Changing Lease Accounting Standards Could Fuel Popularity Of Shorter Lease Terms

New accounting standards could have an impact on how long office, industrial and retail tenants choose to lease properties. Under ASC 842, which will go into effect for publicly traded companies in 2019 and for private companies in 2020, businesses will be required to include lease obligations as part of their reported debts and assets.

While businesses have long been required to disclose lease obligations in the footnotes of their company’s financial statements, the new standards will require future lease payments to be recorded on balance sheets. The change could impact how investors weigh the financial stability of certain companies. Tenants, in turn, have grown wary about longer lease terms that would stand out as liabilities on their financial statements.

“On the tenant side of things, there is pushback,” Berdon LLP Audit Partner Marc Fogel said. “Let’s say they rent out an office space for 10 years, they have to record those future payments on their financial statements as a liability. Investors look at those financial statements, especially in public companies, and they don’t like to see that huge liability. So tenants are trying to lower it as much as they can.”

Restructuring lease terms has become the most immediate solution for lowering the amount of recorded liability. Rather than lease an office space for 10 years, for instance, a landlord could structure the contract as a five-year lease with the option to extend for another five years. This would potentially reduce lease liability by half, Fogel said.

Shorter leases, particularly for office tenants, have been on the rise. As alternatives to traditional office space, like coworking, continue to attract startups and larger companies, shorter terms have become more common. On the retail side, uncertain market activity and changing consumer preferences have encouraged brick-and-mortar retailers to opt for shorter leases. Whether the decision comes from economic factors or changes to accounting standards, the shift has impacted how a building’s net operating income looks in financial documents.

Another solution landlords can offer is to separate variable parts of the fixed rent, like maintenance and operating fees, from the overall lease obligation. Landlords can then determine these costs separately each year based on the current consumer price index. The CPI changes yearly and tenants won’t have to indicate that payment on the balance sheet because it is an unknown number, Fogel said.

While landlords themselves don’t have to alter their accounting methods, those who have a ground lease for their property will have to record the liability in a manner similar to a tenant. Due to the long-term nature of ground leases, upward of 100 years, recording future lease payments represents a large liability recorded for an extended period, Fogel said.

There is also the issue of whether banks and lenders will treat the recording of the asset as a liability when looking to underwrite loans. With many institutions exercising caution when issuing CRE loans and setting strict debt-service ratios for borrowers, ASC 842 could add to an already-difficult process.

“It will be interesting to see what investors are looking at,” Fogel said. “Everyone knows this is coming and many investors have debt with banks with their own debt-service ratios and [it] is unclear whether the banks will recognize this as an asset or a true liability when analyzing a company’s financial acumen.”

There are still several months before public companies need to comply with the new standard, and another year for private companies. While Fogel has initiated conversations over changing lease accounting standards with several of his landlord clients, few of their tenants have asked to restructure their lease terms, he said. But as tenants and landlords get closer to the deadline, sentiments might change.

This feature was produced in collaboration between Bisnow Branded Content and Berdon LLP. Bisnow editorial staff was not involved in the creation of this content.