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Ready or not: real estate managers need to prepare for FAS 13 amendments.

Companies leasing commercial real estate space will now have to list their leases as liabilities--outstanding debt owed to their lessors--affecting their cash flow, loan covenants and credit ratings, among other things.

Real estate management companies will be affected, too, as tenants seek ways to mitigate the repercussions from the transition, namely, pursuing lease modifications. Understanding the changing standards, while collaborating with tenants to modify existing lease terms so everyone benefits, will behoove real estate managers wanting to keep their spaces occupied.

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"OFF BALANCE," NO MORE

The Financial Accounting Standards Board ("FASB") and International Accounting Standards Board ("IASB") are working on amendments to Financial Accounting Standard 13, which sets forth financial accounting standards on accounting for leases.

Historically, companies have listed real estate leases in the footnotes of their financial statements as mere explanations of their expenses. Beginning in 2013, however, the revised FAS 13 will require that tenants recognize operating leases as assets and liabilities on their balance sheets. The "right to use" leased premises will be recorded as an asset while rent owing during the remainder of the lease will be a liability.

By 2013, $1 trillion of real estate leases will be recorded on companies' balance sheets. There will be no grandfathering, so every active lease will be recognized. Such recognition could put tenants in default of their loan covenants because they might not be meeting certain loan ratio or cash flow requirements in the covenant.

Tenants' credit ratings could also decline because of dwindling cash flow, affecting their ability to borrow money, pay rent or even meet real estate managers' credit requirements for leasing space.

In addition, FAS 13 calls for front-end loading, causing many companies to incur disproportionately higher expenses at the beginning of a lease, resulting in reduced profits. It can be a number of years before lease costs fall to the level called for under straight-line calculations.

CONCRETE ABSTRACT

The myriad issues tenants will experience as a result of the changing standard are not the tenants' issues alone. Real estate managers are right in the middle of this quagmire.

When a tenant is in default of its loan covenant, it's also often in default of a lease provision requiring it to avoid default, thereby impacting the real estate manager. If a tenant's credit score drops, it might violate the management company's required credit rating. And like it or not, when tenants are looking for ways to address these issues, they will likely see modifying leases as an as excellent solution.

Initially, tenants will work with various experts to abstract key terms from each of their leases. FAS 13 abstracts will include:

* The original term of the lease

* Minimum or base rent ("rent") imposed during each year of the original term

* Rent from each year of renewal terms that are likely to be exercised; rent owing during the original and renewal terms (likely to be exercised) must be capitalized

* Contingent rents

* Discounted lease payments using the tenant's incremental borrowing rate

* CAM or utility charges in the lease

Tenants will also have to assemble additional information from internal sources. Property managers should note this information, which represents some of the issues that will come up during FAS 13-based lease modifications, as well as during traditional lease negotiations:

* What are the tenant's intentions concerning the exercise of options?

* What is the tenant's incremental borrowing rate?

* What are the tenant's sales projections for each location [bearing on percentage rents]?

NEGOTIATING ROOM

Landlords who take the time to understand the intricacies of FAS 13 and collaborate with tenants to modify leases will more often than not come out ahead. Landlords' mantra for such lease negotiations with tenants should be: The benefit to you is greater than the cost is to me. This way, the negotiated terms will either end up being neutral or to the landlord's advantage.

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In fact, FAS 13 provides landlords with an opportunity to add value without detrimentally affecting their revenue stream. During lease negotiations, property managers should try to satisfy tenants' interests. When tenants believe their interests have been addressed, they may be more willing to make concessions that don't necessarily harm them, but still serve the property managers' interests.

For example, many tenants will need lease modifications to avoid being in default of loan covenants. Responding proactively to modification requests will pay dividends that go well beyond the balance sheet: Because of the property manager's cooperative spirit, the tenant may bring additional occupants to the property. Or, the tenant may expand its footprint at the property, taking relationship-based criteria into account during deliberations.

Property managers might also cooperate by trying to reduce the administrative burdens that the new FAS 13 standards will impose on tenants. They can do this with option-free lease terms and simpler leases, free from percentage rents. This helps tenants to avoid making difficult judgment calls, including determinations about whether options will be exercised, what sales will be generated, and therefore, what percentage rent is likely to be paid. As a result, tenants might be willing to increase their minimum rent payment or agree to a longer lease.

With FAS 13 fast approaching, more tenants may also be willing to substitute reasonable adjustments to the minimum rent for a co-tenancy provision. In fact, such an alternative may be more attractive than a higher rent coupled with a co-tenancy provision. Such an alternative is another way property managers can work with tenants to blunt the impact of FAS 13.

Property managers and landlords can compete for tenants, keeping FAS 13 firmly in mind when negotiating lease provisions. Property managers can also help by being prepared to go beyond FAS 13, accurately contrasting the costs and benefits of lease terms against those offered by competitors.

In some instances, property managers with FAS 13 knowledge can help landlords attract new tenants. In other instances, property managers will be able to facilitate extensions through FAS 13 friendly lease modifications. The possibility of extensions will increase alongside each landlord's willingness to structure terms to minimize FAS 13's impact on its tenants' financial statements.

Property managers who are sensitive to the rigors of FAS 13 will be able to work productively with tenants to further their interests.

With the goal of increasing transparency in financial reporting, accounting regulators are developing standards that will disallow operating leases from being considered "off-balance sheet" obligations--meaning billions of dollars will be transferred to businesses' balance sheets across the nation in the near future.

Randall Airst, Esq., LL.M. (randall.airst@airst.com) is an attorney and managing director with AIRST STANN, a commercial real estate and M&A advisory firm for owners, managers, investors and occupiers.

If you have questions regarding this article or if you are an IREM Member interested in writing for JPM[R], please e-mail Mariana Toscas Nowak at mnowak@irem.org.
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Title Annotation:Financial Accounting Standards
Comment:Ready or not: real estate managers need to prepare for FAS 13 amendments.(Financial Accounting Standards )
Author:Airst, Randall
Publication:Journal of Property Management
Geographic Code:1USA
Date:Nov 1, 2010
Words:1138
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