The great majority of the time we think in terms of stories and experiences, no matter how random and improbable they may be. Consider the story of the hitchhiker last month and its relationship to speculation pertaining to the end of the 1031 Exchange and changing depreciation standards. The statistics never did bear out that hitchhiking is a dangerous mode of transportation just like the proposals might never be enacted despite the powerful stories and fear-mongering to the contrary.
Emotions can be an influential driver. One of the most unfortunate parts of how the random and sensational are shared is that it often hides what is actually troubling. While the referenced tax reform proposals are in committee, and might never be enacted, there is a largely ignored change coming likely to have a significant impact on commercial and investment real estate.
Remember How Al Capone Was Captured?
Despite the series of alleged heinous crimes, it wasn’t anything splashy that put him behind bars, but rather tax evasion. For nearly a decade, the Financial Accounting Standards Board (FASB) has been attempting to bring the standards by which the U.S. accounting industry operates in line with the International Financial Reporting Standard. One of the most significant changes is to the FASB’s Accounting Standards Codification Topic 840, which defines how leases are treated in accounting. Say what you will about the long boring name and make your accounting jokes, but the impact on commercial real estate could exceed $1.3 trillion in balance sheet capitalizations according to JLL’s Mindy Berman. While the parallel between a gangster going to prison and balance sheets is loose at best—the point is it’s not always the most glaring things that are most impactful.
The Small Change With a Big Impact
As GAAP standards are currently written, companies have a choice between two different accounting methods when leasing equipment or real estate. The first is referred to as a capital lease and in its simplest form, it functions much like a purchase. When a company signs a capital lease, it splits the payments into two pieces. The interest portion of the payment is written off, while the portion of the payment that goes toward the principal balance of the lease is treated as a capital expenditure. The value of the leased property gets put on the balance sheet and then gets gradually depreciated down.
The second, and far more popular choice is to structure the agreement as an operating lease. When a company elects this treatment (based on a series of rules), it doesn’t enter the full lease liability on its balance sheet. That is, only one year’s expenses are reported even though the lease may represent a twenty-year obligation. This creates significant reporting benefits (some would say misleading) on the financial statements of those utilizing the operating lease structure. Assuming identical companies with different lease treatment—it is fairly easy to determine which one might have the more attractive financial statements.
This failure to provide accurate representation of leasing transactions on financial statements is seemingly the primary driver of the proposed change. In the most current draft of the proposed changes—operating leases still exist, but the requirements for this classification are expected to be extremely narrow. If the lease doesn’t meet the final criteria it will be treated as a capital lease. Given the intent of the FASB change, it is anticipated that the great majority of tenants using GAAP standards are going to have to capitalize all of their leases on balance sheets. Essentially, they will take present value of operating cash flows and put it on the balance sheet as liability, which has the potential to significantly impact landlords, tenants, and investors alike.
So the $1.3 Trillion Change—What Does It Really Mean?
Ultimately, the details of the change remain in flux, but it is probable that the new standard would strongly incentivize several key changes that will influence commercial real estate decisions. The crux of the issue is this change requiring the full lease liability will likely result in shorter lease terms. Specifically, the impact could most readily be seen in the following:
New Development & Refinancing—Shopping centers are typically developed around a quality “anchor tenant” like a grocery store or national retailer, both of which would likely be subject to the new accounting method. In addition, longer lease terms are typically viewed by developers and lenders as stable, financeable, and secure. In the short term, the absence of these attributes brought on by short-term leases could create issues for developers seeking funding for projects.
Investment Properties—One of the most popular sectors in investment real estate has been single tenant net lease (STNL) property. These properties are the fast food chains, gas stations, grocery stores, and more that you pass each day and they aren’t generally owned by the corporations themselves, but rather investors. They are coveted by investors because of the long-term leases, stable incomes, and lack of landlord responsibilities. Tenants love them because they can invest their resources elsewhere at a higher return and because they are not typically recorded on the balance sheet. With the largest benefit eliminated for both parties, the new rule may push more companies toward owning their real estate rather than leasing it back constricting the supply of available product.
Brokers, Accountants, Attorneys, and Landlords—The process of negotiating a lease, which is already a complex task, is expected to become much more so especially when the lease structure is more complicated than a triple net. The landlord and tenant will incur additional administrative responsibilities and to some degree, be asked to predict the future since all “likely” renewal options must be included on the balance sheet.
Public interest is generally aroused by dramatic events and in the world of commercial real estate, the 1031 exchange and depreciation are fairly compelling topics. However, the lesser-known changes to accounting rules will have the greater impact. While it remains to be seen how everything materializes, those with the potential to be impacted should prepare. Because, as we know, frequent repetition of a half-truth does not create a whole truth and a lack of attention to a whole truth doesn’t lessen the reality.