NEW YORK CITY-Higher interest rates, reduced concessions and other negative impacts on balance sheets were just some of the grim predictions made during Wednesday afternoon’s “Latest Developments in Potential Lease Accounting Changes” panel at this year’s RealShare Net Lease conference, which drew more than 250 attendees. New rules proposed last year by the Financial Accounting Standards Board and the International Accounting Standards Board could bring billions of dollars in leases onto corporate balance sheets for the first time, which could create an enormous impact on financial statements. “These lease changes have been a long time coming,” said panel moderator Rich Murphy, managing director at Calkain Cos. “It is really a game changer in terms of how leases would be accounted for.”
(In an earlier panel that morning, Paul McDowell of CapLease was a bit more blunt. He called the changes “stupid.”)
When the changes were initially announced by FASB in August, the standards board proposed to eliminate the difference between operating and capital leases in the real estate market. Based on tax benefits to the lessor, Murphy said companies generally favor operating leases, while capital leases require more monitoring and compliance checks.
Recently, FASB announced that operating and capital leases would continue to remain separate, at least for now, Murphy said. “It is unclear how to take that, because it seems like a complete reversal of the basic principal that they set forth in the exposure draft,” he said. Nonetheless, “it appears they will be allowing operating leases to exist, but to the extent to which they will exist is unclear.”
David Kessler, co-office managing principal with the Reznick Group’s Bethesda, MD office, said the balance sheet changes could bring additional liabilities for lessees, negative impacts for debt/equity ratios and differed tax impacts. On income statements, interest expenses will be front-loaded on a lessee’s balance sheet, which “gives rise to the negative net income effect as interest is amortized.”
As an example, Kessler said if a tenant has a $20-million, 10-year lease on 100,000 square feet of space with annual payments of $2 million at an assumed incremental bargaining rate at 8%, the new rules could cause asset liabilities at $13 million, approximately five years of net losses. “At the end of the day, my asset is being depreciated over the straight line,” he said, giving rise to the negative impact.
However, Kessler noted that lessees’ EBITDA would be positively impacted by the removal of rent expenses above the line and the replacement of interest expenses and amortization expenses below the line. “If I’m the executive of a large company that leases a lot of space and my compensation is tied to EBITDA, cash flow doesn’t change,” he said.
From a planning standpoint, Kessler advised that all companies review their balance sheets, debt covenants, leases and income statement impact now. Many believe bankers will adjust covenants due to cash neutral impact; however, he explained that there “could be opportunities for renegotiation which could either have positive or negative implications.”
With a high focus on the retail market, Josh Leonard, partner of lease advisory services at Deloitte Financial Advisory, conducted a lessee-based survey sent to 20,000 companies in December 2010 with 284 participants regarding the FASB changes. The results, he said, reflected the issues many corporations could face if the changes are fully implemented by FASB. Roughly two-thirds of participants anticipated impacts on debt to equity and half on return on assets. For the future, 42% of the participants expected shorter-term leases. Conversely, approximately 28% of survey respondents said they would rather buy than lease.
To address a GAAP difference of investment property measures at fair value, Serena Wolfe, senior manager at Ernst & Young, said FASB added a project last year requiring that entities that meet certain criteria relating to their business activities, business purpose or unit ownership. “The key here is if you do meet the requirement to record your investment property at fair value, it’s a ‘get out of jail free card’ because you don’t have to do a leasing project, but on the other hand, you do have to record all your real estate at fair value,” she said, which could impact earnings.
Overall, the panelists agreed that the FASB impact depends on the company. In the retail market, Leonard said margins are “sensitive” and he predicts more retailers will opt for short-term leases. “The only caveat to that is that retail is so sensitive to location and their sales are based upon where they are,” he said, as opposed to office space. Wolfe said since the standards for operating and capital leases are changing constantly, said the economics “will ultimately drive” transactions and how companies react.
Source: Globe Street