Could FASB Be a Major Game Changer in 2019?

Professionals who used to make leasing decisions, may soon be subject to the decisions of the chief financial officer.  New accounting standards from the Financial Accounting Standards Board (FASB) regarding changes to lease-accounting methodologies will begin at the end of this year for public companies and a year later for all other organizations.  These changes may make FASB the projected major disruption agent of typical methods to assess commercial real estate. 

The new lease standards came from a decade of study by FASB and its sister organization, the International Accounting Standards Board.  Both entities were requested by the Securities and Exchange Commission (SEC) in 2006 to look at this issue.  Currently, operating leases are noted as footnotes in the financial statements.  The SEC believed that operating leases should be recognized as a liability on the balance sheet of the tenant.  If a company signs up for a ten-year lease, they have a ten-year obligation for the right to use the subject space which requires ten-years of payments.

A white paper by the Industrial Asset Management Council states, “The intent of the new standards…was to improve financial reporting about lease transactions and, in doing do, gain that transparency for investors and other stakeholders…A major portion of this process will be the review and categorization of all leases, as well as their terms and options to ensure that all appropriate information is collected, a coordinated effort must be mounted internally, including accounting, finance, purchasing, operations, and of course, real estate.” 

K.C. Conway, director of research and corporate engagement at the University of Alabama’s Center for Real Estate, notes in the past, the decision for a company’s real estate department was relatively simple.  All that had to be completed was to align a targeted return on capital with the economics and project cost.  Now this process will move to a new committee level inside these companies.  The focus will change to what is the result on the balance sheet.  This will cause a clash “between the CFO’s objective view of the numbers and a very subjective nature of lease negotiations.” 

These upgrades are not simple.  Deloitte outlined 12 essential points governing the new standards.  These all can be reduced to one question.  What is considered balance sheet and what is not?  The new lease accounting standards will impact how a lease is recorded.  More CFOs will want to book shorter term leases with options than to put a 25-year lease on the books.  This will play havoc to lenders who would prefer to finance the building with a long term corporate lease backing the cash flow. 

Since the entire term of the lease obligation must be booked as a contingent liability, the balance sheets of companies who lease will be greatly impacted.  Current and long-term liability numbers will explode, in some cases up to ten times what was previously reported on the balance sheet.  This change could cause the lender to pull his hair out as he looks at a company who months before was financially well, that now looks insolvent due to the FASB changes. 

The lease accounting change could make owning your buildings more attractive than renting space.  This will impact companies looking to build and occupy single-tenant assets that are essential to their operation.  If the asset of a new headquarters building will be on the balance sheet for a long time, they may as well own it.  But for a retailer who has a spot in a strip center, this will probably not impact the decision to lease or not.  Most multitenant landlords are not going to reshuffle the structure of the strip center into individual condos as occupancies change.

There may be a decrease in the build-to-suit-then-leaseback activity.  Companies like Dollar General, Walgreens, and Panera Bread have used this model to obtain off balance sheet, long-term lease financing with the leaseback model.  As the new rules are implemented, they may elect to own the property.  Their cost of capital as a direct owner may be less than if they must deal with lenders.  Financing the individual owner with the long-term credit tenant lease has been a plum of a loan to have.  These will become rarer in the future. 

It is unclear the impact the new FASB changes will have on the commercial real estate market.  Could this be a major disruption like what the financial crisis did for home building?  Or could this represent a slight shift in larger companies keeping more real estate on the books and the overall impact not being felt?  On the lending side, there could be some major surprises in the financials this year and next as these new standards are implemented and more companies are reporting with the new rules.