Will FASB Accounting Rule Changes Create Demand to Own or Build?
The FASB accounting changes that will be required in 2019 for public companies and 2020 for private companies are going to have some cause and effect changes in the world of corporate real estate. The primary change that is coming soon will require companies to record their future lease rental obligations on their balance sheets, including renewal option years. That is a significant change as compared to today where companies only need to record their annual lease expense on their profit and loss statement and any future year lease liability is not reflected on the company financial statements under GAAP standards.
So, why do these accounting changes make it more conducive to own your building versus leasing space? Here are the top reasons why that might be the case:
- No More “Off Balance Sheet”. Companies have not wanted to own real estate because it would be a drag on their balance sheet. With the new accounting rules, real estate lease obligations must be recorded on the balance sheet, so the balance sheet is going to be growing anyway.
- “Lease Renewal Options Also on Balance Sheet”. Companies with large spaces or specialized improvements / infrastructure within their spaces typically sign longer term leases and also get multiple options to extend those leases so that they can control their destiny. Based on all the FASB rules, in most instances, companies will need to record these option years on their balance sheets. Under the new accounting rules, if the tenant is likely to extend the lease using these options based on a variety of factors, including the cost of relocating, remaining life of existing improvements, and the cost to recreate new improvements at a new facility, all of these future option years need to be shown on the balance sheet. For example, a 10-year lease with two 5 year options to extend the lease will in all likelihood have 20 years of lease related assets and liabilities recorded on the balance sheet.
- Front Loaded Leases. The asset and liability created for each lease will not be recorded evenly. The liability for the lease will be front–loaded, so initially companies will have a larger liability being entered on to their balance sheet with a lower asset value. For companies with multiple leases, the effects will be additive and create a larger disparity between the liabilities and assets. The greatest disparities pertain to the longest lease terms. Over time, the asset and liability values will become even and then toward the end of the lease, the asset will actually be more than the liability. However, for many space users, leases are extended up to 3 years in advance of the lease expiration date, so these future years with higher asset values will likely never come to fruition as the new lease or lease extension will be recorded as soon as it is completed.
- IFRS (International Financial Reporting Standards). For international companies using IFRS for their worldwide accounting, all operating leases will be converted and recorded as finance leases on the balance sheet. So, in addition to the balance sheet growing, the lease expense recorded on the profit and loss statement will also increase due to the inclusion of interest and amortization expenses. The result of this will be a lower net income for international companies. This will especially be true when the new FASB rules go into effect in year one. For international companies, the lease liability is considered as debt based on current regulations, so ownership would seem to make more sense than leasing.
In addition to the above, let’s also consider the current interest rate environment. The cost of capital is extremely low as compared to historical borrowing rates. Low interest rates coupled with generally healthy leasing markets and high rental rates were already causing many companies to consider ownership. Construction costs are also continuing to rise, thus increasing replacement costs for real estate. The new FASB accounting simply put more check marks into the “buy / own” column of the decision tree as compared to the “lease” column. While interest rates have been low for many years, it is expected that they will increase some in the coming years.
The new FASB accounting standards go into effect in 2 years for public companies and in 3 years for private companies, so there is a window of time to transition from leasing space into ownership for corporate space users that want to consider owning instead of leasing. Acquiring a commercial building is a process that takes time to evaluate and implement, so companies that want to consider ownership should start that process now to determine if it makes sense for them financially and operationally to do so.
For more information about this topic please contact Beth Wade, ITRA Global Executive Director, at 706.654.3201 or email email@example.com.
ITRA Global is an organization of real estate professionals specializing in representing commercial tenants and buyers in the leasing, acquisition and disposition of office, industrial and retail facilities. With coverage in major markets around the world, ITRA Global is one of the largest organizations dedicated to representing tenants and occupiers of commercial real estate. Clients benefit by having an experienced professional as their trusted advisor, providing conflict-free representation with total objectivity. To learn more about conflict-free representation and ITRA Global locations, please visit the ITRA Global web site.
Article submitted by Wayne Teig / ITRA Global Minneapolis-St. Paul, Minnesota USA.