Playing off of the words of none other than hip-hop artist extraordinaire Eminem and rock legend David Bowie, as a result of the new rules enacted by FASB, all of us will soon be “Going Through Changes” that ultimately force us to “face the strange” and to a large extent the consequential pain associated with the fallout from these “Ch-ch-changes.”
Historical Perspective and Necessity
- The underlying reasoning behind these changes: Consistency, transparency, comparability and valuation.
- Simply put, whereas most of the world has required the reporting of a commercial lease to be recognized as both an asset and liability on their balance sheets, we in the United States have elected not to do so, effectively making Demi Lovato’s song “Wouldn’t Change a Thing” one of our leasing mantras. In more exact terms, almost all commercial space lease obligations have been classified as operating leases, which in simple terms are merely written off as an expense on a company’s profit and loss statement.
- Since the early to middle part of the 2000’s, the Securities and Exchange Commission, given that financial statements were not accurately portraying the health and well-being of a company’s true financial picture due to the non-inclusion of commercial space leases on a company’s balance sheet, they have been relentlessly pushing FASB to enact these lease reporting changes.
- Until the new FASB reporting changes take place for public companies subsequent to December 15, 2018 and for private companies subsequent to December 15, 2019, commercial leases will essentially continue to be reported as an “off-balance sheet” item. After those periods come into play, commercial space leases will be considered capital leases, which in laymen terms means that:
- both the asset and liability side of a tenant’s balance sheet will – relative to how they are reported during the Summer 2017 – begin to look as if Dr. Alex Rodriguez took a syringe full of human growth hormones to them;
- there will be a front loading of expenses on the accounting side for the majority of leases (notwithstanding the fact a tenant’s rental payments are consistent but for scheduled percentage increases thereto); and
- leases of 12 months or less will not require balance sheet reporting (unless the tenant is “reasonably certain” that it will exercise any renewal option it may have to extend the lease beyond the initial 12 month period).
- For sake of clarity and emphasis, given that a capital lease is essentially treated as if it was a loan effectively the lease will be treated as if it is an asset owned by the tenant requiring it to be reported on the tenant’s balance sheet. As a consequence, careful planning will need to be done as these new found “liabilities” will can potentially impact a tenant’s loan, capital and credit requirements.
Various Scenarios That May Occur as a Consequence of the FASB Lease Reporting Changes
- Tenants may be incentivized to purchase a building for their business operations;
- Tenants may be incentivized to enter into shorter term leases;
- If tenants enter into shorter term leases:
- brokerage commissions accordingly will be reduced;
- there will be greater competition among brokers to retain their customers;
- free rent, tenant improvement allowances and landlord work concessions will be reduced,;
- the decreased size of construction budgets will trickle down to the bottom lines of contractors and to a lesser extent architects; and
- landlord’s will ultimately have less in the way of long term secure and stable cash flow, and as a consequence thereof, underwriting of the underlying mortgage of their buildings will be impacted.
- Where applicable in certain markets, tenants may push to have purchase options included in their leases.
- NNN leases may gain in popularity in certain markets, given that a lower liability will be reported on a tenant’s balance sheet due to payments for operating expenses, real estate taxes and insurance not having to be reported as liabilities under the FASB changes.
- Given the liability associated with a 10 to 15 year lease, certain businesses carrying long term leases may have difficulty attracting financial investors and lenders (in the latter case, due to compliance with debt to service coverage ratios).
- As a general statement, the reporting changes will not impact how a lease will be reported for tax purposes.
Conclusion: No matter how you go about transitioning to the FASB reporting changes, as of August of 2017 my unsolicited suggestion is to acknowledge the following songs of Bob Dylan, Cyndi Lauper, REO Speedwagon, and the motivational quote of legendary UCLA basketball coach John Wooden.
- “Things Have Changed” – Bob Dylan
- “Money Changes Everything” – Cyndi Lauper
- “Roll with the Changes” – REO Speedwagon
- “If You Fail to Prepare, Prepare to Fail” – Coach John Wooden