Accounting Boards Take Aim At Leases

Posted on August 3, 2010 by Michael E. Jones

The Financial Accounting Standards Board and the International Accounting Standards Board are proposing significant changes to real estate lease accounting. At the prodding of the Securities and Exchange Commission, the Boards are attempting to ensure that the assets and liabilities associated with leases are more accurately reflected on a company’s balance sheet, thereby creating more transparency of financial information and permitting easier comparability of balance sheets.

The Boards’ proposed new regulations would in effect treat all leases as an asset with respect to the use of the leased property for the lease term, and a liability with respect to the obligation to pay rent, thereby eliminating the classification of leases as either operating leases or finance leases.

The following are some of the highlights of the proposal:

  1. Leases with a term greater than one year would be affected.
  2. Rent for the entire lease term due under a lease would be discounted to present value using the tenant’s incremental borrowing rate and would be included on the tenant’s balance sheet as a liability.
  3. A lease with a renewal option would be treated as if the renewal option will be exercised if it is likely that the tenant will exercise the renewal option.
  4. Contingent rental agreements (i.e., percentage rent in a retail lease) would require the tenant to forecast its future sales and include on its balance sheet the percentage rent based on such sales forecast together with minimum rent payable during the lease term.

The effect of the proposed changes could significantly impact the leasing market. Tenants may be inclined to negotiate shorter lease terms (including foregoing renewal options) in order to avoid increasing their debt. Commercial condominiums may gain in popularity as prospective tenants turn to purchasing their space rather than leasing it. Percentage rent deals may disappear altogether as retailers will not want to carry increased debt on their balance sheet based on speculative sales forecasts. Potentially there will be more breached debt covenants on loan documents. Clearly, the balance sheets of companies with hundreds or thousands of lease locations will be adversely affected as their debt levels would increase significantly.

The Boards are still in the process of taking comments on their proposals and will soon resume discussions to develop new standards for landlord accounting. The tentative effective date for the revised accounting standards is the second quarter of 2011. We will continue to monitor the development of the new accounting standards as the comment process unfolds.
 

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Warehousing and Distribution Facilities: Have You Considered This?

Posted on March 3, 2009 by Michael E. Jones & Iryna Lomaga Carey

The location of a retailer’s warehouse distribution facility is critical to its ability to meet market demands and to operate efficiently and profitably. Two areas which may not necessarily jump to the forefront of the site selection analysis, are the impact of title and incentives. Business incentives are often critical to a company’s bottom line, while the condition of title can have a more subtle, but often detrimental impact on a location. 

While the benefit of business incentives can be easily calculated into a project, the condition of title can have economic consequences which cannot always be anticipated. A review of title and survey may uncover rights of way, underground and aboveground pipelines for fuel and other combustible products, railroad easements and other encumbrances which may impact the timing of construction and hence on-time delivery of the space. Landlords do not typically consider the impact of these encumbrances, particularly as they relate to access and operations of a tenant. The location of pipelines in an industrial area, predominantly those that carry fuel, as well as obsolete railroad lines, can affect the location of buildings, docks and tractor trailer parking areas and the manner in which product is loaded onto tractor trailers.   Excessive idle time burns fuel unnecessarily and results in increased operational costs. In addition, it is critical to ensure uninterrupted access to a distribution facility seven days a week, 24-hours a day.

Delays and additional development costs are typically the adverse consequences of these types of encumbrances. It is important to analyze the impact of such encumbrances early in the development process. Frequently, removal of the encumbrances, or renegotiation of certain easements requires third parties unrelated to the transaction. Addressing the issues early may avoid costly delays and a prospective tenant may be able to shift the risk and burden to the landlord.

Governmental incentives present another possible benefit. Many governmental agencies offer incentives to entice businesses to locate in their jurisdiction. Such incentives typically offer some combination of tax credits, grants, low cost financing, income tax credits and property tax abatements, which can result in significant savings.

A common incentive is a job creation tax credit which is a refundable tax credit based on income tax withholdings from new jobs created at the facility. Another common incentive is job training grants which are made available to compensate the tenant for a portion of its training costs. In both cases, the tenant will be required to forecast the number of new jobs it will create over a period of time (typically the first three years) and disclose the anticipated salaries it will pay. It is important to note that the forecast must be realistic, because some governmental agencies will require the tenant to pay back all or a portion of the credits if its projections are not met.

Other common incentives include development loans for new building construction, building acquisition, acquisition of machinery and equipment, and other project costs (these loans are at rates and for terms more favorable than conventional financing); property tax abatements; and tax increment financing. The tax programs can result in a significant reduction, or a full abatement of real estate taxes for the project for some period of time, typically ten to fifteen years. However, the process to obtain them may be very time consuming. Often the landlord has already negotiated a real estate tax abatement, and it is important to ensure that the tenant obtains the benefit of that agreement in the lease.

Once the tenant determines what incentives are available, the tenant must either secure governmental approval of the grant of the incentives before signing the lease, or negotiate a contingency and termination right if the incentive is not obtained by a date certain. It is important to make sure the governmental agency knows that approval of the incentive is critical to the project.

Although there are many economic and non-economic factors that should be considered in the site selection process, by addressing the issues referenced above early in the development of its warehouse distribution facility, a tenant will increase the odds that it will have a successful project.

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