Leasing

Counting Leases Before They Hatch

A proposed accounting change will dramatically affect how landlords and tenants treat leases.

The accounting profession is currently evaluating a proposed new standard that promises to fundamentally change the ways landlords and tenants account for — and negotiate — leases.

Under review is a proposed rewriting of the Financial Standards Accounting Board’s Accounting Standards Codification Topic 840, which before 2009 was known as FAS 13. This topic, "Accounting for Leases," is one of many standards that together comprise generally accepted accounting principles, or GAAP, in the United States.

The draft standard has drawn much heated debate for its potential to fundamentally change the leasing market, likely shortening lease terms and dramatically reducing the apparent value of properties with traditionally long lease terms, such as office buildings.

What Is Being Proposed?

According to FASB, the proposed new rule responds to dissatisfaction with the way that operating leases are disclosed on companies’ financial statements. Current financial standards draw a distinction between operating leases — the standard landlord/tenant relationship — and capital leases, typically used as an alternative form of financing. Current rules effectively ignore the documented structure of capital leases, instead treating the leased property as if it were owned by the tenant and financed by the landlord.

FASB notes that many companies have carefully structured their leases in view of the current rules to achieve characterization as either operating leases or capital leases, resulting in strikingly different effects on the company’s financial statements. The proposed rules to a large degree would prevent this by treating all leases with a term over one year as capital leases.

The proposed new standard treats the execution of a lease as the conveyance to the tenant of an asset — the right to use the property — and the creation of a liability — the obligation to pay rent over the term. The standard creates one analysis for the inception of the transaction and a slightly different one for ongoing reporting. It also requires both landlord and tenant to adjust underlying assumptions about the future of the lease as facts that might affect those assumptions change.

Tenant Changes

For the tenant the new standard would require the following considerations.

  • At the beginning of the lease, the tenant must recognize as a liability the present value of all lease payments it is obligated to make, taking into account any extension or termination options it is likely to exercise, and estimating any contingent rent or termination payments it expects to make. The discount rate to be used for the present value calculation is the interest rate the tenant would have to pay a lender for a comparable real estate secured loan.
  • The tenant recognizes the right to use the property for the term of the lease as an asset, measured, at the beginning of the lease, at the present value of the lease payments, plus the “initial direct costs” it incurs in negotiating the lease, for example, broker’s commissions and legal fees.
  • During the term of the lease, the tenant amortizes the right to use the property over the shorter of its remaining useful life or the term of the lease.
  • During the term of the lease, the tenant must reflect any changes as they occur. For example, if, a few years into the lease, a tenant’s business changes so as to make it likely that it will pay more contingent rent over the term of the lease, its financial statements must immediately reflect that change. Or, if a change in the tenant’s business makes it more likely that it will not exercise an extension option it previously expected to exercise, it may be required to adjust its financial statements to reflect that.

Landlord Changes

For the landlord the situation is a bit more complex. The new standards call for the landlord to determine whether, given the term of the lease and the terms and conditions of the lease, it has retained “significant exposure to the risks and benefits” of the leased property. For example, if the rent is largely contingent rent or if the tenant has a kick-out option after just a few years, then the landlord is well exposed to the vagaries of performance of the tenant’s business. Or, if the lease is fixed rent but the term is only three years and the leased improvements have a much longer useful life, the landlord still retains most of the risks and benefits of ownership of the leased property.

If, under the soft tests proposed in the draft standard, the landlord determines that it does retain significant risks or benefits associated with the asset, then, at the inception of the lease, it will recognize the right to receive lease payments, by calculating the present value of the stream of expected lease payments using several possible discount rates, in particular, the yield that the rents represent on the value of the real property, which is the annual rents divided by the value of the property.

After inception, the landlord must continually evaluate the lease and leased property based on its amortized cost, and the corresponding lease liability based on the “pattern of use” of the property by the tenant. And, like the tenant, the landlord must adjust its financials to account for such items as changes in the tenant’s business, whether, in the landlord’s judgment that the tenant will or will not exercise any extension or termination options it may have or will pay more or less contingent rent.

If the landlord comes the conclusion that it does not retain significant exposure to the risks and benefits of the leased property, such as where it has leased the property for most of the improvements’ remaining useful life, then it may no longer recognize the property as its asset, but instead may recognize only the rental stream, calculated at present value as described above, plus a factor for the residual value of the property at the end of the lease. In making this calculation, the landlord must make various estimates of the probability of various lease terms where the tenant has options to extend or terminate the lease, as well as the probability of receiving various imagined levels of contingent rent.

Criticisms

As noted, the proposed standard has come under a number of criticisms. For one thing, it assumes a level of information, certainty, or ability to calculate probability simply not present in the real world. Both landlords and tenants will be put the to burden of calculating probable future contingent rents and probabilities of exercising future options that real estate practitioners will recognize as at best wild guesses, not necessarily leading to more reliable financial statements.

The standard in many respects converts operating lease rentals, which are based on very specific and changing supply and demand factors relating to local real estate conditions, into fictional interest rates, likely to lead to some very apples to oranges comparisons.

Many commentors believe that the proposed standard would create strong incentives for tenants to prefer shorter leases, with more options, which they already prefer for business flexibility. Property types with traditionally long leases, which are therefore viewed as stable and good investments and good collateral for loans, will thus become substantially more volatile, negatively affecting value and financeability — and just at a time when values are starting to recover.

In corporate real estate, the trend over the past decade has been to move real estate off the books so as to enhance return on assets. If the new guidance requires that a leasehold interest be on the books, this trend may reverse.

One highly predictable result of implementation of the new standard is that there is going to be a lot more accounting work. The proposed guidance calls for substantially more data management, complexity, guesswork and analysis than the existing standards for leases. For that reason, one can expect strong support for the new standards from manufacturers of lease management software, and, of course, accountants.

FASB is accepting public comments on the proposed standard until December 15, 2010.

Tom Muller

Tom Muller is a real estate partner at Manatt, Phelps & Phillips LLP in Los Angeles. Contact him at tmuller@manatt.com.

Nov.Dec.10

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