On February 25, 2016, the Financial Accounting Standards Board (FASB) issued its new lease accounting Standard, FASB Accounting Standard Update 2016-02 – Leases. The new standard introduces a right-of-use model that brings most leases onto a lessee’s balance sheet. This could significantly change the accounting for real estate leases, whose leases aren’t typically included on the balance sheet because they are typically classified as operating leases under current United States Generally Accepted Accounting Principles (U.S. GAAP). The new standard retains much of the current lessor accounting model, and lessors should expect very little change in accounting.
Given the significant changes the new standard has on lessee accounting, tenant behaviors could change and influence the way they do business with real estate entities.
Increased Balance Sheet Leverage – This standard will result in increased leverage on the lessee’s balance sheet; therefore, tenants may try to negotiate shorter lease terms. They also may try to negotiate more variable lease payments (such as rent based on a percentage of sales), since most of the time, these kind of payments will not be recorded on the balance sheet.
Shorter-Term Lease Agreements - An increase in shorter-term leases could also result in higher rental rates and, therefore, additional operating costs. This could have an impact on obtaining financing for the lessor as well the fair value of the lessor’s property.
Impact on Balance Sheet Ratios - Since the new standard will affect balance sheet leverage, balance sheet metrics and loan covenants could be negatively impacted. Real estate entities that are also on the lessee side of lease agreements should consider whether the impact of adopting the new standard could trigger debt covenant violations.
Potential Changes in Tenants Approval Process – This standard may complicate the tenant’s approval of new leases or lease modifications, since the tenant may need to pay more attention to the effects on their financial statements. Under current U.S. GAAP, a tenant’s decision to enter into an operating lease may not receive much opposition. Going forward, operating leases could be scrutinized as much as a purchase because of the effect on the balance sheet.
Overall, this new standard may not significantly impact the accounting of leases for real estate entities, but could have a noticeable change in tenants behavior in future lease negotiations.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.