New Real Estate Accounting Tail May Wag the Dog

By James Brennan, ES Group: The Financial Accounting Standards Board and the International Accounting Standards Board are finalizing an approach to lease accounting that will impact deal-making in the not so distant future. The new standard, set to come into play in 2011, will shoot a hole in the sails of credit-rated sale-leasebacks and triple-net leases just as they have been gaining back some momentum in 2010. The changes would impact new leases and current leases going forward.

Whether the food group is retail, office, or industrial, landlords and tenants are trembling when it comes to a proposed new accounting standard. The Financial Accounting Standards Board and the International Accounting Standards Board are finalizing an approach to lease accounting that will impact deal-making in the not so distant future. The new standard, set to come into play in 2011, will shoot a hole in the sails of credit-rated sale-leasebacks and triple-net leases just as they have been gaining back some momentum in 2010. The changes would impact new leases and current leases going forward.

The proposed standard will capitalize many operating leases which are currently not reported on balance sheet for tenants. The new approach creates a large non-cash expense, in which the amortization of the right of use capitalized lease asset plus the recognition of imputed interest expense on the capitalized lease obligation exceeds the cash paid for rent in the first half of the lease term. The process of applying this amortization on a lease motivates tenants to demand shorter leases, as the longer the lease term the greater the impact of frontloading lease costs.

For accounting purposes, tenants will push for shorter term leases without renewal
options or contingent rents to minimize the non-cash lease costs. The new standard recognizes the lease term amorphously as the one more than likely to occur (however, the Boards will give taxpayers facts and criteria to properly estimate). The rental stream, any contingent rentals, and any residual value a landlord would be expected to receive would be amortized over the lease term. Landlord and tenants would match these values on a consistent and systematic basis. Landlords and tenants would both reassess on each reporting date to see if any expectations have changed with regards to lease term, and the overall leasehold obligation. Questions remain, for example, how retail landlord and tenants can project percentage rent for purposes of determining the leasehold obligation.

However, certain impacts appear clear. Most likely tenants will push for shorter-term leases without renewal options to minimize the non-cash lease costs factored into the amortization. Landlord-investors will be directly impacted as the shorter lease terms will impinge upon their ability to obtain long-term financing from banks. The “finance-ability” of credit-rated sale-leasebacks and triple net lease deals has always been a huge aspect of their appeal. Diminishing an investor’s ability to place debt on the asset will impact his return on equity and internal rate of return; and perhaps lead that investor to look elsewhere.

As FASB and IASB drive home the standard change, landlords and large tenants hesitate to act. Many private clients continue to orchestrate deals; however, all parties, large and small, will be swept into the blanket changes that like death and taxes, appear to be inevitable.