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The Impact on Real Estate

All industries will be impacted by the issued changes in lease accounting but the extent of the impact will to a great degree depend upon individual company circumstances. Many companies rely on leasing real estate holdings as a core part of their business strategy and these companies (which we will call Real Estate Lessees) will be particularly impacted by the proposed change.

Real Estate Lessees use leasing as a relatively straight forward means of financing their needs for office, retail and industrial space. Much of this activity has been done through medium term leases, currently classified as operating leases, which allow the lessee to avoid recognizing the lease obligation as a liability on its financial statements and making expensive investments in fixed assets. The tentative conclusions reached by the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) would require that all leases, except certain narrowly defined short term leases, be recognized on the Real Estate Lessees balance sheet as a Lease Liability with an offsetting Right to Use asset. The definition of a lease would become more complicated and many provisions in the lease would have to be identified and evaluated to determine whether there are accounting implications that must be addressed. With respect to expense recognition, the FASB and the IASB have tentatively reached different conclusions in this area. The FASB would classify leases into two types (A and B) with most equipment leases falling into Type A and most real estate leases falling into Type B. However, for many leases, judgment will have to be applied to ensure that the lease classification is appropriate. For Type A leases, expense recognition would be accelerated while for Type B leases, expense would be recognized basically on a straight line basis. The IASB would apply accelerated expense recognition to all leases. As one can see, lease accounting will become extremely more complicated for Real Estate Lessees. And remember, to the extent that Real Estate Lessees also lease equipment, those equipment leases also will fall under the scope of the proposed new lease accounting standard.

The net effect of the new lease accounting standard will be a major increase in liabilities that must be recorded on the balance sheet of the lessees and a negative impact on debt to equity ratios. For many Real Estate Lessees that use debt financing vehicles which contain restrictive financial covenants, any increase in liabilities could present a particular challenge and may well require a waiver discussion with the lender.

Certainly, lease versus purchase analyses will become more important and could result in a decrease in leasing activity. But it is difficult to envision any significant decrease in leasing for a number of reasons. Many companies are cash strapped and leasing presents a particularly advantageous form of financing for those organizations that want to minimize upfront cash outlays. Additionally, leasing of real estate allows companies the flexibility to relocate to another location after the term of the lease, possibly to a more advantageous location. Owning real estate may well inhibit this flexibility. To be sure leasing strategy may change, particularly for real estate leases. Shorter term leases will result in smaller liabilities that must be recorded. But there is a business trade off. Shorter term leases mean more frequent lease renegotiation risk with the possibility of prime real estate locations becoming more expensive. What can Real Estate Lessees do now to prepare for these changes?

Presented below is a partial list of actions steps that should be considered immediately.

• The issues considered are more numerous and complex than under the current accounting standards and require a complete understanding of all of the terms of the lease. In addition, the reassessment requirements are much more are rigorous. Remember that existing leases at the time of adoption will not be grandfathered. It is critical that the terms of each lease be documented clearly and consistently in a manner that allows for ready review. Real Estate Lessees should strongly consider the need for a technology solution that captures all of the key provisions of the lease and stores them in an easily accessible format.

• How will lease strategy change as a result of the new accounting standards, if at all? Leases consummated now may well have to be transitioned to the new accounting standard. No one wants the accounting implications to drive the economics of the organization but they will undoubtedly be a consideration. We mentioned these issues previously. Will lease versus buy decisions change? Will lease terms change? Longer lease terms will result in larger liability balances; however, shortening lease terms may not be in the best operational interests of the organization.

• Financial statement analytics will change dramatically. Real Estate Lessees should consider the implications on among other things, debt covenant compliance, employee compensation plans, contractual agreements and other key legal documents. Determining the impact of the proposed changes on these critical financial metrics at an early date will allow for timely planning and discussions with interested parties.

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