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Companies Brace for Powerful Impact of Lease Accounting Changes

Proposed new accounting standards have been drafted in order to push lease liabilities back onto corporate balance sheets. Such a change would represent a major shift for companies that have typically favored the off-balance-sheet treatment of operating leases, and it could have a significant impact on corporate decisions to lease or purchase real estate in the future.

The proposed guidelines are a joint initiative by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board to create a uniform global standard and greater corporate transparency in lease accounting procedures. The most recent draft issued Aug. 17 would establish one method of accounting that requires firms to recognize all lease liabilities and assets on their corporate financial statements.

Another key component is that companies would be required to record the lease value or rent commitment over the entire lease term, including renewal options. Although the intent is to stop off-balance-sheet activity, the changes would add significant weight to corporate balance sheets.

For example, a firm that pays $1 million per year in rent for its corporate headquarters would quickly see its liability multiply depending on whether it has a five-year or 15-year lease. Companies would appear more highly leveraged, which could affect factors such as corporate credit and existing debt covenants.

Crux of the matter
What makes commercial real estate industry professionals nervous is that it is not clear to what extent the new accounting guidelines would influence tenants’ decision-making process. Based on the universe of leased space, the potential impact is enormous.

Although FASB cites data that values leasing activity at $640 billion in 2008, other industry sources estimate that current volume as high as $1.3 trillion in operating leases for U.S. firms alone. Once the guidelines go into effect, which many in the industry believe will occur in 2013, both new and existing leases would be immediately affected.

One fear is that the new accounting practices could deter companies from signing long-term leases, or encourage firms to own rather than lease facilities. Both of those factors could be a detriment to the sale-leaseback and net-lease finance niche where leases typically extend 15 years and beyond.

Sale-leaseback transactions have accounted for $24.8 billion, or slightly more than 50%, of the $46.6 billion in single-tenant sales globally over the past 12 months from June 2009 through June 30, 2010, according to New York-based Real Capital Analytics.

“I think there will definitely be a bias toward shorter-term leases in order to show less debt. But that is going to be offset by the fact that shorter-term leases are going to be more expensive, and landlords are still going to want longer-term commitments,” says Amie Sweeney, CPA, a senior financial analyst in corporate finance at Grubb & Ellis in Grosse Pointe, Mich.

Although long-term leases could become a disadvantage for some companies, many in the industry don’t expect it to result in a significant decline in sale-leaseback and net-lease transactions.

“As long as companies can sell assets and lease them back and free up cash, net lease is still a viable financing source,” says James McCartney, CFA, managing director at Net Lease Capital Advisors in Nashua, N.H.

“To the extent that the financing rates are lower today, I don’t know why someone wouldn’t want to lock that up just because you’re going to put that on your balance sheet,” adds McCartney.

Wait-and-see attitude
Ultimately, the impact of the new accounting changes on the commercial real estate industry is going to depend on the reaction by lenders, rating agencies and the companies themselves.

“We really don’t know until we get these rules finalized, and get a full understanding of the reaction, what the impact of this is going to be,” says Randy Blankstein,
president of The Boulder Group, a net lease advisory firm based in Northbrook, Ill.

“My guess is that investors and lenders will be slightly uncomfortable with the new debt levels, but not dramatically uncomfortable,” adds Blankstein.

FASB issued its exposure draft on Aug. 17. The draft was issued in order to solicit comments from the public. The deadline for comments is Dec. 15. The board will take those comments into consideration when writing its final proposal.

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