Lease Standard Update - Possible Unintended Consequences

 

The new FASB/ IASB standard is weeks away from release with implementation scheduled for late 2018. A recent IBM study estimated that this accounting change would add potentially $1.35 trillion to company balance sheets in the form of assets (right of use) and liabilities. Clearly this enormous increment to a company’s capital structure will have both expected and unexpected consequences. Here are a few of possible unintended consequences:

Leasing Demand: There will be some measure of reduction in leasing demand, which will have the effect of creating property surpluses in the near term. Property owners will be compelled to lower market rental rates to stimulate demand. It’s possible that this disruption to property markets could in some cases lead to failures and even bankruptcies. Loan covenants on commercial property could be stressed by the fall off in the rental market. It’s possible that we’ll witness real estate company mergers and consolidations to pick up the slack in the rental markets.

Shorter term leases: Lessees will opt for shorter term leases as a means to mitigate the balance sheet effect of their lease commitments. Lessors will compete on asking rental rates and other terms that will reduce the net present value of the lessees’ rental stream.

·      There will be a myriad of techniques to move some portion of rental to alternative non-balance sheet accounts, as a way to respond to tenant demand for lower rental commitments. For example, tenants may opt to pay for services that historically have been part of the base rent such as insurance, property tax, etc.

·      Another unintended consequence may be the emergence of various forms of barter. A law firm, for example, may barter its legal services for lower rental in its offices. A retailer may offer special discounts on its merchandise such as building supplies in exchange for lower rent. Architects may enter into a barter deal with its landlord to exchange design services for lower rent.

·      Because of the differences between the IASB and FASB standard relative to Type A versus Type B leases, US companies will place a higher premium on property ownership, particularly in the United Kingdom and Continental Europe. Since all leases internationally will be classified as capital leases (Type A) some companies will opt to own commercial properties (as investments) as opposed to forgo asset appreciation in a capital lease structure. This possibility may shift demand for commercial properties more toward corporate owners and away from institutional investors.

Brokerage Fees: Because of the demand for shorter term leases, it’s possible, maybe inevitable, that commercial brokerage fees will, in the aggregate be lower, over time. To what extent this possibility will impact real estate company profitability is an open question. Certainly the brokerage community will see a reduction in their fee income, and may well lead to an eventual reduction in brokers.

Stock market effects: This accounting change will restructure company balance sheets, and have a net effect of reducing stock holder equity and thus share price. This will be particularly true of corporate entities which have leased large portfolios of properties such as retailers, tech companies with large portfolios of leased equipment, and airlines who typically lease their fleets. How this impact on corporate equity will translate into devaluation of stock value is uncertain, but a possibility.

 The coming change in lease accounting standards will create significant uncertainty in property markets as the standard is implemented. And uncertainty creates both opportunities and risks. In essence the accounting standards boards will have turned building tenants into property owners. How this change will impact property markets relative to demand, supply, pricing, and lending is fraught with uncertainty. One thing is for sure: there will be increased demand for experienced corporate real estate professionals who can help their companies transition to the new world of balance sheet transparency.