Lucernex expert Jim Duport discusses the potential impact of the FASB GAAP lease accounting changes on the lease versus buy decision.
The law of unintended consequences
A FASB goal is transparency and to match revenue and expenses including commitments of future expenses. Towards this goal, the PROPOSED FASB change in the GAAP lease accounting would require that the Rent Calculated (or estimated in the case of percentage rents) would be booked as an expense to the P&L and shown as an asset on the balance sheet taking into account “probable” renewal periods.
Instead of a simple straight-lining of rent on the P&L, the new rent (called by some as a Right-to-Use) would be derived by starting with the Transaction Date, the date the lease is executed, and then using a somewhat convoluted formula to portion out a balance sheet account that includes discounted rent from the start of lease, including probable renewal periods. The P&L Right-to-Use also includes an internal interest rate of the declining balance.
Today’s intent is to discuss the possible impact of the proposed inclusion of MULTIPLE renewal options. In simple terms, owning a property will become much more favorable than leasing since, in either case, the property becomes a depreciating asset on the balance sheet.
Certainly, for special purpose, big box NNN tenants, Mall Anchors, or critical properties, owning will become more favorable FINANCIALLY than leasing. A Lx LseMod customer just sent me an email about a presentation she attended in which the presenter said that TODAY, some tenant’s are already buying instead of leasing due to the PROPOSED change in the accounting rules.
As currently proposed, for example, a retail lessee with a 20-year lease and two “probable” 20-year renewal options may be required to include in their year 1 rent an estimate of their rent for the entire 60 year term. The rent, e.g. rent for year 60, is discounted for present value, but candidly, this approach sounds unreasonable to me. However, that is how the proposal reads today. To learn more about timing and the draft, see my previous blog title “Thoughts on the proposed FASB GAAP lease accounting changes”.
So, it is better, much better, to own. If you are a tenant in a multi-tenant office building, perhaps the landlord will decide to create office condos, which is common in some submarkets and some international markets. Sounds good, now you own your space. BUT, this is a good case of the devil being in the details. For example, what happens if you want to expand? Do you buy another space? Where? Is it adjacent? OR, what happens if you decide to contract or leave? Now you need to SELL your space or you can become a landlord and lease it out. From my perspective as an 18-year veteran CRE Manager, I do NOT want to be a landlord, nor do I want to be in the business of selling real estate. As I said in the title, The Law of Unintended Consequences.
By the way – From the landlord’s perspective, once the office building is condos, they have lost control of the space, which may be good or bad, depending on the landlord. Then there is the issue of capital improvements needed for the complex such as roof replacement, security systems, new code requirements for common areas and how to enforce them against owners who either refuse or cannot pay their pro rata share.
Another office scenario to which I do not know the answer: Assume a 10-year lease with two 5-year renewal options and furthermore, assume you have used the proposed accounting basing your P&L rent on 20 years, the total probable term. Now it is year 4 and “whoops”, the plan changed, now we are closing the office. UGH!!! What happens to my P&L? Is the write-off for 16 years? At this stage, I have no idea.
Now, let’s look at a shopping mall. Same story, does the landlord Condo-ize the shopping center, SELLING spaces? Same issues, expansion and termination. AND, add in “going dark” and hours of operation. There is yet another factor – what if the anchor tenant leaves? Did you take that into account when determining the probability of exercising your renewal options? What about zoning? Will zoning laws allow for the shopping center condos? Office condos?
Like most tenants, I used to pay for flexibility. e.g. I was willing to pay a tad more if it got me lots more flexibility, since plans always change. If I “need” to purchase vs. lease, I have a whole lot less flexibility.
What is driving these decisions? It is NOT the concept of including lease commitments on the balance sheet. The driver is the idea of including ANY reasonably probable renewal options in the P&L rent calculation. As I said in my previous blog, there is a fix. Limit the renewal term to 10 years maximum beyond the current lease period.
AND, there is a work-around to the “probable” renewal provision being considered. A friend of mine, a Managing Director at CBRE, suggested this – create a new clause in the lease, a Right of First Refusal to Renew with a long fuse on the response time and details of the offer to be matched, which should discourage most interested parties in submitting a ROFR and create a long enough period for FMV negotiations either prior to or post receipt of a ROFR.
In essence, the tenant would have the right to exercise a renewal, but not have to commit until the landlord has another offer on the space. I think this is saying I do not have a renewal option, but instead an option to renew, if and only if, there is another offer. The downside is that there would be no assurance that the landlord would entertain renewal discussions, making each renewal a real test of wills requiring real relocation options being developed by the tenant with ample lead time to credibly threaten relocation. As I said in a previous blog – people much smarter than me will figure out ways around the renewal provision.
A few other random thoughts:
Tenants may decide not to negotiate renewal clauses because of this GAAP provision. You have just given landlords a major win. Any renewal clause is to the tenant’s benefit since the tenant controls the space and also has an option to not exercise the renewal and re-negotiate. No renewal option; the tenant is in a significantly weaker negotiating position if they want to renew.
How do I estimate the rent given that many renewal options are at 90% to 95% of fair market value? The proposed renewal provision is not just including the term, but you need to have an associated rent. Now we are building Assumption on Assumption, i.e. assume the renewal is probable, and now assume a rental rate sometime in the future.
Another impact. Since buying is much more advantageous than leasing, there will be more buying. Good for the real estate brokers, BAD for the company. Instead of investing cash in the business, their real core asset; they will be investing in real estate. Not, to my mind, good business.
What is the key issue?
Including MULTIPLE renewal options makes owning MUCH MORE financially favorable than leasing.
Change the multiple renewal options to a rolling 10-year period, thus re-balancing the lease vs buy decision.
Please check back, as I learn more I will keep you posted.