Understanding the accounting factor in leasing decisions
For nearly 10 years, the Financial Accounting Standards Board (FASB), which regulates accounting standards in the United States, has been in negotiations with its international counterpart to bring a key standard into alignment. The result is ASU 2016-02, which the FASB formally introduced in 2016.
The regulation change is meant to increase transparency through the disclosure of lease assets and lease liabilities on balance sheets. It also satisfied the requirements of the International Accounting Standards Board (IASB), plus gets the FASB and the IASB on the same page.
Public companies implemented the new accounting standard in 2019, and 2020 will see private companies come into compliance. Although the regulation is specifically geared toward the accounting profession, it’s important for real estate investors, tenants, and brokers to understand the changes. These updated regulations directly affect business decisions when leasing or purchasing everything—from equipment to property.
The critical component of ASU 2016-02
Generally speaking, there are two types of leases: capital and operating. Most people are familiar with capital leases. It merely means that to own an asset (such as a building), an individual is taking on debt, like a mortgage. At the end of the mortgage, that individual owns the asset. Capital leases, now referred to as financial leases under the new regulation, always have and will continue to appear on balance sheets.
Operating leases, on the other hand, mean that the individual never owns the asset. Essentially, it’s a rented property. And as such, it was an off-balance-sheet item—until now. The ASU 2016-02 standard requires operating leases with terms longer than 12 months to show an asset or a liability—and this information must be recorded on the balance sheet.
What does ASU 2016-02 mean for CRE?
The FASB regulation change has had and will to continue to have a lasting effect on the CRE sector. ASU 2016-02 impacts tenant and landlord business decisions, lease agreements, accounting data, and mindsets.
- In some cases where tenants had lease debt—if they were renting several properties at once, for example—that debt would not appear on their balance sheet. It would, however, be on a financial statement, thereby creating the illusion that the tenant had less debt. The new standard corrects that.
- The new operating lease regulation applies to leases longer than 12 months. As a result, potential tenants may be reluctant to enter into long-term leases. Instead, they may be more interested in short-term arrangements, and this environment could have significant impacts on the capital markets and the way lenders make CRE loans.
- In essence, ASU 2016-02 creates a new mindset for tenants. On the one hand, they may be hesitant to enter into too many lease arrangements for fear that their lease debt will be too apparent. But while a long-term lease allowed tenants a sense of stability while they worked on growing their business, short-term leases may interfere with that. As a result, tenants may want to weigh the benefits of a “capital” or “finance” lease (owning their property) over an operating lease (renting).
- Impacts don’t begin and end with the tenant. Building owners, for example, will also have to adapt to the FASB change. Specifically: how to market their property to make it a more attractive long-term or short-term lease option for potential tenants.
- For everyone involved in the CRE equation, ASU 2016-02 could mean higher operating and administrative costs. This results in greater scrutiny while making business decisions.
Working with a CRE team to navigate new regulations
Ultimately, the FASB regulation change has made the leasing process more complicated for all parties. Therefore, it’s essential to work with experts who can advise owners and tenants on how best to proceed, no matter if it’s a lease or a purchase.
Morris Southeast Group has a long and successful history of working with investors, owners, and tenants. To learn more about what we can do for you, call us at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.
Tags: accounting factor, FASB Rule, Impact on CRE, navigate new regulations
