Rethinking leasing in a new age of accounting rules

The countdown is on as corporations prepare for investors to step up their scrutiny of real estate decisions in January 2019.

October 17, 2017

Corporate real estate executives are collaborating more than ever with their finance and accounting colleagues as new U.S. lease accounting standards loom on the horizon.

It may sound like a minor accounting change to some, but the impact of this massive transfer of leasing obligations will be significant for many companies. Currently more than 85 percent of lease commitments held by listed companies do not appear on balance sheets. These companies will find the shift directly affects many of their loan covenants and key financial ratios, like return on assets and debt-to-equity. They’ll also find that the potential implications ripple across the organization.

“These new reporting processes are more than just an issue for corporate accountants,” says Steve Miller, Managing Director and Global Lease Accounting Lead at JLL. “Lenders, investors and analysts are likely to scrutinize the increased debt load resulting from leasing liabilities, putting new pressures on leasing strategies—and in turn, corporate real estate executives.”

New standards, new questions for leasing strategy

From restructuring terms to avoiding leases altogether, there are a number of ways corporate real estate executives can help their organizations to minimize the impact of the new standards.

“Financial reporting alone should never dictate leasing strategy, but it’s a factor that needs to be part of the conversation,” cautions Miller. “Real estate portfolio decisions should be grounded with broader financial and operational objectives. It’s now more critical than ever for executives to understand the long-term impact of leasing decisions on the company.”

As corporations comb through their current lease agreements to report the terms and renewal options, many are asking whether a change in leasing strategy is warranted. Here are two potential strategy adjustments to minimize the financial impact of moving leases to the balance sheet.

  • Reconfigure leasing strategies

There’s no one right way to structure a lease, especially now. A shorter lease term might suddenly seem like a no-brainer, for example, because it means less expense for the balance sheet. “But any short-term financial benefit should be weighed against other related effects, such as higher fees or fewer landlord incentives,” says Miller. In every case, it’s vital to examine lease language very carefully. Renewal option clauses are a particular area of focus. For example, a two-year lease might have a two-year renewal option—which will translate as a four-year lease liability under the new rules. Is keeping the option open worth the heavier up-front reporting?

Operating fee language is also important as these fees will be excluded from balance sheet calculations. “We expect triple net leasing to gain favor,” says Miller. “Since the tenant pays a fixed fee in addition to property taxes, maintenance and insurance, this eliminates the administrative burden of separating out the operating fees.”

  • Reconsider the ‘lease versus own’ decision

Some of the capital efficiencies that have typically made leasing advantageous for many companies will soon be eliminated. “Under the new accounting rules, the full commitment will hit the balance sheet whether you’re leasing or owning a property,” says Miller. “So it makes sense that large organizations are revisiting the ‘lease versus own’ decision.”There are many factors to consider, from capital allocation strategy to portfolio flexibility and operational requirements. Miller advises careful examination of issues like whether the lease liability will be greater than the value of the underlying property, how the lease would be structured, and how important it is to have control over the asset.

Cross-functional collaboration is key

While some organizations are ahead of the game when it comes to preparing for the accounting changes to come, many are still dragging their feet. A recent survey found that more than two-thirds of respondents were still assessing the rule’s impact on their business as of May 2017—if they had even begun the process at all.

“Preparing for the new standards can be daunting,” says Miller. “But organizations can mitigate the potential disruption by taking time now to assess their options, with a strong, cross-functional team of stakeholders across finance, real estate, operations and IT.”

Recognizing the need for strategic, organization-wide coordination is a critical first step. From there, it’s time to ask some tough questions, develop new processes and learn to look at a much bigger picture when it comes to leasing decisions.