Real Capital Analytics Website - August 5, 2010
Sweeping changes proposed in the accounting treatment of leases will have steep implications for investors should they take effect in the next few years. Just how great the resulting impact is up for debate, but implementation would compel many tenants to avoid making long term lease arrangements. For real estate investors, the potential implications loom large, and could have a profound impact for those with strategies that include single-tenant properties and sale-leasebacks, both large segments of the property markets.
Over the past 12 months, 23% of all commercial property trades globally, or $46.6 billion in assets, have involved single-tenant properties. By number of properties sold, the proportion of single-tenant properties changing hands is much higher, at close to 40%, up from 25% before the downturn. Investors typically flock to the security of single-tenant properties, particularly those with long-term credit tenants when economic conditions stumble.
The proposed regulations, part of an ongoing effort between US and international accounting bodies to converge global standards and provide greater financial transparency, would essentially require tenants to report all leases as liabilities. The March 2009 discussion paper is available from the Financial Accounting Standards Board (FASB). Instead of reporting rent as an operating expense, occupiers would have to book the value of the lease as a liability using the full term of the lease, including renewal options. The added liability could endanger existing debt covenants or be a hurdle for companies looking to raise credit. And so while some in the market will argue that accounting treatment does not impact underlying economics, practical issues do arise.
The primary concern for real estate owners is that tenants will opt for shorter lease terms – the longer the lease, the greater the liability a company would have to book. In addition, more companies are likely to buy and own their properties outright. Indeed, the proposals are already coming into play. When aerospace contractor Northrop Grumman announced that it will acquire a vacant 334,000-square-foot building for its headquarters just outside of Washington DC, it cited these potential accounting changes as a factor behind the decision.
The most vulnerable part of the property sector may be sale-leaseback transactions, where the seller/occupier is required to execute a long term lease. These have accounted for $24.8 billion, or just over 50%, of all single-tenant deals over $10 million globally over the past year. Over the same period, there have been $4.0 billion of sale-leaseback transactions in the United States, representing just under 40% of all single-tenant deals domestically.
Corporations that found traditional credit routes frozen often turned to sale-leasebacks to raise capital, and top-rated companies often use the sale-leaseback market as a vital component of their corporate finance strategy. The top ten companies engaged in the practice have used it to raise $30.0 billion globally since the start of 2007.
Although the changes have not been finalized by FASB and the International Accounting Standards Boards (IASB), most experts believe that some changes to current standards are inevitable and will take effect as early as 2012. A final draft is expected to be published for comment this fall. As the date for implementation moves nearer, single-tenant properties with long-term leases are sure to gain in desirability and value, since with adoption, long-term leases could become scarce.
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