Transactional professionals used to calling the shots may soon find someone else riding herd on leasing decisions - the chief financial officer. New accounting standards are shaking up the traditional power structure.
There's an old saying about breaking eggs to make an omelet. That also could describe the regulatory shifts that will take place next year as changes to lease-accounting methodologies developed by the Financial Accounting Standards Board kick into gear.
Simultaneously, FASB also will be rolling out new rules for reporting credit losses of financial assets (formally christened current expected credit loss, or CECL). These changes combine to make FASB a 2019 Top Pick among major disruptors of traditional methodologies.
New Lease Accounting Standards for 2019 Webinar
Take a look at the recent CCIM Institute webinar below, featuring industry experts from RE/MAX and BDO USA, to help you tackle the challenges of the new lease accounting rules head on.
Accounting for New Reporting
“It's not going to be a fun year,” says CCIM chief economist K.C. Conway, MAI, CRE, as corporate real estate departments scramble to adjust to new reporting methodologies. The end result, of course, is intended as a net positive for investors; namely, greater reporting transparency on lease structures. Getting to that point will demand both a change in how real estate departments are structured and transactional activity.
The new lease accounting standards are the result of a decade of study by FASB and its sister organization, the International Accounting Standards Board. They were launched “at the behest of the SEC [Securities and Exchange Commission] in 2006,” says Amie Sweeney, vice president of Corporate Capital Markets for CBRE in Detroit. “They wanted to see operating leases recognized as a liability, as a financial obligation for tenants. Right now, operating leases aren't on the balance sheet; they're just footnoted. The SEC felt that the users of financial statements should see that if a company signs a five-year lease, they're signing up for a five-year financial obligation for the right to use that space.”
As a white paper produced last year by the Industrial Asset Management Council makes clear, “The intent of the new standards - or upgrades, as FASB refers to them - was to improve financial reporting about leasing transactions and, in doing so, gain that transparency for investors and other stakeholders.
“A major part of this process will be a review and categorization of all leases, as well as their terms and options,” the paper states. “To ensure that all appropriate information is collected, a coordinated effort must be mounted internally, including accounting, finance, purchasing, operations, and of course, real estate.”
The result, Conway says, is that “You're going to have a new committee-level process in these organizations that didn't exist before.” Conway, who is director of research and corporate engagement at the University of Alabama's Center for Real Estate, says that in the past, “Generally, no one had to worry what John in the real estate department did with a lease. It was a process of aligning the economics with the construction costs and a certain return on capital.”
New complications will overlay that fairly straightforward process. “Now the real question becomes the impact on the balance sheet,” Conway says, “and you'll likely see a lot more friction between the CFO's objective view of the numbers and the very subjective nature of the lease negotiation.”
Needless to say, the new lease accounting “upgrades” are voluminous. In 2016, Deloitte enumerated 12 essential points governing the new standards. But they all boil down to one essential question: What is considered balance sheet and what is not?
“The new lease accounting will have an impact on recording the liability of the lease,” Conway says. “I don't think it's going to be sufficient to offset the full lease liability.” Instead, he says, the CFO or the head of accounting will be warning the real estate pros to avoid 20-year leases in favor of five-year agreements with options to renew.
“The fact that the entire term of the lease obligation is being booked as a contingent liability is going to radically change some balance sheets for tenants,” says CCIM Institute Treasurer Les Callahan, CCIM. “You'll have companies reporting current liabilities as opposed to long-term liabilities, and that number is going to balloon - as much as five or 10 times what was previously reported on their balance sheet.”
As a result, “You're going to have more users who want to own their own buildings as opposed to renting,” Callahan says, who is also president of First Colony Financial Corp. in Atlanta. “When you own, you do not have an obligation for such things as security deposits, tenant improvement costs in excess of landlord allowances, and prepaid rent.”
Sweeney agrees, to a point. “The owned-versus-lease decision will certainly change, on the margins,” she says. “So for companies looking to build and occupy single-tenant core assets, a new headquarters, or manufacturing facility, they may choose to own because it probably becomes a long-term asset, and if the asset is going to be on the balance sheet anyway, they might look to own it. But for most tenants and most landlords, it really won't impact the decision that much. Most tenants are in multitenant buildings, and a multitenant landlord is not going to convert his building to condos and rejigger all that ownership as occupancy changes.”
Deadlines for compliance are approaching fast. The lease accounting upgrades kick in on December 31 of this year for public companies, and a year later for all other organizations. (CECL kicks in on December 15, 2019. See Sidebar.) As Callahan and Sweeney indicate, those dates will trigger both a rethinking of the lease-versus-own question and a new dynamic between real estate and finance departments.
“This will decrease build-to-suit activity,” says Joe Muratore, CCIM, principal and co-founder of NAI Benchmark in Modesto, Calif. “Companies like Walgreens and Panera Bread that often make use of the build-to-suit model are essentially achieving off balance sheet, long-term financing through their leases. With the new rules, they may be better off owning, as both activities will now be on the balance sheet and their cost of capital as a direct owner will be less as they deal directly with lenders.”
Muratore sees new policies coming down from the CFO's office to determine for corporate real estate departments when it's best to own or to lease. “We will see different thresholds where doing a build-to-suit is the right model, and thresholds where owning will be the right model,” he says. “But then it will come back to the corporate real estate department to provide guidance on how long they are likely to be in that location, how strategic the site is, and what the likely resale value will be in 10 or 20 years. If it is a strategic, long-term location, then using a fee-based developer and owning the site for a period of time before selling it as a leased investment is likely to provide the greatest return on investment for the occupying company.”
These decisions will be guided by the general rule that, “When a company owns the real estate directly, they do not have to pay the developer for his risk and profit, which is factored into their lease rates,” Muratore continues. “They can borrow directly from a variety of lenders and their occupancy cost will go down, since the developer/investor profit layer is removed or reduced.”
Likewise, regarding sale-leasebacks, Muratore says, “The reason companies do a sale-leaseback is to free up capital. If I own something, it is already on my books. If I replace it with a lease, then under the new rules, I may not get to take it off my balance sheet, which reduces my incentive.”
Impact of Changes
How severe will these new rules of engagement be? The answer depends on whom you ask. Conway likens the coming climate to that of another period of disruption in our not-too-distant past. “A good analogy is the disruption of the homebuilding industry following the financial crisis,” he says.
Callahan agrees. “The fact that the entire lease obligation of the term is being booked as a contingent liability is going to radically change some balance sheets for tenants.”
But Sweeney doesn't envision that degree of upheaval. “We just don't see that,” she says. “At the end of the day, it's about an occupier's efficient use of capital, and it's not every company that's going to have the financial capacity to build a big building and own it. And, as I said, a landlord with a multitenant occupancy isn't going to change their habits.”
She takes a very practical stance when advising her corporate clients: “We have advised them for years to talk with those they have banking relationships with to make sure they're taking these new rules into account. And as we go through different scenarios, we'll recommend different structures based on their credit quality and what their long-term objectives are, corporately and for specific locations.”
It's wise advice, and the best practitioners can do is prepare to weather the coming storm of change, however severe, with as much of a view to the long-range as possible. The one constant in this industry is change, and we all know we've weathered worse.
There's something else we know about this coming year of transformation. “It'll be a lot more work for occupiers and for landlords,” Sweeney says. But will all that work result in a more transparent and efficient industry? “It really doesn't matter. It'll simply be the way things are.”
Lending Institutions: Meet CECL
by John Salustri
Welcome to FASB’s
new guidance for current expected credit loss, or CECL.
end of 2019,” says
CCIM chief economist K.C. Conway, MAI, CRE, “every
public financial institution has to be able to forecast its loan loss reserves
on real estate transactions on a loan-by-loan and forward-looking basis.” That, he says, will entail a
Herculean effort of transactional research that will dump directly at the
doorstep of every client of those loan institutions.
A sleeping giant of sorts, the new standards began shaping
up when FASB started looking at how banks calculated allowances for loan and
lease losses (ALLL) after the 2008 financial crisis, according to ALLL.com.
the new expected credit loss model,”
the website explains, “financial
institutions will be required to use historical information, current
conditions, and reasonable forecasts to estimate the expected loss over the
life of the loan. The transition to the CECL model will bring with it significantly
greater data requirements and changes to methodologies to accurately account
for expected losses under the new parameters.”
In the past, Conway says, “Basically,
banks and public financial institutions have forecast their CRE losses by
putting their finger in the air and averaging their annual losses and reserves
accordingly, often with no data to support it.”
But the SEC doesn’t
want lenders to reserve too much. “They
can do nefarious things with that,”
Conway says. “You can
influence earnings with this extra pot of money.”
But the Fed, on the other hand, wants lenders to hold some capital back,
essentially for rainy days. That push/pull is expected to be resolved through
CECL by reporting losses and reserves “at
a micro level, loan-by-loan and region-by-region.”
Just as with the new lease accounting standards, it is
expected that the result of this depth of analysis on the part of banks and
their real estate clients will be greater transparency and reduced risk of
another financial debacle.
That will come, however, after a year of
redefining how real estate is accounted for, and any appreciation for CECL will
be realized post-2019. In the near term, as Conway jokes, somewhat
sardonically, “CECL will be the most unpopular guy at a real