Part 1 of this series discussed the upcoming implementation of the new Tenant Lease Accounting rules (also known as ASC 842) and how companies could prepare for the January 1, 2019 or January 1, 2020 effective dates – depending on whether you are a public or private company.
In Part 2, we will explore some high-level real estate strategies companies can implement because of these rule changes:
Purchase strategic long-term assets that are currently leased. Over time, rent paid for a single-tenant building can exceed the value of the property at lease inception and, despite the lease cash flow creating property value, the tenant will likely not participate in property value appreciation. However, what may now appear to be a bad financial decision could have been justified at the time because the lease was structured as off-balance-sheet. Since these assets (and lease liability) are now going to end up on the balance sheet either way, companies should examine buying real estate that is considered to be long-term core to the business. In addition to potential rent cost savings and future value appreciation, trading rent expense for depreciation will improve EBITDA.
Consider sale-lease backs for undervalued or non-strategic properties – or as a recapitalization strategy. Since the line between owned and leased properties is blurring from an accounting standpoint, companies should consider:
Owned real estate is sitting on the balance sheet at depreciated book value, often artificially understating the value of the company. Selling the property at current market value – even with resulting leaseback payments – allows the company to recognize hidden real estate asset value;
Assuming it meets requirements, GAAP now allows immediate recognition of the book gain of the sale – not amortized over the leaseback period as per prior rules;
Cash generated from the sale can be set aside to cover future lease payments, used to pay down debt, or reinvested into the company for operating needs;
Sale-leasebacks can be structured to facilitate the exit from non-strategic or declining markets and locations. A sale can take advantage of current market conditions, locking in current values, and the leaseback term aligned to allow a “walk away” exit. The alternative could be trying to sell a vacant building in a down market.
Separate operations from the real estate. Under ASC 842, a lease conveys the right to control the use of identified property. So, for example, manufacturing companies with the goal of minimizing lease liabilities could consider the alternative of engaging third-party logistics (3PL) companies to handle/store materials instead of leasing warehouse space or selling/outsourcing component manufacturing facilities.
Consider self-financing your tenant improvements
This can reduce the lease liability required to be capitalized;
Your company’s cost of capital could potentially be lower than the landlord’s imputed rate; you and your broker can ensure that you ask the landlord to quote rental rates with and without a TI allowance
Similar to point #1, rent expense can be replaced by amortization, improving EBITDA.
If your company is EBITDA-focused, structure your leases to FAIL the Operating Lease Test. Admittedly, this sounds strange after decades of landlords and tenants laboring to make sure leases did not trip the lease classification test based on lease terms and rental rates. So, while both type of leases will end up on-balance-sheet, Finance leases (formally known as Capital leases) offer front-loaded expense (in the form of interest and depreciation) both of which will be added back into EBITDA; Operating leases are recorded as straight-lined Rent Expense. The disadvantage of this strategy is that Finance lease liabilities are classified under Debt.
Tom Elmer is CFO of Colliers International | Minneapolis-St. Paul and has over 40 years of experience managing and optimizing commercial real estate portfolios, from both landlord and tenant perspectives.
+1 952 225 4204
Coming next in Part 3 -- Negotiating tenant lease terms to minimize amounts capitalized under the new standards