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On February 25, 2016, the Financial Accounting Standards Board (“FASB”)^[1] issued Accounting Standards Update No. 2016-02 (the “ASU”), which will materially alter how tenants account on their financial statements for most real estate leases. Substantially all businesses that lease space, including office, retail, warehouse and industrial space, and prepare financial statements in accordance with GAAP, will be impacted.

Under current FASB, only “capital leases” (i.e., a lease which is effectively a sale or a method of financing the sale to the tenant of the real property) are required to be recognized as an asset and a liability on a tenant’s balance sheet, while other leases are simply noted in a footnote to the financial statement. This will change under the ASU pursuant to which, among other qualitative and quantitative disclosures that will now be required, tenants will be required to recognize “operating leases” as both an asset and a liability on their balance sheets. Under the ASU, an “operating lease” is generally defined as a lease providing for the use of the leased asset for a term of greater than one year and which is not effectively a sale or a method of financing the sale to the tenant of the leased asset. In accordance with the ASU, the liability under each operating lease will be calculated based upon the present value of the remaining payments over the term of the lease, and the asset valuation will be calculated based upon such present value as adjusted for a tenant’s lease prepayments, lease incentives and initial direct costs.

Background

The newly-issued ASU is meant to promote financial transparency and comparability among businesses, as well as to close a perceived loophole with respect to off-balance-sheet financing. As mentioned above, currently under GAAP only assets and liabilities with respect to capital leases are required to be recognized on a tenant’s balance sheet, while operating leases typically are disclosed in the footnotes. By only requiring certain disclosures in the footnote, the FASB concluded that in many cases the economic impact of operating leases was not being adequately considered by parties relying upon a company’s financial statements; and in some cases, the relevant liability was being overlooked completely. Accordingly, the FASB concluded that the failure to include these assets and liabilities on the balance sheet rendered the financial statements inaccurate and misleading. By requiring the recognition of an asset and liability with respect to a company’s operating leases directly on the balance sheet, the FASB believes that the users of financial statements, such as lenders and investors, will have a more complete financial picture of the company.

Potential Impact on the Commercial Real Estate Market

As is often the case with changes in accounting standards, as well as laws, the changes may have unintended consequences on the affected industries. Paradoxically, the following consequences could arise notwithstanding the fact that no economic change has occurred in the financial condition of the tenants by reason of this change in reporting requirements.

Financial coverage ratios and financial covenants: By now requiring the inclusion of operating lease liabilities (i.e. rent payments) on a tenant’s balance sheet, the tenant’s financial ratios (such as the debt/equity ratio) could be negatively impacted. In addition to potentially having an adverse effect on how the tenant is viewed by potential investors and lenders, the new rules under the ASU could increase the tenant’s liabilities (or negatively impact such ratios) to such an extent that would put the tenant in violation of financial covenants under applicable leases, financing documents or other applicable agreements.

Shorter lease terms, more net leases: Where market forces permit, tenants may negotiate shorter-term leases with more renewal options^[2] in order to reduce (or even eliminate) the amount of the liability that needs to be reflected on their balance sheets. Also, because the present value of fixed rent payments, as opposed to payment of real estate taxes and operating costs (such as insurance, maintenance and repair costs) must be recognized as a liability under the new rules, tenants may seek to have leases structured on a more “net” basis (i.e., reduce the fixed rent, in exchange for tenant’s payment of taxes and operating costs). The impact of tenants desiring shorter lease terms and structuring leases on a more “net” basis could have a considerable impact on lease underwriting for both real estate investors and lenders.

Purchase vs. leasing real property: For almost all business organizations, the decision to purchase or lease space in order to meet their space requirements involves the consideration of many factors, including costs, availability of financing, desired flexibility and risk assessment. Given the adverse impact that the ASU will have on a tenant’s balance sheet, many tenants may reconsider the option of purchasing real estate, in lieu of leasing, in order to meet their space needs. Although it is too early to predict whether the commercial real estate sale and leasing market would actually see any shift due to these new rules, it is certainly something to be mindful of as these rules get implemented.

When ASU Is Effective

The reporting requirement changes under the ASU are to be implemented at different times for public and private companies. For public companies, operating leases will be required to be incorporated on balance sheets in fiscal years and interim periods within those fiscal years beginning after December 15, 2018. For a calendar-year public company, this change would therefore go into effect on January 1, 2019. For non-public companies, the financial reporting change will take effect for fiscal years beginning after December 15, 2019 and for interim periods within fiscal years beginning after December 15, 2020. All companies are permitted to voluntarily begin reporting in compliance with the ASU before these dates.

Actions to Consider

While there is time before businesses must implement ASU, companies that lease commercial space and are subject to GAAP should take a proactive approach and examine whether their existing operating leases might violate any financial covenants and consider taking steps to address them. In addition to tenants, real estate investors, lenders and landlords should certainly note these changes in financial reporting standards in connection with their financial due diligence and underwriting activities in the future.

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^[1] The FASB is a not-for-profit organization that establishes financial accounting and reporting standards for non-governmental organizations in the private sector, which follow Generally Accepted Accounting Principles (GAAP). FASB had initially worked together with the International Accounting Standards Boards (IASB) (for companies that follow International Financial Reporting Standards) to jointly issue guidelines on financial reporting for leases. The IASB issued IFRS 16 in January 2016, which aligns with ASU 2016-02 in many respects (i.e. requiring leases to appear on balance sheets), but differs in certain material areas.

^[2] Under FASB accounting standards, certain renewal option periods may need to be included in the calculation of the term of the lease.

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For more information on the topic discussed, contact:

• Eric S. Schoenfeld  |  schoenfeld@thsh.com  |  212-508-6713
• Ari Davis  |  adavis@thsh.com  |  212-508-6796