For corporate real estate decision-makers, will the new lease accounting standards make an already challenging job even more difficult? You already have many factors to consider when choosing locations, negotiating lease terms, and defining your overall corporate real estate strategies. Soon you will also need to consider how your leases impact your organization’s financial reporting.
Why lease accounting may impact corporate real estate strategies
The new lease accounting standards from FASB (U.S.) and IASB (international) essentially require all leases to be brought onto the balance sheet. That’s a big change. According to JLL, currently more than 85% of lease commitments don’t appear on the balance sheet.
After the new rules take effect, balance sheets will show very different debt-to-equity ratios and return on assets. These changes may have far-reaching impacts on the organization, such as loan covenants and greater scrutiny on lease policies and decisions. And it’s happening soon: January 2019 for public companies.
The questions for corporate real estate is, should these lease accounting standards change your corporate real estate strategy? And if so, how?
Corporate real estate strategies you may have to re-think
If you’ve researched the impact of lease accounting on corporate real estate management strategy, you’ve probably seen a wide range of opinions. However, there’s one thing everyone agrees on. The increased financial impact of leasing will mean increasing scrutiny of your corporate real estate strategies and decisions. You may also face new approval requirements from finance leaders for real estate leasing decisions.
Now is the time to think through your current corporate real estate strategies, understand how the new lease accounting rules may impact your organization, and adjust accordingly.
The buy vs. lease decision
Under the new lease accounting rules, you will lose some of the financial benefits of leasing space. Does that mean you should decide to purchase buildings instead of leasing?
Some experts predict that when looking to occupy all or most of a building (like a corporate headquarters), more organizations will now consider the option to buy. According to CBRE, if you’ve got excellent credit you may find that the cost of capital to purchase is lower than the long-term cost to lease.
However, others experts argue that many other factors (besides balance sheet impact) will continue to be the main drivers in the decision to buy or lease space. Some of these include:
- business requirements and forecasts
- availability of capital
- debt and equity covenant restrictions
Remember that the lease accounting changes, in most industries, will impact everyone equally. Your competitors are facing the same challenges you are. However, if you are the lone company in your vertical with a lot of leased space (versus owned) then you may want to rethink your corporate real estate strategies related to leasing.
Lease term length
Under the new rules, longer leases can have a more detrimental effect on the balance sheet due to larger lease liabilities. Does that mean you should consider shorter lease terms as one of your corporate real estate strategies?
There’s already a trend toward shorter lease terms globally. The average lease length for commercial space in the U.S. is 7 years, but in some international markets the average is 2 to 3 years. With the lease accounting changes factored in, some predict that trend will grow.
However, there are practical considerations that may preclude shorter lease terms. For one thing, there’s a lot of risk for landlords with shorter leases. Tenants may also not want to risk having to move every 2 to 3 years. And for certain industries where leasehold improvements are common, having to depreciate that cost over a short lease may not be realistic.
That being said, it’s possible we may see leases for smaller turnkey spaces becoming shorter with more options. But remember, options that you are “reasonably certain” to exercise will be included (for accounting purposes) as part of the lease term anyway.
In many industries, fixed, all-inclusive lease payments are common for the sake of simplicity. However, under the new lease accounting standards, a higher proportion of variable payments (i.e. with payments for taxes and maintenance separated out) may result in smaller lease liabilities. Should you consider modifying lease structures as one of your corporate real estate strategies?
To be sure, structuring leases with separate payments for lease and non-lease components will simplify the workload for your financial reporting team under the new standards. But that can be more work for accounts payable (unless you have lease management software that makes variable payments simple and automatic).
Even with fixed lease payments, you can ask landlords to provide details about breakdowns of your payments for reporting purposes. However, landlords may consider that proprietary information and may not be willing to comply. If you face that situation, outsourced real estate partners can also provide helpful information.
Sale-leaseback is another lease structure that changes significantly with the new standards. Until now, these transactions served as a form of off-balance sheet financing. With this advantage taken away, you may find this lease structure a less attractive option in your playbook of corporate real estate strategies.
More resources for strategic corporate real estate leadership:
Lease Portfolio Management: Policies & Procedures to Reduce Risk
The Uncertain Future of the Corporate Real Estate Profession
The bottom line: how to decide what’s right
Who is right in all these debates? The fact is, there is no one correct answer for everyone. You need to make decisions that are best for your organization. That means considering lease accounting impacts along with other factors that currently affect your corporate real estate strategies and decision making.
Here’s the difficulty: you can’t possibly do that without all your lease data in a central repository. And without software that makes it easy for you to analyze your lease data, find out where your risks and opportunities lie, and make informed decisions about corporate real estate strategies.
Just about every organization is rushing out to get lease accounting software to push out balance sheet calculations. But lease accounting software alone can’t help you with the critical decisions ahead. The lease accounting changes can serve as your opportunity to implement a comprehensive end-to-end lease solution that helps you improve corporate real estate strategies along with lease accounting.