Elaine Wilke, Portfolio Analyst for IPD Occupiers in Germany, explains why the new lease accounting rules look set to have a big impact on property users. 

Substantial changes to the accounting for leases were released in a joint proposal by the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) on 17 August 2010.

The board has received an unprecedented number of challenges to the proposal, which will especially impact companies with significant real estate portfolios.

Until recently, accounting regulations recognised a distinction between operating and capital leases. Operating leases, by which tenants only had the right to occupy a property, allowed for rents and other occupancy costs such as maintenance, taxes and insurance to be treated as expenses and reported off balance sheet, while capital or finance leases were treated similarly to a property purchase, with assets reported on balance sheet and depreciated over time.

The ongoing overhaul of lease accounting rules, to bring conformity to international standards under the umbrella of IAS 17, (see figure 1 for schedule) is likely to mean that the distinction between operating and capital leases will be eliminated. All leases will go on balance sheet and rent will no longer be treated as an operating expense, while the lessee’s rights and obligations will have to be capitalised at present value, discounted at an appropriate interest rate.

Figure 1 - Implementation schedule for lease accounting changes  

Source: PricewaterhouseCoopers “The overhaul of IFRS lease accounting: Catalyst for change in corporate real estate”,  July 2010

Impacts for Occupiers

The consequences of these lease accounting changes will be to swell company balance sheets and increase debt loads. Occupancy expenses will be front-loaded over the first half of the lease, and reported capital spending will be greater, leading to a larger reported cash flow (EBITDA). Overall financial reporting will become more complex with additional requirements for continuing re-evaluation of the underlying assumptions. This means that rents contingent on lease renewal will need to be continually re-assessed, with estimates adjusted as circumstances change. Banks and other regulated entities whose performance measures such as capital ratios are closely monitored will be particularly impacted by the new regulation.

The proposal will also have a major impact on covenants and financing agreements, forcing the management to start discussions with banks, rating agencies, financial analysts and other users of the financial data. This will further the position of corporate real estate departments in their strategic role within the organisation.

What should occupiers do now?

The new model will require significant systems and process changes, and considerable maintenance on an ongoing basis. Companies will face different challenges as the effects of the proposed model will vary significantly, depending on the national jurisdiction as to the specific depreciation rules, limits on the tax deductibility of interest and treatment of existing transfer pricing agreements that will come into effect.

The new accounting rules will increase the need for occupiers to hold good quality information on their properties. All existing leases, lease terms, renewal options and payments will need to be catalogued in order to calculate inputs to the balance sheet. Gathering and analysing this information could take considerable time and effort, depending on the availability of data, number of leases and international spread of the portfolio.

IPD has recently worked with multinational occupiers who needed to develop complete lease databases to support newly formed global real estate management teams. The process of gathering lease details for all properties, not only allowed them to identify their total liabilities and opportunities for breaking leases, in order to dispose of poor performing or surplus assets, but also helped to identify hidden risks such as missing leases. Amongst the outcomes were complete datasets of leases and a monthly reporting process; these will also make it much easier to identify the effects of the coming lease accounting changes.

Market impact

Traditionally, companies preferred to lease their real estate when their long-term property needs were unclear, operational flexibility was highly desirable, or expected access to acceptable alternatives was good. But with the new lease accounting changes, companies may now prefer to own their occupational property, especially for sole occupancy office buildings. As a consequence, property values and market rents may be affected as investors and occupiers are competing in the property market to buy the same premises, whilst landlords may be more willing to modify leases, perhaps by lowering rents in exchange for longer leases.

For more information please contact Elaine Wilke.