Changing the Rules of the Game

New lease accounting rules will have a big impact on public and private company balance sheets.



Companies that rent real estate should consider re-structuring leases to be ready when recently announced changes in accounting rules take effect in late 2018 and 2019, experts say.

The changes, designed to provide outside parties a clearer view of a business’ financial picture, will force businesses to recognize nearly all their leases as debt on their balance sheets.

This will cause many businesses – especially those that lease large amounts of real estate, such as retailers – to appear to have significantly more debt than they do now.

Companies’ financial statements must disclose all lease obligations under existing rules. But for now, their balance sheets account only for what amount to rent-to-own obligations, and not shorter-term lease deals.

As a result, footnotes in financial statements of some lease-heavy businesses disclose billions of dollars of shorter-term rent contracts. 

Starting in 2018, lease agreements of at least 12 months will appear on balance sheets as debt for all U.S. companies that follow generally accepted accounting principles, or GAAP, experts say.

“It will definitely impact companies that have more real estate (under lease) than those that own or have minimal rental obligations,” says Maureen Kelly Cooper, a Dallas-based senior managing director at Cushman & Wakefield. “It’s an added component when evaluating the pros and cons of leasing versus owning.”

When the new rules kick in, they will apply retroactively to all leases an organization in effect at that time.

Since rental agreements of commercial real estate typically last at least five years, it is vital for tenants to factor the upcoming guidelines into rent contracts they are signing today, experts say.

“Surprisingly, a lot of our clients haven’t tackled this issue yet,” says Torrey Littlejohn, a Dallas-based senior vice president at JLL. “These changes will most likely require additional administrative manpower to accurately track and implement. We are ensuring we keep clients abreast of the pending changes, deadlines and resources to help them deal with this.”

 

Lease: Operating vs. capital

The rule changes affect how companies account for what are known as “operating” leases.

Historically, GAAP considered operating leases roughly akin to what many people may think of as rentals, covering a small amount of the useful life of a piece of property. 

This means financial statements currently do not include operating leases on balance sheets, which show what an organization owns and what it owes.

For now, the opposite type of rental arrangements under GAAP are called “capital leases”

These are similar to installment-based loan agreements to purchase properties, except that legal ownership of the properties remains with the party that is leasing it out until all payments were made.

The new rules give capital leases a new name: Finance leases. 

The new rules come from the Financial Accounting Standards Board, or FASB, a non-profit that sets accounting rules for U.S. organizations that follow GAAP.

Under FASB’s existing rules, leases are treated as the capital variety if they meet any of four tests, such as the duration of the contract exceeding 75 percent of the life of the asset.

Those tests will remain essentially the same for finance leases under the new rules, experts say.

After nearly a decade of work, FASB in February announced new rules that will require all leases of more than 12 months to be recognized on balance sheets.

Although leases of more than 12 months may fall under the “operating” or “finance” categories, both will be part of balance sheets under the new rules, experts say.

“Real estate leases typically qualify as operating leases,” said Michael Bodwell, a Dallas-based partner at Whitley Penn. “The way we think about operating leases is changing.”

The rule changes could have some affect on landlords, as certain tenants might gravitate toward short leases to minimize impacts on the balance sheets, according to Greg Greene, senior vice president at CBRE’s capital markets group.

“The impact of this should be minimal” for building owners, he added. “I do not expect tenants to move to less expensive space only for this reason.”

Ultimately, the new rules are of most concern to organizations that lease real estate, according to Tom Wilkin, the New York-based US REIT leader at PwC.

“The bigger impact is how tenants might react, and the impact on real estate and real estate valuation,” he said.

 

Debt/equity, EBITDA or net income

The new rules mean all tenants should re-consider the structures of their real estate leases to ensure they help meet the goals they have for their businesses, according to Karra Guess, chief financial officer at E Smith Realty Partners.

Here are three examples:

Large debt loads: Heavily leveraged firms should avoid leases with “material” up-front incentives, such as free rent, Guess said.

In this context, material refers to anything large enough that, if omitted from financial statements, could result in those financial statements misstating the organization’s financial position.

“Under the new rules, the right to use an asset – the real estate space, in this case – means incentives like free rent wind up shrinking the value of the asset on the balance sheet,” Guess said.

Meanwhile, the amount of debt – that coming via the lease — remains the same under the new rules, Guess said.

“Much like a homeowner who owes more on their mortgage than their house is worth, this can worsen the ratio of a business’s debt to its shareholders’ equity,” Guess said.

If that ratio increases, that can mean the company may violate its covenants on existing debt it holds.

For public companies, that could negatively impact the trading value of their stock, she said.

“Firms that have been purchased by private equity investors, or that have done large expansions, should be wary of up-front incentives,” Guess said.

EBITDA focused: Private companies seeking either minority investors or to sell themselves outright may do better with finance leases under the new rules, Guess said.

The values these firms receive from investors typically are multiples of their “EBITDA,” or earnings before interest, taxes, depreciation and amortization.

EBITDA essentially measures how much profit a firm’s operations generate.

The advantage from finance leases for EBITDA-oriented companies stems from the fact that these leases include interest, which the tenants can deduct from their taxes, Guess said.

“This can help boost their EBIDTA - which does not include interest – and potentially mean better valuations from investors,” she said.

Even better, the company’s payments on finance leases will include more interest during the early years of the lease, the time frame when the business likely will be seeking outside investment.

Public companies: Companies seeking to maximize net income under GAAP – something most lay people equate with profit – should opt for operating leases under the new FASB rules, Guess said. This includes most public companies.

“Under the new rules, operating leases essentially provide predictable expenses year after year. Finance leases wind up costing more in the early years, and less in later years,” she said.

 

Operating leases therefore have a consistent impact the impact on a firm’s net income throughout the durations of the leases.