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Tuesday, July 6, 2010

Accounting Rule May Trigger Change in Commercial Real Estate

I likely think about accounting standards more than most people involved in real estate law, probably because I was in-house at a public real estate investment trust for five years.  So this recent article in the New York Times caught my eye as one example of the impact that accounting standards can have on customs and practices in the real estate industry.

If you're interested, more after the break.

Apparently FASB (Financial Accounting Standards Board) is attempting to merge the American standard of GAAP (generally accepted accounting principles) with the international standards.  A sticking point, according to The New York Times, is how companies should account for leases.

Many companies, particularly retailers with many locations, prefer to lease rather than own real estate because their rent liabilities are kept off their balance sheets under GAAP.  But the new proposed standard, which should take effect in 2013, will require companies to book leases as assets and liabilities on their balance sheets. 

"As a result of the change, public companies will have to put some $1.3 trillion in leases on their balance sheets, according to estimates by the Securities and Exchange Commission. Because many private companies also follow GAAP accounting, the number could be closer to $2 trillion, experts said."

“It is going to get ugly,” said Mindy Berman, a managing director of corporate capital markets at the real estate services company Jones Lang LaSalle. “On the day the standard gets implemented, all these companies will suddenly have to record much higher rent, and they are going to have to record this as a significant liability on their balance sheet.”

This change is anticipated to have an impact on debt covenants with lenders and possibly credit ratings.  It will probably also shake up the market in terms of average lease terms.  Some retailers, like grocery stores, convenience stores, and department stores, commonly have lease terms (including options) that may last 75 years.  Adding such long terms to the balance sheet as debt may significantly change that practice.

This can have some interesting impacts on leasing.  The pressure is on both landlords and tenants to have longer initial terms (let's say 10 years) for a few reasons.  Landlords and tenants may both want a longer term because of perceived stability, i.e. the tenant is committing to a particular location.  Tenants generally want a longer term if the landlord is investing in a tenant improvement allowance (i.e. loaning the tenant the money necessary to build out the space so that tenant can conduct business there) because such allowances are normally amortized over the initial term, so a longer initial term means the rent is lower.  (Example:  if the cost of tenant improvement is $50,000 and I amortize that over a 10 year term, it adds $416/month to the rent, but if I amortize over a 5 year term it adds $833/month to the rent, assuming no interest for ease of math.)

One example that attorneys focused on real estate transactions would be well advised to have some familiarity with accounting rules, because they can have a significant impact on their client's behavior.

Tanya Marsh

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