Gumbiner Savett Inc.

Operating Lease or Capital Lease?

Standardized accounting treatments have become a topic of hot debate. Fueled by the Enron debacle and the myriad of corporate bankruptcies, off balance sheet accounting methods are raising eyebrows. Currently, treatments differ between the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). As companies continue to push into the global market and shareholders demand and expect more transparency in reporting, the move to standardization has become a priority. While the implementation of these changes is expected as early as 2012, savvy real estate entities are preparing for it now.

Changes in Lease Accccounting

One area that will clearly influence how a company handles its real estate is the method in which lease accounting standards will be reported. The proposed changes for lessees will require all leases to be classified as capital leases, which are known as financing leases under the international financial reporting standards. Thus, the change effectively eliminates the distinction between capital and operating leases. The FASB has decided to exclude lessor accounting because a comprehensive analysis would be complex and likely delay publication of a new standard on lessee accounting. There are also other current FASB projects, such as revenue recognition, which would need to be completed as well since any changes here would also affect the lessor’s accounting.

Essentially, the reclassification will move the obligation to pay lease rentals and a right-to-use asset to company balance sheets. The amount of the obligation will be equal to the lease rental payments discounted at the lessee’s incremental borrowing rate. The lease rental payments include: an estimate of cash flows relating to the lease term, contingent rents, purchase options and residual value guarantees. This obligation will be re-measured at each reporting date, including reassessing the estimate of cash flows relating to lease terms and purchase options, contingent rentals and residual value guarantees. This will drastically change company financials, since recoding these obligations may change the way investors analyze company balance sheets. Clearly, it will alter key balance-sheet ratios, such as debt-to-equity ratios.

Under the proposed standards, a tenant assumes a valuable right: the right to use the leased space. This meets the definition of an asset. The lease payment meets the definition of a liability. Under current standards, however, when leases are classified as operating, these assets and liabilities are not recognized; thus, they are recorded in the income statements as lease expense when paid. With the anticipated changes, all leases will fall under the capital lease designation and must be included on the balance sheet. Needless to say, for those in the real estate industry, this fundamental change will shift how real estate is transacted.

This shift of all operating leases into the capital lease category will also move trillions of dollars to the balance sheets of companies in the United States. Given that most office leases are currently classified as operating leases, the shift to the capital category will have a dramatic impact on company debt. While the changes are inevitable, the backlash will be considerable, and company management will be taking a new look at how to manage the balance sheet.

Preparing for the Impact

The change is currently under review by both the FASB and IASB, but it is anticipated to go into effect sometime in 2012. As companies become aware of the shift, real estate leasing will take on a different strategy aimed at diminishing the negative impact.

The move to a capital leasing environment will have a strong impact on how transactions are negotiated. There are several fundamental changes that may take place:

  • Lease or buy: For those companies that are committed to purchasing their real estate, there won’t be much of a change. For those that lease most of their space, management may consider rethinking that strategy. The challenge? In the larger markets that carry long-term leases in the 15- to 20-year range, there are fewer opportunities to purchase office space. In markets that offer ample supply of office condos, there will be an up-tick in interest.
  • Long-term vs. short-term leases: Tenants will take a closer look at the length of the lease, and may shy away from long-term transactions. While shorter leases will reduce the impact on the balance sheet, they offer fewer incentives; landlords are unwilling to offer strong incentive packages that may include free rent or tenant-improvement budgets. Since the tenant is only there short term, there is less stability for an asset and more wear and tear on the building as companies move in and out more frequently.
  • Balance sheet impact: With an increase in debt on the balance sheet, many companies will appear heavily leveraged. In addition, EBITDA (earnings before interest, taxes, depreciation and amortization) will increase because the rent expense will now be replaced with depreciation and interest expense, which is a positive.
  • Creative lease structures: Given the new changes on the horizon, securing cost-efficient leases will become critical. Corporate sale/leasebacks, which involve selling an asset then leasing it back, have increased in popularity as companies seek sources of cash.
  • Financial ratios: New financial ratios will come into play. As a measurement for securing capital, borrowers should consult with lenders to determine how the new rules will impact their risk position.
  • Prime central business district space: Companies may consider relocating into less expensive markets, particularly for back-office functions that can be housed separately.

No one can predict how soon the new procedures will be implemented. Given the impact these changes will have on the real estate industry, careful — and early — analysis will allow company management to put the correct initiatives in place. Understanding the new reporting standards and developing a well-thought-out strategy on how real estate leasing should be handled will not only protect the company today, but position it for growth well into the future.

For the pdf version, go here. This article was published by Western Real Estate Business. Learn more about the publication here.