Renewal probability and the New FASB Rules

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses questions surrounding how renewal option probability will be calculated under the new FASB rules.

This is the third in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.

Under the proposed FASB rules tenants are required to estimate the probability of exercising their renewal taking into account past practices which includes assigning “more likely than not to occur renewal probability”. For example, assume a tenant has 30 offices with similar leases and renewed 20 of them and allowed the other 10 to lapse; then the past practice is to renew for 2/3rd of the portfolio of similar leases (66% probability of exercising).

However, what if of those 20 renewals, ONLY 10 of the renewal options were exercised by the tenant as drafted and, for the other 10, there was a renegotiation including rent or lease term (as we believe is the case in many renewals). Although the lease was renewed, what really occurred was the term was extended and possibly the rent and concessions changed from what the lease initially provided.

Now, “in terms of the new FASB proposal” does the tenant’s past practices include exercising 2/3rds or 1/3rd of their renewal options since in only 10 of the 30 offices did the tenant exercise the “renewal option” as initially provided in the original lease? Unfortunately, I do not know the answer and, until the new rules are approved and in use, we may not get a concrete judgment. This is one of the several questions I will be submitting to FASB in their request for input that is due by December 15, 2010.

One other thought; many renewals say “95% of Fair Market Value” (FMV). When was the last time you actually did an appraisal for FMV using an independent 3rd party? In my experience, the tenant and landlord typically agree on a new rent, concessions, etc. Was that 95% of FMV? Was the “renewal option” exercised per the terms of the lease and does it count as a renewal option “in terms of the new FASB proposal”?

Shameless Plug

The new Lucernex financial engine has been upgraded to support the new, proposed FASB rules. This was a massive undertaking led by Jim Duport, our resident financial modeling expert, which, once complete, was verified at the formula level by an independent CPA. The new engine was released initially inside Lx LseMod Corporate version 15, at the end of 2010. We then used the upgraded financial engine in Lx Contracts, our lease administration and rent accounting solution and as part of our Q1 2011 release of the Lease Analysis module of Lx Retail. Lx Retail, Lx Contracts (which is sold alone or as part of the Lx Retail suite) and the financial engine all share a single platform and single database.

Past Blogs by Jim Duport

Thoughts on the proposed FASB GAAP lease accounting changes
5 GAAP Rules you need to know
GAAP in Commercial Real Estate Sublease Accounting
Go Beyond a simple and potentially misleading Cash Flow analysis
What is GAAP rent and how does it impact SOX?
Sale Leaseback transactions
The proposed FASB changes and the impact on the lease vs. buy decision
When is the Proposed NEW FASB / GAAP Cheaper in Year 1 vs. Old GAAP?