Charles C. Pilchard
The most recent Financial Accounting Standards Board (FASB) draft of proposed lease accounting changes and its potential adoption would have a severe impact on real estate owners, lenders and occupiers. While FASB is moving quickly to implement this draft aimed at greater lease transparency, several areas must be clarified now to avoid misinterpretation and to ensure adherence and accurate reporting. More importantly, adoption of this draft will result in substantial time investment by tenants, real estate owners and service companies, and lenders both at inception and on an ongoing reporting basis.
Occupiers would immediately feel the impact of the accounting changes as leases will have to be capitalized, including future estimated renewals, contingent rents and, possibly, operating expenses and real estate taxes. The capitalization of leases will do three things: 1) it will result in higher front-end lease costs; 2) it will require constant re-evaluation of contingencies in light of changing market conditions and business objectives; and 3) it will impact financial ratios, loan covenants and EBITDA (earnings before interest, taxes, depreciation and amortization).
Faced with whether to enter into longer-term leases that result in greater reportable liabilities, tenants will naturally move to shorter leases and likely forego renewal rights that would also require upfront recognition. Now, the ripple effect occurs. With shorter-term leases, property values will drop as guaranteed net operating income decreases. In turn, decreased property values will also impair financing/refinancing with owners having fewer and less attractive debt products available.
All categories of real estate activity could end up being adversely impacted, including future development and the acquisition of office buildings.
The recent buy decision (versus lease) by aerospace contractor Northrop Grumman of a 334,000-square-foot headquarters building in Northern Virginia was directly influenced by this pending FASB provision and the possible retroactive accounting of such a lease.
Even though accounting and related industry specialists for the most part agree that leases will have to be capitalized, the cost of achieving the goal of greater transparency must be weighed against any potential benefit.
The immediate impact of retroactively booking the value of existing leases and the related transition period, as well as the ongoing need to estimate future potential payments for items such as renewals and contingent rents, places an undue burden on owners and tenants. Clearly, these are areas that need the focus, a clear cost/benefit analysis, and modification by FASB. With the hope of real improvement, lenders, investors/owners and occupiers must come forward immediately on all fronts to strongly voice the certain adverse impact of this draft on property values and on how real estate activities will be transacted in the future. The real estate community, with its sizable and consolidated voice, can influence the outcome of the proposed accounting changes to minimize the financial costs to occupiers and the overall real estate industry.
— Charles C. Pilchard is principal and senior vice president with the Washington, D.C., office of Avison Young.
More information may be found using the following links:
Avison Young White Paper, “FASB planning sweeping changes to GAAP rules” – www.avisonyoung.com
KPMG Institutes – www.kpmginstitutes.com
Financial Accounting Standards Board: www.fasb.org
IFRS Foundation – www.ifrs.org