The Financial Accounting Standards Board (FASB) has elected to make a key change in how leases are accounted for. These changes will kick in for public companies on December 31st of 2018 and for everyone else a year later. This will have wide ranging impacts on company’s financial statements. Verizon is said to have to add $18 Billion in future lease obligations to its balance sheet. In this article we will talk about what that means for the commercial real estate industry and the likely impacts it will have on the investment property business.
What is FASB?
The Financial Accounting Standards board is a non-profit group that the United States Security and Exchange Commission (SEC) has designated to set standards for GAAP, the “Generally Accepted Accounting Principles.” When they make changes to accounting standards, American companies must implement them.
What is ASC 842?
ASC stands for “Accounting Standards Codification”. These are the rules for GAAP. ASC 842 governs how leases—both real estate and equipment—are reported on a company’s balance sheet. The key change is that before companies simply had to disclose their leases and now they need to report them as both an asset and liability on their balance sheets.
Why did FASB make this change?
Companies are currently able to achieve long-term, off balance sheet, financing through their leases. Rather than having a loan, which would show up on the balance sheet as a liability, they have leases, which simply need to be disclosed. This can distort the actual financial picture of a company. The new rules would require that leases be reported on the balance sheet and this will cause companies to rethink when they will opt to enter leases and when they will choose to buy instead. A key part of the incentive to lease is being removed with this change.
How will this impact the commercial real estate business?
This will have significant impacts in several areas. Let’s detail each area:
Many retailers, as well as office and industrial occupiers, grow through a build-to-suit model. Walgreens, Dollar General, Panera Bread, Starbucks and many others use this financing vehicle regularly. This allows them to occupy the buildings they need without weighing down their balance sheets with long term facility financing. Instead, under current GAAP rules, they simply must disclose their leases.
This new change will likely reduce build-to-suit activity. Companies will now have less incentive to lease and more incentive to own real estate as both will now appear on their financial statements. A key factor now will be the cost of capital. With a build-to-suit, the developer/ investors risk, profit and cost of capital are reflected in a much higher lease rate for the occupier. If companies own their real estate directly then their cost of capital will be much lower as a variety of lenders will compete for their business. There will be more incentive for the occupier to remove the developer/ investor profit layer.
- Sale/ Leasebacks:
Companies normally do Sale/ Leaseback transactions to free up capital that is stored in their facilities but unusable by the business. When cash sits as equity in a property, it is hard to use or reinvest. By selling a building and leasing it back, a company can free up cash. Often, they can invest it in their businesses and achieve a greater return than they can while it is held in their real estate.
Under the old GAAP rules there was also the additional reason to do a sale lease back in that long-term debt might be taken off the balance sheet. Under the new rules the lease obligation will have to be recorded as a liability. They will be replacing one obligation with another and one asset value with a leasehold interest value, which is likely to be much less than the value of the fee-simple ownership of the property.
- 1031 Exchanges and Investment Activity
This will have some impact on investment sales. It is unclear how much the impact there will be but it is likely that fewer build-to-suits will happen and fewer leased investments will be placed on the market. This will put downward pressure on CAP rates for newly built properties with long term leases—the typical Walgreens investment—because there will be fewer properties on the market for sale and more competition from investors.
Potential Strategy Change
If I were the CFO of Panera Bread and I was using the build-to-suit model to grow, I think that I would react to this change by using a fee-based developer to build my stores and then would own them directly for a number of years based on the time that I projected that I would be in a certain location. If I thought I would be there for 20 years then I would have the site developed but then hold the real estate directly for ten years and then sign a new ten-year lease and sell it as a leased investment. This allows me to get the store built more cheaply and my occupancy costs to be lower and then, after ten years, when the newness of the store has worn off, I would do a small remodel, sign a new ten-year lease with options and sell the store to free up cash.
This is a partnership between the spreadsheet and real estate location strategy. It is a fight between getting the best return on investment and having available cash that can be invested in expansion. Slow growing, more conservative companies are likely to own more stores and fast-growing companies are likely to shoulder more risk and free up as much cash for expansion as possible.