If I got paid a dollar for every time a client asks me “What is this property worth?” then I wouldn’t be writing this blog – I’d be fishing or playing golf.
As I tell my clients the market value of real property is what a knowledgeable, willing and able buyer would pay to an unpressured seller who is in the market to sell.
How does that apply to leases?
The Financial Accounting Standards Board on February 25, 2016 recently announced that the value of publicly traded companies must now include the value (as an asset and a liability) of its leases. You may be thinking, “Why do I care?”
Currently, most companies do not report leases on their balance sheets. Some argue this makes valuing a company that has extensive locations more difficult.
Supermarkets, drugstores, retailers, banks, hotels, restaurants and chains that have numerous locations will soon have larger balance sheets. But will they accurately reflect the value of the company?
The Financial Accounting Standards Board thinks the balance sheet reporting of leases will result in a more accurate company value. I am unconvinced.
It is reported that in the U.S., off-balance sheet leases may exceed $1 trillion in liabilities. None of which are booked on company balance sheets.
This will change with the new IASB and FASB standards by 2019 when the new standard — Accounting Standards Update 2016–02, ASC 842 — becomes effective for public companies.
If you are not a public company, do not think you will be unaffected.
Your accounting may not change and your bank balance will not change. But what about your tenants, your lenders, your borrowers or your clients? The new accounting treatment for leases may have serious repercussions for them and consequently for you if you are involved in the real estate market. Even if you are uninvolved in the real estate market, this accounting treatment, through trickle down and pass-through costs, may impact you.
While FASB’s standards are not immediate, be aware that public companies may start applying the new accounting methods, or at least putting in place methods, beginning in 2017.
As public companies prepare themselves for this new standard, this may lead to their reviewing their current leases — not simply for accounting issues, but for other issues such as renewal dates, CAM audit rights, rental bumps and adjustments. Similarly this review could lead to many public companies converting to more sophisticated technology to track their lease terms and expenses, pass-through or not. If you are a landlord, then make sure you put your lease summaries in order as many of your tenants may be doing the same.
What impact this will have on the lending and real estate industry has yet to be seen but with more sophisticated tenants, owners may see a push-down of already slim margins for NOI. This in turn could lead to lower CAP rates in the market, leading to overall decreased property values. Lower property values could lead to less capital in the market.
Real estate lenders may be slow to realize the impact, but their loan documents will always cover debt service coverage covenants and loan to value covenants that will address any market movements.
Lenders who are insensitive to dynamic changes may miss lending opportunities or may chase the same deals as competitors which will likely negatively impact their return on capital.
Asset based lenders will also be impacted as FASB standards which include airplanes, vehicles, cruise ships, and manufacturing and construction equipment.
The accounting standards may also impact the tech industry since many tech companies lease their equipment.
For major retailers and airlines, some experts are reporting the balance sheet impacts could be in the tens of billions of dollars.
It is difficult to accurately grasp or predict the increased values. Currently the only financial reporting of leases is in footnotes, if at all. Only lawyers read footnotes anyways.
Some experts are reporting that company balance sheets could double (e.g. airlines) while other companies’ balance sheets may only increase slightly (pharmacies and fast-food chains).
While the accounting treatment will require booking of lease assets and liabilities, the resulting balance sheet figures may not accurately reflect the values (and liabilities) of the lease nor the value of the company.
In a real estate context, it may be that there is no accurate way to book the real value of a lease since it is a market based asset – and in many ways will always be tied to the local real estate market.
So what’s the value of the lease? Pay me a dollar first. Remember, the basic market value of the leased property is what a knowledgeable, willing and able tenant would pay to an unpressured landlord in the market to lease. How do you book that on a balance sheet over a 30-year supermarket lease with numerous 5-year extensions?