October 6, 2010
Proposed Changes To Accounting Rule Rankle Real Estate Community

Proposed changes to an accounting rule, requiring companies to place the expense of operating leases on their balance sheets, is raising alarm within the commercial real estate community. Opponents say the restructuring of Financial Accounting Standards 13, or FAS 13 as the rule is called, might upset debt ratios, making it harder for companies to secure loans. Supporters of the changes, however, say they will make financial statements more transparent.

At the end of the summer, the Financial Accounting Standards Board, the panel that sets guidelines for tracking the financial performance of U.S. companies, released its updates to FAS 13, requesting comments on the draft before the close of the year. The board has been working with the International Accounting Standards Board, another architect of the rule, to make accounting practices uniform in the wake of the global financial tumult. The pair plan to finalize the leasing standard no later than the second quarter of 2011.

"Investors are [presently] left to rely on estimates based on arbitrary rules of thumb, and information in footnotes, to assess the economic effects of these leases," said Marc Siegel, a member of the FASB. "Requiring assets and liabilities to appear on the lessee's balance sheet would eliminate the need for such guesswork."

More than $1 trillion in operating leases would be reclassified under the proposed changes, according to estimates from the Securities and Exchange Commission. Shifting that sum onto the books could weigh down balance sheets with liabilities that give pause to already leery loan underwriters. That kind of constriction of credit may stymie expansion plans, protracting the slump in the commercial property market.

Steve Harding, chief financial officer of Transwestern, said many companies will be "forced to renegotiate loan covenants with their banks" in light of impacts to their debt coverage ratios. That may prove challenging, he added, given the tighter credit environment.

Lenders, however, already take lease obligations into consideration in their underwriting decisions, according to Louis P. Mathews Jr., deputy credit officer in M&T Bank's commercial real estate group. "Bankers are by nature pretty analytical types," he said. "It's my expectation that bankers will make the appropriate adjustments so that borrowers are not impacted by a simple accounting change that doesn't change the cash flow. It's cash flow that creates capacity to repay loans and support debt."

Detractors of the changes also bemoan the complexities of the new lease accounting process itself. Companies must measure assets and liabilities for each lease based on expected payment over the course of the lease term. But that term is not determined by the actual length of the contract, but rather by the longest possible duration. For instance, if a tenant signs a five-year lease, with an option to extend for two additional five-year terms, then it must assume a 15-year liability. What's more, the accounting boards want to include an estimate of contingent rent -- a fee retailers pay on a percentage of sales -- based on the same long-term assumption.

"We are measuring things that may not occur," Harding said. "A lot of people get what [the accounting boards] are trying to do, it's just the subjectivity and the variability that they are introducing, relative to lease term and contingent rent, that are causing angst."

Another anxiety is the proposed replacement of the current assignment of rent expenses with interest and amortization expenses. Similar to a residential mortgage, where interest is front-loaded, the interest expense will be more in the early years of the lease. If a tenant has signed a 10-year lease, for instance, the expenses will be higher for the first five years. During that time, tenants will "report lower net operating income and, obviously, that has an impact on stock value, how analysts and bankers look at your company," Harding said.

Many in the real estate community have questioned the logic of altering FAS 13 at a time when the industry is still trying to regain its footing. Vacancies remain fairly high in most markets nationwide, while rents are generally flat.

To lower lease liability, tenants could sign shorter contracts, creating problems for landlords that need long-term leases to hold up the value of their property. Signing shorter leases, however, exposes tenants to losing their space, having to pay higher rent upon renewal or receiving fewer tenant improvement concessions.

Tenants may also opt to purchase their building rather than lease. Defense contractor Northrop Grumman, for instance, told the Wall Street Journal in July that the pending accounting changes influenced its decision to buy a building in Falls Church for its headquarters.

Source: The Washington Post, October 4, 2010

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