Over the past two years, there has been a shift in tenant behavior due to the pandemic. This includes efforts to reduce office space, offer more flexibility in lease duration, and perhaps even reduce lease duration. It is important to understand the mechanics of the new lease accounting standard as it may further change tenant behavior in the coming year.
The good news is that lessor accounting will be largely unchanged as a result of the new lease standard. The new lease standard (ASC 842) is effective for reporting periods beginning after December 15, 2021. This will require lessees to recognize a lease liability (lessee's obligation to make lease payments) and a right-of-use asset (lessee's right to use the asset for the lease term) on their balance sheets for all leases, not just finance leases (previously known as capital leases).
Here are some of the details and key considerations of the lease standard that real estate lessors should be aware of:
- Do you have ground leases? Being on the lessor side as a developer, an understanding should be obtained to determine if your ground leases should be reported as a right-of-use asset and lease liability on your balance sheet.
- Tenants may have problems with debt covenant compliance after placing leases on their balance sheet or may have other motives to try and reduce their right-of-use asset and lease liability. As a result, they may:
- Explore shorter lease durations and other flexibility in lease terms. An overall reduction in lease duration will reduce the asset and liability to be recorded. Additionally, short term leases under 12 months without renewal options, may be scoped out of balance sheet recognition. However, the short-term lease exception is subject to specific terms and likelihood of renewal with the lessor.
- Try to negotiate lower fixed rent with higher variable payments to reduce their balance sheet liability.
- Want to ensure the contract is specific as to lease vs. non-lease components as non-lease components may be left off the balance sheet.
The above has a trickle-down effect to the lessor’s business operations. As a lessor, will reduced or modified rent rolls (assuming a change in leasing behavior):
- Have a negative impact on the valuation of your real estate?
- Affect your ability to refinance or restructure debt arrangements in the future?
- Affect your ability to recapitalize or restructure your real estate entity?
There will be some financial statement considerations and disclosure changes for lessors due to the new leasing standard. However, the biggest impact will be on business operations and the change in tenant behaviors in the coming year.
If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.