Real Estate Forum - November/December 2009

Corporate Strategies
By Richard Kadzis
Lease Accounting Changes:
Big Impact, Little Preparation

UNCERTAINTY CHARACTERIZES THE CURREN T period starting with the global economy. Even with some encouraging signs at the macroeconomic level, corporate real estate is confronting record-low transaction volumes, an absence of credit, air-tight capital, devaluation, falling rents and occupancy rates, several tranches of toxic CMBS refinancing and then some. Now, add to the list a serious revision in lease accounting standards as proposed by the Financial Accounting Standards Board and its global counterpart.

A study recently conducted by CoreNet Global Research and Jones Lang LaSalle shows 99% of CRE executives have not fully evaluated the accounting rules changes that could take effect as early as 2012. The survey underscores the need for CRE to align with corporate finance in approaching the proposed changes, which apply to publicly traded and privately owned corporations as well as to real estate and equipment.

“This means that CRE executives, whether at their initiative or otherwise, are going to be talking a lot more to the finance side of the house to understand the changes and manage for the future,” according to Mindy Berman, managing director of corporate capital markets at JLL.

The current proposal applies only to the base leased amount and not to common expenses such as utilities and property taxes. Since all leases will be converted when the standard becomes effective, leasing decisions can affect future financial statements.

Two-thirds of the executives surveyed believe the changes will have a major or substantial impact on corporate earnings, mainly because the new rules would force companies to treat leases as capital, not operating expenses.

One expected result is that P&L expenses would be higher for former operating leases and more similar to capital leases today. The move would mean that at least $1 trillion in leased property and facilities could be added to corporate balance sheets, according to a 2005 SEC study. Lease-intensive industries that would be most affected are retailers, airlines and commercial banks with retail branch networks.

The survey shows the new standards have begun emerging in stealth fashion. Until now, at least, it’s remained a potential threat to industry shifts like less ownership in favor of more leasing flexibility; the ability to capitalize, then lease back and occupy, assets at less cost; or the advantage of not carrying facilities, property and all kinds of equipment on balance sheets.

that much shorter lease terms will result. This is especially worth noting, with nine in 10 respondents indicating that nearly all of their real estate leases are structured as operating leases, implying high-volume restructuring. By comparison, the SEC estimates that 70% of all operating leases are for real estate. Whichever metric applies, the need for shorter leases could generate a mini-Y2K-like wave of transactions and lease revisions as the standards take hold.

Both of the accounting governing bodies foresee higher levels of financial transparency and a truer view of corporate asset values as desirable outcomes. But survey respondents fear a massive shock. For example, more than half have not fully considered the total impact that the changes could have on earnings.

However, there is another possible silver lining to the scenario. If enacted, the revised standards could spur a new set of data needs and fees along with higher transaction volumes due to shorter-length leases coming to the fore.

Plus, ownership levels might increase, adding to the transactions stream. Participating executives were evenly split on the question of owning versus leasing. But 58% of them either agree or strongly

Richard Kadzis is director of membership at CoreNet Global in Atlanta. He may be contacted at rkadzis@ corenetglobal.org.

Corporate real estate executives have not fully
evaluated the accounting rules changes that
could take effect as early as 2012.

agree that they may alter the structure of leases should they be capitalized on balance sheets.

Will it also change the way that analysts and investors consider lease liabilities when they value companies? Less than one-third said that the accounting changes would alter those views, while fewer 22% disagree.

Regardless of the expected outcome, as JLL’s Berman notes with some irony, “Lease accounting is a stealth issue, one that will be nipping at our heels at just the point when many expect the economy to kick back into gear.” ◆