Leasing is perhaps one of the most pervasive forms of financing in the global economy, yet traditional accounting standards remain essentially silent on the off- balance sheet treatment of leasing. This has now changed with the release of new accounting standards which essentially require all leases of one year or more in term to be placed on the balance sheet assets (value in use) and corresponding liabilities.
FASB published the new standard in February 2016, stating that it will be effective for public companies starting at the fiscal year 2019, but requires look back figures for three years: 2017, 2018, and 2019. A recent IBM study estimated that this accounting change would add potentially $1.35 trillion to company balance sheets in the form of assets (right of use) and liabilities. Clearly this enormous increment to a company’s capital structure will have both expected and unexpected consequences. It’s uncertain how these changes will affect rental markets, leasing strategies, and corporate capital structures. In reviewing several hundred corporate responses to the exposure drafts in 2013, most respondents cited the incremental cost of implementation and complexity associated with the implementation of the standards. In its final form, the two standards differ in one major way and that is, the IASB standard treats all leases regardless of size as capital leases, whereas the FASB differentiates between capital leases (interest expense and depreciation) and operating leases (straight line amortization).
Here are a few of the unintended consequences which may transpire over time.
Leasing demand: There will be some measure of reduction in leasing demand, which will have the effect of creating property surpluses in the near term. Property owners will be compelled to lower market rental rates to stimulate demand. It’s possible that this disruption to property markets could in some cases lead to failures and even bankruptcies. Loan covenants on commercial property could be stressed by the fall off in the rental market. It’s possible that we’ll witness real estate company mergers and consolidations to pick up the slack in the rental markets. We may also see a disproportionate growth in corporate development and a parallel decline in sale/leaseback transactions, again an unintentional response to leasing bias.
- Shorter term leases: Lessees will opt for shorter term leases as a means to mitigate the balance sheet effect of their lease commitments. Lessors will compete on asking rental rates and other terms that will reduce the net present value of the lessees’ rental stream. Another response will be the advent of various leasing options that will provide various methods to increase leasing flexibility without necessarily increasing the over-all asset value of the lease.
- There will be a myriad of techniques to move some portion of rental to alternative non-balance sheet accounts, as a way to respond to tenant demand for lower rental commitments. For example, tenants may opt to pay for services that historically have been part of the base rent such as insurance, property tax, etc. This shift will also affect escalations, such as shifting away from such traditional formulas as porter’s wage escalations, or CPI formulas.
- Another unintended consequence may be the emergence of various forms of barter. A law firm, for example, may barter its legal services for lower rental in its offices. A retailer may offer special discounts on its merchandise such as building supplies in exchange for lower rent. Architects may enter into a barter deal with its landlord to exchange design services for lower rent.
- Because of the differences between the IASB and FASB standard relative to Type A versus Type B leases, US companies will place a higher premium on property ownership, particularly in the United Kingdom and Continental Europe. Since all leases internationally will be classified as capital leases (Type A) some companies will opt to own commercial properties (as investments) as opposed to forgo asset appreciation in a capital lease structure. This possibility may shift demand for commercial properties more toward corporate owners and away from institutional investors.
- Brokerage Fees: Because of the demand for shorter term leases, it’s possible, maybe inevitable, that commercial brokerage fees will, in the aggregate be lower, over time. To what extent this possibility will impact real estate company profitability is an open question. Certainly the brokerage community will see a reduction in their fee income, and may well lead to an eventual reduction in brokers. Or we may see another form of brokerage compensation that is decoupled from total rental as a way to mitigate the effect of brokerage fee as a function of total rental.
- Stock market effects: This accounting change will restructure company balance sheets, and have a net effect of reducing stock holder equity and thus share price. This will be particularly true of corporate entities which have leased large portfolios of properties such as retailers, tech companies with large portfolios of leased equipment, and airlines who typically lease their fleets. How this impact on corporate equity will translate into devaluation of stock value is uncertain, but a possibility. This effect will be heightened for the retail and airline industries which rely heavily on leasing to finance their assets.
The coming change in lease accounting standards will create significant uncertainty in property markets as the standard is implemented. And uncertainty creates both opportunities and risks. In essence the accounting standards boards will have turned building tenants into property owners. How this change will impact property markets relative to demand, supply, pricing, and lending is fraught with uncertainty. One thing is for sure: there will be increased demand for experienced corporate real estate professionals who can help their companies transition to the new world of balance sheet transparency.