Part 1 of this series discussed the upcoming implementation of the new Tenant Lease Accounting rules (also know as ASC 842) and how companies could prepare for the January 1, 2019 or January 1, 2020 effective dates – depending on whether a company is publicly-traded or privately held.
Part 2 explored some high-level real estate strategies companies can implement to effectively deal with the rule changes, to minimize financial statement impact and possibly even take advantage of financial opportunities that may align with the rules.
In this third and final installment, we list some behaviors tenants may exhibit and lease terms tenants may seek in the future as they deal with the new rules and the impact they have on financial statements.
Shorter fixed lease terms with market renewal options. Tenants will be required to recognize a liability for the present value of the total base rent – which excludes free rent and includes fixed rent increases – over the fixed lease term. The lease term needs to include periods under tenant renewal options if exercise is likely, due to favorable economic terms or if the cost of relocating the premises at the end of the fixed term will be cost or operationally prohibitive. Those seeking to minimize the lease liability required to be recorded will work toward shorter fixed lease terms, while balancing the trade-off of lower liability with the likely corresponding reduction in landlord concessions.
Right of first offer instead of “reasonably certain” renewal options. In situations where option terms could create fixed term issues, tenants may instead ask for the continuous right to make the first offer on the space at the expiration of the lease term. In these cases, tenants must weigh the financial statement advantages with the risk of losing control of the space. While the landlord must consider the offer, they are also free to entertain and consider competing offers for the space.
Longer flat rate terms, back-loaded rent increases, or CPI-based escalations instead of fixed increases. As noted above, stated fixed increases in base rent are to be included in the lease liability, recorded at the present value of the lease stream. Deferring rent increases later into the term – even though total rents may be the same – will reduce the present value of the lease to be recorded. Under U.S. GAAP, future estimated rent increases based on changes in the CPI or other similar financial indices are considered contingencies and not included in the initial calculation of base rent. Note: this treatment is one difference between the final rules under GAAP and international reporting under IFRS. While CPI-based escalation is not a new concept, both tenants and landlords need to evaluate the uncertainty of these changes and understand that they may or may not reflect changes in market rents.
Make real estate taxes and insurance recoveries “net” – not part of modified gross lease CAM base years or landlord “stops”. As discussed in Part 1 of this series, common area maintenance (CAM) base year amounts or stops included in base rent can be excluded from the lease liability calculation, since they represent payment for services received by the tenant – not rent. However, the new rules concluded that the costs of real estate taxes and insurance protecting the landlord and its property that are included in base years or stops are not tenant services – they are effectively additional rent in disguise. So base year amounts relating to those expenditures cannot be excluded from the calculation. Tenants seeking to minimize recorded lease liabilities will ask for these two costs to be treated “net” in the lease – effectively a $0 base year or stop – and have the base rent reduced accordingly.
For example, consider a $30 per square foot modified gross lease that includes base years of $6.00 per square foot for CAM and $4.00 per square foot for property taxes and insurance. Under a typical lease structure, the tenant would record a lease liability of $24 per square foot per year:
Base Rent $30.00
Less: CAM base year considered to be services -$6.00
Capitalized Rent Obligation $24.00
If the tenant negotiates a lower base rent, but agrees to pay actual property taxes and insurance instead of excess over the base year, total occupancy cost for the first year will still be $30 per square foot but capitalized rent is reduced to $20 per square foot per year:
Total “Rent” obligation $30.00
Less: Tenant’s net tax & insurance responsibility -$4.00
Contractual Base Rent $26.00
Less: CAM base year considered to be services -$6.00
Capitalized Rent Obligation $20.00
Have free rent apply to base rent only – tenant pays CAM, taxes, and insurance during free rent period. Since total dollars will likely turn out the same, and since properly-structured expense recoveries will not be included in the lease liability calculation as noted above, tenants seeking to minimize capitalized lease liabilities will apply available free rent concessions offered by the landlord to base rent only, reducing the contractual base rent paid over the term.
Requests for rent to be quoted with and without landlord tenant improvement (TI) contribution to evaluate self-financing. Astute tenants recognize there is no such thing as a free lunch when it comes to TI’s. To the extent local market conditions allow, landlords will seek to recapture the cost of requested TI’s through increased rent – either buried in the overall rental rate or in some cases amortized back to the tenant as additional rent.
Historically, this has been a convenient way for tenants to obtain TI capital without tapping lines of credit, taking out loans, or using corporate cash for facilities. Since this (inflated) rent obligation was typically structured as an operating lease and not required to be recorded, TI capital financing ended up off-balance-sheet.
The new rules change this. To the extent landlord TI contributions increase base rent, the recorded lease liability increases and TI ends up on the balance sheet. In many cases, particularly at properties with private partnership or other non-institutional owners, the landlord’s cost of providing TI capital can be expensive but, once buried in the rental rate, not be apparent.
By requesting separate rent quotes, tenants will be better able to:
Calculate the landlord’s implicit cost of capital and compare it against their own, to determine if self-financing TI would be a better capital management alternative; and
Measure and control the combined balance sheet impact of TI assets, lease liability, and potential TI financing. As discussed in Part 2, these two paths have different income statement impacts. Landlord-provided TI incorporated into rent will be reflected only in Rent Expense. TI’s paid for by the tenant will become assets that will be amortized or depreciated, and any TI-related corporate debt will contain an Interest Expense component – both of which will improve EBITDA.
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
Re-read Part 1 or Part 2