COVER STORY, DECEMBER 2010

FINANCIAL STATEMENT EXPLOSIONS
Know the new accounting rules for operating leases and the impacts on the commercial real estate industry.
Thomas Morgan and G. Douglas Lanois

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have recently issued an “exposure draft” seeking comments on proposed rule changes to the way leases are treated in financial statements. The new rules will significantly change lease accounting, including the elimination of operating lease accounting from most companies’ financial statements. Tenants will be required to treat all leases, including those already in effect when the new rules are implemented, in a manner similar to how capital leases are accounted for today.

Most who have examined this topic agree that the changes will impact the commercial real estate industry in significant ways. This article provides a summary of the proposed changes and their likely impacts.

It’s All About Disclosure

Since 2006, with encouragement from the Securities and Exchange Commission, FASB has taken the position that existing accounting treatment for leases is “broken,” particularly with respect to tenants’ financial statement presentations. FASB has determined that users of financial statements will benefit from the great transparency of eliminating these “off-balance sheet” transactions that do not reflect either the value of the underlying “right-of-use” of the asset or the corresponding long term obligation to make payments for that right-of-use.

FASB and IASB are moving towards finalizing the rules to require all operating leases to be treated like capital leases for purposes of GAAP. The new rules will have broad implications for owners and tenants of commercial real estate and the professional advisors involved in all leasing transactions.

The Specific Changes

The proposed changes would require that the parties apply a “right-of-use model” in accounting for all leases. In short, this means that tenants will now reflect the “value” of the lease as an asset on the balance sheet, and also show the total value of all anticipated lease payments as a liability. The idea is to treat the lease more as a purchase of an asset with the lease payments reflecting the “financing terms” that have been agreed to by the parties and reflected as long term obligations.

In valuing the assets and liabilities inherent in the lease, the parties will be required to assume the longest possible lease term that is “more likely than not to occur”, including options to extend. The parties will also use an “expected outcome technique” to reflect the lease payments, including contingent rent and all other payments specified by the lease. These assumptions are not static and must be revised to reflect changes in expectations of future events periodically.

Owners will similarly treat the right to receive payments as an asset (e.g. similar to a “note receivable”) and set up a performance obligation representing the obligation to permit the tenant to use the leased asset. The leased asset (building in this case) would continue to be recorded on the balance sheet of the owner. The performance obligation is satisfied (and revenue recognized) over the lease term.

The proposed accounting model for leases is expected to have the greatest impact on tenants of “large-ticket” items, such as real estate, manufacturing equipment, power plants, aircraft, railcars, and ships. However, with few exceptions, the rules apply to all leases including automobiles, computer equipment, copiers, office furniture and telecommunications equipment. The impacts will be far reaching to say the least. Many feel financial statement comparisons over prior periods will be very challenged requiring expensive re-statements for public companies.

Commercial Real Estate Impacts

With respect to commercial real estate, given the current complete upheaval in the capital markets, the inability to come to grips with true asset valuations and the lack of a strong transactional market; these rule changes are just one more uncertainty to throw into the mix. Nonetheless, we believe that there are a few general impacts that can be identified.

The primary impacts will affect the tenants’ and the owners’ Balance Sheets and Income Statements, including:

• Balance sheets will be grossed-up to reflect the right-of-use asset and the lease obligation;

• The expense recognition pattern will change: Expense will be higher than straight-line expense during the early part of the lease term and lower during the latter part of the lease term. While the asset will typically be amortized using the straight-line method, the obligation will be accounted for using an effective yield model. Accordingly, like an amortizing mortgage, the interest expense will be higher during the early part of the lease term;

• EBITDA will increase as rent expense will be replaced with interest and amortization expense, which are below-the-line charges;

• Record keeping procedures and lease accounting system requirements will increase: The estimates utilized in recording the leases will need to be re-measured at least annually. Public companies will need to restate their prior two years in order to comply with SEC requirements;

• Investor communication and education will be critical. The range of impact will vary by company; how these changes are explained to analysts and investors may greatly impact the value of a company.

There are numerous secondary impacts. For example, financial covenants in loan documents will be impacted negatively by including the full value of the leased asset and corresponding liability in the calculation. Similarly, EBIDTA targets in most incentive compensation arrangements will be affected. We would expect banks, employers and others impacted by these covenants to review and adjust accordingly (by either modifying current covenants to specifically exclude lease obligation impacts from the calculation, or to include a new debt/equity ratio covenant that would specifically consider the impact of the new accounting). In addition stock prices for certain companies may be negatively affected as higher leverage ratios impact investors.

Another important secondary impact will be the pressure to have shorter term leases as healthy companies seek to minimize the impact of capitalizing the leases on their Balance Sheets. How this affects owners’ abilities to finance their CRE remains to be seen. This may end up as the “great transparency” as companies who elect to own with modest leverage will have a significant advantage over firms who lease and now must reflect a major liability.

Furthermore, potential tenants will now evaluate lease versus buy decisions with more scrutiny. The conventional wisdom says that the new rules will encourage more buy versus lease decisions since the benefits of leasing from an expense perspective will be removed and add an effectively 100 % leveraged asset to the balance sheet. However, this assumes that the accounting rules are the primary determinant in the lease versus buy decision today. That may be true for some companies (particularly some REITs and other highly tax driven investment vehicles). But for most of the CRE world, the issue in the current economic environment is more complex. A second school of thought says that the market has already been effectively dialing in the impacts of lease obligations in financing/investment decisions, and therefore, the new disclosure rules should not have an impact on most transactions. In other words, the treatment of these leases on the balance sheets has more to do with reporting than actual cash flow, which is the ultimate determinant for most companies considering lease versus buy options.

Finally we also see a number of negative impacts on owners, including:

• Tenant credit mix may be adverse as better credit tenants may be more likely to purchase property, leaving only those not able to obtain financing (i.e. poor credit risk) in the potential tenant pool.

• The underwriting of tenant roll over risk may be more difficult if tenants demand shorter term leases.

• Such changes will impact both real estate values and credit underwriting.

• Impacts will vary by property type – some not affected at all and others more: retail property, large office and sale/leaseback or triple net lease property types most affected.

Conclusion

While the total impact of the rule changes is uncertain, what is clear is that these changes are going to affect large segments of the commercial real estate industry. The opportunity for owners, tenants, accountants, lawyers, brokers and other intermediaries is to understand the rule changes and adapt accordingly and quickly.

Thomas Morgan is general counsel to Tremont Realty Capital LLC in New York, and G. Douglas Lanois is CFO and portfolio manager at the firm, where he oversees
corporate finance /tax issues and manages Tremont’s investment portfolio.

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