The Financial Accounting Standards Board standard on leases, ASC 842, is far more than a simple accounting change. The rule’s impact reveals widespread consequences not only for lessees, but also for landlords and real estate investors.
Adoption of the standard has already begun. The required effective date for public companies began with fiscal years beginning Dec. 15, 2018; private companies will need to be in compliance for fiscal years starting after Dec. 15, 2021. It requires lessees to recognize assets and liabilities associated with most leases.
The immediate impact is on lessees who are adjusting their balance sheets to reflect the increased assets and liabilities. That’s a large undertaking, particularly for those companies with a high volume of geographically scattered leases. The standard change could bring nearly $3 trillion worth of liabilities onto the balance sheets of American companies adopting ASC 842 and IFRS 16, according to the International Accounting Standards Board (IASB).
Here’s a look at how ASC 842 may affect the commercial real estate industry going forward:
An accelerated shift from long-term leases
ASC 842 may hasten the move away from long-term leases. While the bookkeeping requirements of long-term leases under the standard require significant data tracking, companies can avoid the issue entirely by moving to short-term leases, which can continue to be recognized over the term of the lease on a straight-line basis.
ASC 842 permits lessees to make an accounting policy election by class of underlying asset for leases with lease terms of 12 months or shorter.
For years, the commercial real estate industry has been experiencing a pullback from long-term leases as companies increasingly demand flexible space to accommodate quickly changing business needs. Retailers have scaled back their brick-and-mortar operations in favor of pop-up and other experiential models; office tenants have been experimenting with shared spaces such as WeWork or Regus. With the pandemic upon us, the pull back from leases, especially traditional long-term leases, has been more apparent. Many companies, have learned that office space is not as crucial as it was previously and are efficiently working in a remote or hybrid environment.
As company leases come up for renewal, they may choose to enter into short-term leases and annually reassess whether traditional office space or brick-and-mortar storefronts make sense for their business.
To remain competitive, landlords may need to begin accepting more tenants on a short-term basis or providing other incentives to encourage them to commit to a longer-term agreement.
Debt covenant issues
Leveraged companies that are bringing long-term leases onto their balance sheets due to ASC 842 may face another immediate challenge: failed debt covenants. The added noncurrent assets and noncurrent liabilities from the leases could create lower liquidity metrics (such as current and quick ratios), lower performance metrics (return on assets), and higher leverage metrics (debt ratio or debt-to-equity ratio), seriously compromising a borrower’s ability to satisfy their debt covenants. Even borrowers without significant debt should consider how their revised balance sheets could affect their future ability to access credit.
Both borrowers and lenders must recognize the potential impact to balance sheets and work together to mitigate the issue by restructuring existing loans or arranging for waivers to keep them in compliance. In addition, both borrowers and lenders will need to carefully analyze future debt financing agreements that understand the increased liability that many borrowers will face going forward as they bring leases onto their balance sheets.
Evolving building valuations
While a move toward short-term leases and more flexibility may serve the changing needs of tenants, it introduces greater uncertainty into the budgeting and planning process for landlords and real estate investors. The commercial real estate industry has historically preferred to use discounted cash flow models to value buildings, which could become an issue if there’s a significant increase in short-term leases.
While short-term leases command higher rents, they also come with more expenses, including leasing commissions, legal and marketing costs and, potentially, a change in the vacancy assumptions in the cash-flow analysis. If those rental premiums don’t offset the added expenses, the value of the building could fall. Asset managers and appraisers may have to consider weighting other methods, such as replacement building costs or comparable sales more heavily or prepare for lower valuations.
Overall, the new leasing standard may have significant ramifications on not only how lessees are leasing space, but also on how landlords are reacting to the standard’s effect on their leveraged properties, and on how asset managers and appraisers value real estate properties.