There is no (little) cause for worry in response to the increasing presence of whispers of heightened regulation in regards to lease accounting procedures, sale-leasebacks, and 1031 like-kind Exchanges. There are two main regulations that have caused the most interest amongst real estate professionals, credit agencies, and investors; the change in accounting practice requiring all leases to be placed as assets and liabilities on the balance sheet of companies, and the various tax plans that propose limitations or the elimination of the 1031 Exchange in some manner. Due to the obligatory nature of a company’s lease obligations, there is widespread consensus that these obligations should have been placed on their Balance Sheet all along.
In early 2016 the Financial Accounting Standards Board (FASB) introduced Accounting Standards Update (ASU) 2016-02 Leases (Topic 842). ASU 2016-02 requires US companies to capitalize all leases, operating or financing (previously capital), as an asset and liability on their balance sheet. FASB decided that leases longer than 12 months should be reported on the balance sheet in order to more accurately represent the guaranteed lease payments a company is contracted to make. The majority of changes have been made to the lessee accounting records. However, lessor accounting has been updated to align with the changes in the lessee model and the new revenue recognition standard. This standard will not affect the income producing capability of single tenant properties, or companies’ attitudes towards sale leaseback strategy.
ASU simply requires companies to place a pre-existing financial obligation in an area more easily accessible to investors. Moody’s Credit Rating agency estimates that 3% of nonfinancial global companies will experience a credit rating upgrade due to Moody’s newly established debt analysis parameters. Moody’s stated they do not foresee any credit downgrades as a direct result of the new lease accounting standard.
For companies such as Walgreens (NASDAQ:WBA) which leases roughly 80% of their 8175 stores as of August 31, 2016, and CVS (NYSE:CVS) which leases 95% of their 9655 stores, this can be an enormous dollar amount on their balance sheet. In fact, on their 2016 financial statements, Walgreens had a $27.48 billion present value of lease obligations. CVS boasted an amount totaling $16.201 billion. Their total liabilities including the lease obligations were reported at $46.508 and $43.732 billion respectively. These numbers indicate that their lease obligations represent 59.1% of Walgreen’s total debt and 37% of CVS total debt.
Price Waterhouse Cooper surveyed companies in 2016 regarding their thoughts on the new regulation’s effect on their companies. The majority of companies surveyed stated that the regulation will have little impact on their operational decision making, but will take an extensive amount of time and effort to develop a process to consolidate the entirety of their lease agreements into one database and balance sheet number. 30% of companies surveyed had begun implementing the regulation and developing processes to consolidate leases, despite the required compliance date not being until 2019.
Despite companies indicating that the new regulation would not affect their operational decision-making processes, a guidance publication from Deloitte Touche Tohmatsu LP proclaims that there may be alterations in lessee practices as a result of ASU 2016-02. The publication indicates the following possible outcomes as a result of the standard:
- Tenants may want to negotiate leases with shorter-terms or leases that include more variable lease payments.
- An increase in shorter-term leases could also result in higher rental rates.
- The new guidance may complicate a tenant’s internal approval of new leases or lease modifications since different individuals may need to closely consider the effects on the financial statements. Under current U.S. GAAP, a tenant’s decision to enter into an operating lease may not necessarily receive much opposition or challenge from management. However, operating leases potentially will now be scrutinized as much as out-right purchases because of their effect on the balance sheet.
While it is important to be aware of the possible outcomes of regulatory action, there are no certain terms that indicate an absolute result of the new standard. Similar to the tax reforms and overall current economic environment in the United States, we will just have to wait and see.