, particularly some of the weaker credit tenants. But the vast majority of retailers are not going to give up prime locations to improve their balance sheets.
“At the end of the day, the accounting tail will not wag the economic dog,” says Deloitte's Leonard. “Companies are going to maintain the locations that they need in order to produce sales.”
Office and industrial tenants that are less dependent on specific locations may be more influenced by the accounting changes. Those tenants might say that a five-year lease is just as good as a 10-year lease.
Shorter-term leases could create a significant ripple effect across the commercial real estate industry as it relates to property values, financing and capitalization rates.
According to the Deloitte survey, 27% of respondents said that the new accounting standards could result in lower valuations due to higher capitalization rates and discount rates. Another 23% said that it could result in higher interest rates and/or lower loan-to-values to finance buildings.
The changes will not affect all companies equally. “What I'm hearing is that the companies that are more borderline in terms of economic health are the ones that are going to be more sensitive to this,” says Leonard. “If I'm a strong company like McDonald's, I'm going to go where I need to go.”
Private companies also may feel a bigger pinch. Private companies looking for financing will have to disclose their lease obligations, whereas in the past that wasn't the case.
The dust has settled somewhat since the release of the original proposal. Yet there is still a lot of uncertainty swirling around what exactly the final lease accounting rules will be, when they will go into effect, and what impact they will have on businesses and the commercial real estate industry.
For the most part, firms are sitting back and waiting to see what the final version entails before making any radical changes.
“They are not as up in arms as they were at one point,” says Mumaw of Jones Lang LaSalle. Companies are not leaping to the conclusion that they have to automatically rethink their entire lease-versus-own strategy.
“Now we have some calm, educated decision-making time,” adds Mumaw, “and people are waiting to see what FASB comes out with.”
Beth Mattson Teig is based in Minneapolis.