Summary: Recent high profile retail administrations have not been good news for the sector. But it faces another challenge: lease accounting changes. The effects, for retailers and others with large lease portfolios, should not be underestimated. There are implications for landlords also.
The current rules
Leases are currently classed as either finance or operating leases.
In accounting terms, a finance lease is treated as if it were a financing arrangement. The lease appears in the tenant’s balance sheet as both an asset and a loan liability (for the discounted amount of future rental liability). Its P&L will, therefore, show for each period charges both for depreciation of the asset leased and notional interest reflecting the unwind of the discounted amount of the future rental liability.
In contrast, an operating lease is treated as a contract for the use of an asset over an agreed period of time for an agreed consideration. No asset or associated loan liability appears on the tenant’s balance sheet and no depreciation or notional interest is recognised in its P&L. Instead, rental expenses appear as an operating expense (usually, on a straight line basis) in its P&L. So operating leases are, effectively, currently ‘off balance sheet’.
Most retailers’ occupational leases are currently treated as operating leases.
The new rules
A new international lease accounting standard - IFRS 16 - comes into play, principally for publicly quoted companies (and other companies in their groups which are consolidated in their accounts) for accounting periods beginning on or after 1 January 2019.
The change for retailers is significant since IFRS 16 abolishes the distinction between finance leases and operating leases. All leases will be treated as finance leases. So pretty much all lease liabilities will come on to retailers’ balance sheets. Only ‘low value’ leases (around £3.5k p.a.) and those for less than 12 months are ignored.
The lack of transparency of retailers with significant off-balance sheet liabilities who got into difficulty - Woolworths, for example - was one reason behind the changes.
Impact - retailer tenants
A change in accounting rules does not, of course, directly change retailers’ cashflows. It will, however, change the presentation of payments and lease obligations. What are currently shown as operating expenses will become, in part, financial expenses.
A PWC study suggests that the reported debt on retailers’ balance sheets will increase by a median of 98% when the changes take effect. This gives a sense of the impact in the presentation of debt to shareholders, creditors, analysts, investors and rating agencies, which retailers will need to manage.
The changes will also affect key ratios under which retailers and others operate. It will for example mean an increase in EBITDA. Existing lending arrangements and other financial covenant tests used (in leases for example) may need to be revisited, in consequence.
It should be noted that UK GAAP accounting rules have not changed (and won’t change until 2022 at the earliest, based on recent HMRC comment) so a retailer operating under UK GAAP (an unlisted group for example) will see no change to the current accounting rules for its property portfolio.
Impact on leasing transactions
The accounting model for landlords remains largely the same. But changes to the tenant accounting model are likely to change tenant behaviours. In an effort to reduce committed rentals which they must discount back and recognise in accounts, tenants are increasingly likely to seek:
- shorter leases (perhaps coupled with an option to renew);
- break rights (though the preferred accounting treatment will only apply if exercising the break is reasonably certain);
- rent free periods in preference to other incentives such as cash for fit-out;
- variable rents (linked to RPI/turnover/OMV) rather than fixed/stepped increases.
The changes also remove the rationale for accounting driven sale and leaseback transactions.
Tenants should assess existing financial commitments, and the financial ratios used, to determine the extent to which changes may be needed.
Landlords may before too long begin to see changes in the requirements of tenant multiples.