What is the fundamental issue?
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) proposed lease accounting changes that would reduce the overall borrowing capacity of many commercial real estate lessees and lessors. The proposal would bring nearly $1.3 trillion in leased assets back onto companies’ balance sheets, with roughly 70% being real estate leases. Under the proposal, companies would be required to use a “right-of-use” accounting model where both lessees (renters) and lessors (property owners) recognize assets and liabilities arising from lease contracts. Currently, accounting rules allow many businesses to classify leases as operating expenses, which do not appear on their balance sheets. Both FASB and IASB believe these changes would improve transparency as well as provide investors with more consistent and concise financial reporting. However, if enacted, this proposal could negatively impact the financial stability of many businesses, which could prolong our nation’s economic recovery.
I am a real estate professional. What does this mean for my business?
If ratified, this proposal would hurt businesses of all sizes, especially lessees and lessors of commercial real estate. With more bloated balance sheets, some companies may see their debt-to-equity ratios increase and find it more difficult to obtain credit, especially those with heavy debt loads or still recovering from the recession. The proposed accounting changes could also complicate compliance with debt covenants or agreements between the bank and borrower, which usually prohibit companies from borrowing more than they are worth. By capitalizing new and/or existing leases, some businesses could show more debt than allowed in their agreement with the lender, and therefore be in default of their loan. This could force some firms to put up more capital for existing loans or even have their credit lines revoked.
Additionally, the elimination of off-balance-sheet financing would be detrimental to commercial property owners. More frugal lessees will want less space and shorter-term leases without renewal options or contingent rents, which will decrease cash flow for property owners. Shorter-term rents will likely reduce the borrowing capacity of many commercial real estate lessors, who rely on leases and the value of the property as collateral in order to obtain financing. Ultimately, property owners would be forced to increase rent rates due to market uncertainty and reduce tenant improvements due to shorter recovery periods. Conversely, this change could encourage some firms to consider buying instead of leasing commercial real estate.
NAR believes the new lease accounting proposal will be detrimental to our nation’s economy. Also, NAR is opposed to lease accounting standards changes that would treat the income producing real estate business as a financing business on company balance sheets.
The new lease accounting proposal reduces the overall borrowing capacity of many commercial real estate lessees and lessors, by requiring them to recognize leases on their balance sheets as liabilities and assets, as opposed to their current treatment as operating expenses, which are not reflected on balance sheets. Including leases on balance sheets may have the effect of “bloating” them, and some companies may see their debt-to-equity ratios increase as a result, making it more difficult for them to get credit. Treating income producing real estate business as a financing business on company balance sheets will not accurately depict the unique characteristics of the investment real estate sector and in turn discounts the usefulness of the industry’s financial statements.
Opponents of NAR policy believe that real estate should not get special treatment over other asset types. Thus, they believe, all assets, including real estate should be reflected on company balance sheets.
FASB/IASB will likely finalize their proposal in early 2015. The effective date of this proposal will likely be in 2018, where virtually all new and outstanding leases would be subject to the new accounting standard. In August 2014, the FASB and IASB announced that they have not been able to come to an agreement on the lease accounting proposal, with the FASB pursuing a dual-model (allowing leases to continue to be listed as either operating expenses, off the balance sheets, or capitalizing them onto balance sheets), and the IASB continuing to pursue a single lease accounting standard. If the organizations cannot come to an agreement, the FASB approach, which is more favorable as it allows leases to continue to be classified as they always have been, will control in teh U.S. NAR continues to work with FASB/IASB and other stakeholders to ensure that any modifications to lease accounting rules will not negatively impact commercial real estate practitioners.
Current Legislation/Regulation (bill number or regulation):
No actions at this time.
Here is a comprehensive timeline of the issue and associated legislation: Timeline
Here is a video interview that NAR produced to update members on the status of the lease accounting project.