The Financial Accounting Standards Board (FASB) and its international counterpart, the International Accounting Standards Board (IASB), are in the midst of a joint project to craft new accounting rules that will result in fewer inconsistencies between standard American accounting practices (generally accepted accounting principles or "GAAP") and the standards commonly applied internationally. One major issue generating significant controversy and comment within the United States real estate community is the proper accounting for leases. The boards jointly issued a "Discussion Paper" addressing the lease accounting issues in March 2009 and accepted comments on the Discussion Paper through July 17, 2009. The boards continued to work to resolve the matter and issued a revised exposure draft in August 2010 with comments to be accepted through December 15, 2010. The final new Rule 13 is currently expected to be issued in 2011 and implemented in January 2013.
Under GAAP, operating leases are listed as footnotes in a tenant's financial statements — the leases are "off balance sheet" transactions; keeping such assets off the balance sheet can enhance a company's return on assets (ROA). In addition, by leasing (rather than owning) its less profitable assets under an "operating lease," a company can essentially finance certain assets without reflecting the associated debt on its balance sheet. Moreover, public companies prefer to avoid depreciation, which reduces earnings per share (EPS), often a key measure of stock price. GAAP requires that capital leases be treated like owned assets; the asset and associated "debt" are included in the company's financial statement. Under current rules, a lease is considered to be "capital" if (i) the ownership of the asset is transferred to the lessee during the lease term, or (ii) the lessee can buy the asset at a nominal price at lease expiration, or (iii) the asset will be leased for at least 75 percent of its economic life, or (iv) the present value of the minimum lease payments equal at least 90 percent of the value of the asset. If even one of these elements exists, the lease is a capital lease, rather than an operating lease.
Under the proposed new Rule 13, all operating leases must be converted to capital leases and, consistent with current FASB rules, be reflected on financial statements. If enacted, the impact of this change on the real estate community will be tremendous. Estimates vary widely but the Securities and Exchange Commission predicts a recharacterization of over $1 trillion worth of assets; some experts predict an even higher total value of recharacterized leases, when including both public and private companies that use GAAP accounting. The recharacterization is anticipated to work as follows:
- The Asset. The lease term (the tenant's right to occupy and use the premises) will become an asset of the company with an initial valuation equal to the discounted present value of the rental payments under the lease. While seemingly straightforward, the analysis is actually somewhat complicated. The term of leases with renewal and termination options must be booked based on the "most likely" term, as determined by reasonable and justifiable analysis of contractual, non-contractual and other business factors. It is important to note that an updated evaluation of the "most likely term" is required at each reporting period.
- What Factors Determine "Most Likely?"
- Contractual factors to consider in determining the most likely term of a lease are those explicit terms within the lease that may affect the tenant's decision concerning term length (for example, a stated termination penalty or below-market renewal option);
- Non-contractual factors include analysis of costs and benefits that may result from extending or terminating the lease (but are not specifically named in the lease), such as relocation costs or value of current improvements in the premises; and
- Other business factors that may affect the "most likely" term include location, whether the asset is a core or non-core asset and the like.
- The Liability. The tenant must book as a liability the present value of rent obligations under the lease (discounted by the lower of the interest rate the tenant would have paid had it bought and financed the asset or, if known, the lessor's implied interest rate).
- Potential Complications. The actual amount of a tenant's liability will be calculated by multiplying stated rents by the "most likely" lease term. While potentially complicated for any lease, calculations for leases with contingent rents (such as retail percentage rent) practically require a crystal ball. The tenant must calculate both the term as well as the actual percentage rent based on the "most likely" approach. By example, a retailer will calculate its liability by first determining the "most likely" term of its lease(s) and then must refine that calculation by the "most likely" volume of anticipated sales levels to include the "most likely" percentage rent amount within the calculation.
Proponents of the new rule point out that the conversion of operating leases to capital leases (and their inclusion in a company's financial statements) will improve the ability of investors to accurately evaluate a company's financial strength. On the other side of the coin, however, a reclassification of this magnitude will result in a huge administrative burden for companies with multiple leases (especially public companies). It is also likely to impact a company's compliance with debt coverage and similar loan requirements, and may well affect calculation of employee incentive payments that are based on stated financial benchmarks for a company. The internal ripple effect of this rule change on any company will likely take years to be fully ascertained.
The enactment of "new" Rule 13, as currently proposed, will also impact a company's analysis of future leases, including at the most basic level, whether to lease at all. If lease payments receive essentially the same accounting treatment as debt, some companies may decide to buy real estate rather than lease it, perhaps even creating an internal or outsourced property management team to deal with maintenance, repair and other property-related issues.
In addition, new leases may well be shorter — especially in the immediate term as companies assess the impact of the new rule on their financial statements. Since a company's balance sheet liability will be determined by the lease term, the company will have an inherent incentive to sign shorter leases to minimize that amount. Likewise, renewal options, long considered a "must have" for tenants, may lose some popularity since they too will increase the amount of the company’s balance sheet debt (depending on the "most likely" analysis).
While many in the real estate industry view the new rule as potentially devastating to real estate leasing, the "doom and gloom" scenario is not a foregone conclusion. A company's decision whether to lease or own its real estate, its determination of an optimal lease term and other similar business decisions will always include analysis of multiple economic factors in addition to accounting treatment. For example, leases with shorter terms will necessarily have higher rents in order to cover the landlord's cost for tenant improvements, commissions and the like, making the choice of a shorter term potentially less advantageous than one would initially think. Moreover, certain lease structures that fell out of favor over the years due their "capital" nature, may enjoy resurgence in popularity since under the new rule, all leases are treated as capital.
As we await the final adopted version of the new Rule 13, the anticipated impact on the real estate industry (and more specifically, real estate leasing) remains murky — but it is quite clear that the real estate industry must be ready for change.