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Rules for reporting: A change in accounting standards is prompting tenants and appraisers to take a hard look at leases.

A decade ago, the Financial Accounting Standards Board started looking into how companies handle leases in their financial reporting, and determined change was in order. After years of deliberation, the board came up with a new standard that takes effect in less than a year--and will dramatically alter the way businesses account for their leases.

By Jan. 1, 2019, the new FASB standard, Leases (ASC 842), will require companies to start including their leases on the balance sheet instead of as notes in the back of financial reports. Putting lease information on the balance sheet, the thinking goes, will make it easy for investors to find it, and will better clarify the impact of lease obligations on the bottom line.

With such fundamental change to the way accountants handle leases, appraisers undoubtedly will be affected. The question is, how--and how much? The answer appears to be that while the FASB standard may not trigger a boom in valuations, it may well open several industry opportunities, and appraisers will need to understand how the changes affect them and the clients they serve.

Why change the rules?

The new FASB standard has its roots in a 2005 U.S. Securities and Exchange Commission report that called for changes to lease accounting. The issue was that information about operating leases was not always easy to find. Generally, leases were discussed in a paragraph or a footnote somewhere in the financial report--that is, buried. As a result, investors could be unaware of how those leases affected a company's financials and its lease obligations, which essentially is debt contractually owed by the company.

Under the new standard, public companies will need to separately recognize right-of-use assets and corresponding lease obligations. "The goal here is more transparency for investors and greater comparability across firms," says Marius W Andreasen, MAI, senior managing director and national practice leader of the Valuation & Advisory Financial Reporting Practice at Cushman & Wakefield in Chicago.

"Now, if one company decides to buy a property and finance it, while another one decides to do a long-term operating lease, there will be a degree of balance sheet comparability between those two firms," he explains. "Before, the firm that decided to lease wouldn't have that liability reflected on the face of the balance sheet. All that is going away. Those liabilities won't be lurking in the footnotes anymore."

The FASB standard covers a range of lease types, including equipment leases, but real estate accounts for a significant proportion of the total--and that total is huge. Estimates vary, but Moody's Investors Service projected that the change will add about $1 trillion in liabilities to corporate balance sheets. And existing leases will not be grandfathered out of the rule, which means this shift will happen quickly since the standard takes effect for public companies in January.

Shorter leases on the horizon?

Just how this change will affect the real estate valuation process depends on how lessees respond--and at this point, they appear to have their hands full working through the initial stages of implementing the new standard.

"Right now, most, if not all, public companies are really focused on being in compliance with the new standards by the effective date," says Jeff Beatty, senior managing director of CBRE's Financial Consulting Group and director of the company's Global Task Force on Lease Accounting. "They're intent on finding their leases and getting them abstracted or re-abstracted to get the necessary information from them."

The new standard, he explains, requires additional information that originally may not have been abstracted from the leases. Many companies also are spending a great deal of time and effort exploring new technology platforms, or upgrading existing platforms, that will need to be deployed and populated with data.

For appraisers, there may be opportunities to help companies value their lease-related liabilities as they adjust to the new rule. "The amount that is going to come on the balance sheet is to be calculated as the present value of the remaining lease payments, and that's going to be determined using either the company's incremental borrowing rate or the rate that's implicit in those leases," says Andreasen. "So there's potential for some valuation work there."

However, Andreasen points out that this may not happen as often as one might think because of the FASB standard's language. "It is very prescriptive in the way the asset is calculated," he says. That is, it takes a formulaic approach that may not require the use of a licensed appraiser.

With that in mind, the opportunity here might be for large valuation firms to "tie in with international accounting firms," says Richard Maloy, MAI, principal at Maloy & Co., in Birmingham, Alabama. "They might work on projects like providing lease values on a REIT that owns hundreds of shopping centers."

The standard may also motivate companies to seek shorter leases, says Michael Hedden, MAI, a director of the Houlihan Lokey investment bank in New York. "There is some thought that the new standards will cause tenants to shorten the length of their leases--that they are not going to do 15- and 20-year leases because of the huge liability it puts on the balance sheet. That's one of the things that appraisers need to think about in their analyses of income flows as part of the income approach," he says.

Shorter leases would increase the risk of turnovers and renegotiations, which would need to be factored into valuations.

Access to lending could be a concern, as well. "Imagine a retail chain with 400 or 500 locations," says Louis Yorey, MAI, senior managing director of Advisory Services at BBG, a national commercial real estate valuation, advisory and assessment firm. "If they start seeing hundreds of millions of dollars of lease liabilities hitting their balance sheet, are they creating an issue with potential debt covenant and debt ratios?"

Some companies that have been leasing may find it worthwhile to reevaluate their lease-versus-own strategies, since both ownership and leasing will result in amounts being recorded on the balance sheet. In general, the lessees that are most likely to reconsider their ownership strategies are "large, mature companies with strong balance sheets that currently lease core assets on long-term leases in freestanding buildings that potentially could be purchased," says CBRE's Beatty.

In practice, the impact of these factors is likely to be limited because companies thinking about lease term and ownership typically will look at the bigger picture. When contemplating shorter leases, for example, companies need to consider ramifications such as higher rent, fewer concessions from landlords and losing the ability to control the space.

Similarly, companies thinking about ownership primarily look for the best use of their capital rather than worry about how their leases are accounted for. Indeed, in a CBRE/PwC survey of more than 500 companies, only 10 percent said the new standard would prompt them to consider changing the length of their leases. In terms of ownership, only "8 percent of those surveyed said they might prefer to own versus lease assets going forward, 68 percent said no change, and the remaining 24 percent were not sure," says Beatty.

However, the business world is still in the early stages of digesting the new standard, and the situation may change, as evidenced by the nearly one-quarter of "not sure" survey respondents. As Beatty notes, "We haven't seen or heard much about lessee behavior changing. Given the looming deadline, most companies are focused on simply being compliant with the new standard and therefore haven't had the time to give much thought to strategy decisions."

The appraiser's perspective

Looking ahead, several potential opportunities for appraisers may develop. "I think there will be times when companies will call in valuation professionals to analyze leases that are very complex, where they want to be sure that they are booking the right liability," says BBG's Yorey. "In addition, there are developing opportunities where we are seeing proposals with detailed analysis being developed to provide support on the borrowing rate, which is used in the lease liability calculation. Leases under the new standard will get more scrutiny from both a compliance and a valuation point of view."

Meanwhile, says Andreasen, "The new standard doesn't have what is termed 'bright line' guidance for classifying whether a lease is an operating lease or a finance lease. That increases the level of judgment that's required, and there may be issues pertaining to the value of the underlying asset of the lease. That could potentially create opportunities for appraisers to assist corporations, particularly with new leases."

The specifics of how the standard is implemented and used may evolve, and appraisers should look for opportunities to weigh in on the issue, says Maloy. For example, valuation professionals can focus on helping the accounting industry understand how an appraiser's perspective could help meet the SEC's goal of increased transparency for investors.

He notes that the new rule's formulaic approach to valuing leases does not appear to include "a realistic opinion of what having that lease in hand is worth to a lessee." Thus, the formula approach might not accurately reflect below-market rent as an asset. Or it might provide an incomplete picture of liabilities.

For example, Maloy says that in looking at a grocery chain years ago, his firm found that a significant number of stores were paying very high rent--so much so that the stores would never be profitable and were dragging down the rest of the chain, which eventually went bankrupt. "We found that they had 20-some stores that were dark, that they were still paying rent on," he says.

But that kind of problem did not show up on the balance sheet back then and, he says, may not do so even under the new rules. A more rigorous approach to valuing leases for financial reporting could help investors gain better insights into such risks.

Maloy also suggests the industry consider changing some of its practices to make it possible to provide reports that are tailored to the needs of the accounting industry. Companies will need to update valuations on an annual basis for their balance sheets, he explains, but they don't want full narrative appraisals on every property every year.

One way to meet that need is to have state appraisal boards allow appraisers to provide full initial valuations on property (for non-banking/lending purposes) that could be followed up with abbreviated annual updates of perhaps a few pages. However, regulators need to avoid constraining appraisers just to satisfy the needs of the client base.

Once the dust of implementation settles, appraisers should closely monitor what happens in the marketplace because lessees may rethink some of their lease-related plans. "From an appraiser's perspective, there should be a heightened awareness of this in 2019 and 2020," says Houlihan Lokey's Hedden. "The changing landscape around the new FASB standard is still being worked out."

Peter Haapaniemi is a freelance writer based in metro Detroit.

* Find more on the new FASB standard at http://bit.ly/FASB-ASC-842.
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Title Annotation:Best Practices
Author:Haapaniemi, Peter
Publication:Valuation Magazine
Date:Jan 1, 2018
Words:1830
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