Doing business in the United States is about to get a whole lot more complicated and expensive.  Recent proposed rule changes by the FASB (Financial Accounting Standards Board), if set in place, will have a dramatic and severe impact on the way that US companies treat their leased real estate.  If the proposed FASB change takes effect all lease expense based accounting will be eliminated and all leases will be treated as a debt obligation to be reported on the balance sheet.  The proposed standard replaces FAS 13 in the United States and will affect companies that lease real estate in the following manner:

• There will no longer be any difference between operating leases and capital leases, meaning the elimination of  ‘off balance sheet’ accounting
• Leases will be capitalized based on the present value of the lease obligation – a straight line rent expense will disappear to be replaced with interest expense for an asset financed by debt
• The capitalized lease value will include the base rent, residual payments, obligated renewals – any renewal options that are likely to be exercised are added to the overall amount of the liability
• Balance sheets will show all leases as a debt liability
• Pre-existing leases will not be grandfathered
• Corporations with multiple locations will be burdened with complex reporting and administrative costs

The proposed changes currently scheduled to take effect in 2013 could not come at a worse time for the US economy struggling to recover in the worst economic environment since the Great Depression, and presently could be headed into a “double dip” recession.  The commercial real estate and banking sectors of the economy already weakened by the steep correction over the previous two years could be hammered to its knees by the proposed rule changes.  Very few sectors of the economy are as interwoven as commercial real estate and banking into the overall equation.

The net effect of the proposed change will be profoundly negative –  far reaching in scope and time.  Companies will soon be required to report a significantly higher amount of debt on their balance sheet, which could affect the overall valuation of the entity and perhaps trigger defaults with their lenders on preexisting debt covenants.  The dynamic between commercial landlord and tenant will change as the rule creates an incentive for the lessee to sign shorter term leases in an effort to lower the negative impact on the balance sheet – lease options to renew will soon be a thing of the past. Consequently,  landlords will charge a higher rent and shift more of the burden of renovation costs to the tenant as the ability to amortize those costs diminishes for those shorter term leases.  Landlords will suffer because they will no longer be able to secure long term financing as  lenders will not provide a ten year loan for a property that could only have three year leases on average – constantly having to chase after financing every 3-5 years will be expensive and time consuming.  Buildings with short term leases are considered less stable, hence worth less, and so its likely that property values will decline further which will also result in more volatility in the property and capital markets.  US companies could be valued dramatically lower due to the effect of placing all operating leases on the balance sheet which could have a profoundly negative affect on the equities markets for some time to come.

Why is this happening? The FASB and it’s international partner the IASB (International Accounting Standards Board) got together to develop a unified approach to accounting in recognition of a globalized economy.  The FASB/IASB recommendations are designed to provide more transparency and comparability and to eliminate off balance sheet transactions. At present, it is estimated that the value of operating leases for publicly traded companies in the US is between 1.3 and 2 trillion dollars. The proposed rule changes stem in part from spectacular business failures in the past such as Enron, which was a company that borrowed more than it was worth in part by using off balance sheet transactions.

While its understandable that the FASB (which answers only to the US SEC) would strive for greater clarity in US accounting practices the far reaching and grossly negative affects the proposed rule changes will have,  must be studied and carefully considered by all stakeholders.  The  way commercial real estate is leased and sold will change overnight.  Already, US companies with multiple locations are  scrambling to analyze how the rule changes will affect their balance sheets and overall real estate strategies. Many companies will soon start asking whether its better to own their real estate instead of leasing it because it will be on the balance sheet anyway. Those companies with multiple locations (like retailers and banks) could be at a competitive disadvantage to those that have a lower real estate footprint or already own their facilities. 

Members of the accounting community have been quoted  that the solution in many cases would be for companies to purchase their real estate now instead of leasing, and frankly, I find that to be extremely naive.  A company that leases a space or a floor within a multi-tenanted property won’t easily be able to just convert its leased space to an owned space, especially if the property is owned by a REIT or another institution that purchased that asset based on a specific set of parameters (including longer lease terms for the tenants in the property to create a minimum rate of return for that asset). Furthermore, I don’t think  it likely that REITs, pension funds and insurance companies will be eager to start carving up their ‘tier-1′ assets into condominium vehicles for their tenants to convert to owners as a result of the new accounting rule. One of the primary reasons that companies lease their real estate instead of purchase it is because it is hard to predict what their needs will be beyond a typical 5-10 year lease term.  The purchase of real estate is not a liquid asset and cannot be disposed of easily which means making strategic changes over a shorter time period will be exceedingly difficult.

So, here we find ourselves already mired in an era of overwhelming uncertainty with the old paradigms seemingly and unnervingly being killed on a daily basis.  Along comes the FASB, rushing like a fireman late to the fire with a can of gasoline in hand - all in the name of clarity and the prevention of another ENRON.  The economic cost of the new FASB rule will be devastating as its likely that there will be a global devaluation in  the value of real estate assets as well as equities already during a time of – you guessed it, devaluation.  The FASB may just have created an economic stimulus package for the accounting profession, and I am sure that the accountants hired to find every last nickel of assets and debts will do so. After the dust settles a few years from now, after the great upheaval this will cause, the accountants who did the finding   of the last nickel will find that its made out of wood, and will have to be tossed in the bonfire at company headquarters to keep themselves warm…

Let me know what you think.