Although accounting rules usually don’t end up as front page news, there are some recent proposals to change the Financial Accounting Standards Board (FASB) accounting rules that should have a significant impact on the commercial real estate industry. The rules may make it more likely that companies will choose to own property rather than rent it, and may also change lease negotiations for those who do rent.
Currently, a lease can be either a capital lease, which is reflected on the tenant’s balance sheet, or an operating lease, which shows up on financial statements in the form of rent as a monthly expense. The proposed rule would treat almost all leases as capital leases. FASB argues that this rule would encourage transparency and give a more accurate picture of a company’s financial condition.
Although the new rules may improve disclosure and transparency, they have the potential to have a significant effect on the commercial real estate and equipment leasing industries. Many large companies have thousands of operating leases and one reason some of them choose to rent rather than acquire property is the way the property is treated for accounting purposes. The new rules would require a company to include virtually all of its leases on its balance sheet, as if it had purchased the property and was making loan payments rather than paying rent.
What are the expected effects of these changes?
The accounting benefits of leasing space versus buying property will be eliminated, so some companies are expected to decide to acquire property rather than lease it. This change should increase the volume of sales activity and 1031 exchanges.
• Financial covenants in loan documents will be affected by this change, so debtors will need to discuss this issue with their lenders in order to ensure that they do not breach the financial covenants in their loan documents.
• As currently written, the rules do not grandfather in any existing leases, so the administrative burden on tenants could be significant during the transition period.
• Because the lease term would affect what is put on the balance sheet, and because some option periods would be included when computing what the lease term is, lease negotiations may be affected. More tenants may want shorter term leases and may consider the accounting rules when deciding whether to ask for options to extend their leases.
These rules are not final, but if they are enacted in their current form, they will have a significant impact on some companies who lease property.
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