Transparency and consistency are the driving changes to lease
accounting but the impact on tenants and the appetite for leasing arrangements will be significant, likewise the supply and quality of opportunities. Christine Senior reports

The accounting rules for leases that will come into effect with the adoption of IAS17 are set to have a profound impact on the real estate industry, mostly from the tenant perspective but with knock-on effects for investors and asset managers. A major element of the new standard will be to abolish the distinction between finance leases and operational leases. In future all leases are set to be reflected in a company's balance sheet, not just finance leases as is the case now.

For the tenant the lease will be recognised on the balance sheet as a liability, which represents the obligation to pay rent, and as an asset, which represents the right to occupy the property. For landlords it is the reverse: the asset of the right to receive rent, and the liability of not having use of the property themselves.

The final version of the new standards will be the result of many years of discussions. The two accounting standards boards, IASB for international standards and FASB for the US, are expected to announce the final standard in June, following industry consultation and feedback.

The exercise was considered necessary because the boards felt the current rules do not properly reflect the economic value of a leasing transaction. Companies were using leasing as a way of financing assets for use in the business for productive purposes, so logically leases should appear on the balance sheet, which operating leases do not.

Leases for investment property, which are held at fair value under IAS40 accounting rules, are outside the scope of these changes, so property investment businesses are unlikely to be affected as far as their own accounting goes. But they will certainly suffer the fallout from changes in their tenants' property strategy. Changes for tenants come into three categories: the impact on their property requirements, on their financing arrangements and on their compliance burden.

As far as property requirements go, the suggestion is that in future tenants will prefer shorter leases, which in turn will lead to more volatility in rents; they may prefer to buy rather than rent; and sale-and-leaseback arrangements will become less attractive.
None of these decisions can be taken lightly. But the result could be that the management of real estate requirements moves up the corporate agenda, and perhaps even has an influence at board level.

Shorter leases reduce the liability on the balance sheet, so it might be expected that companies would prefer that. Lease terms have in any case been reducing for some years, so this will be one more push to a change that is happening already. But other considerations come into play. Shorter leases mean higher rents, and fewer incentives from the landlord, such as rent-free periods.

"There is an economic disadvantage for shorter leasing," says Doug Jones, associate director in DTZ's corporate real estate consulting team. "So depending on the company and the pressure on the balance sheet that these leases might cause, you might get one company saying we are going to look for a better economic position, the better cash perspective of the longer lease. Another company that is more concerned about balance sheet impact will stick to shorter leases."

Security of tenure is another consideration. Companies will not want to risk losing a building that is important for their business by signing up to a shorter lease.
An increase in popularity of shorter leases could lead to higher rental volatility, as leases come up for negotiation more often, and rental levels will reflect the ups and downs of the economic cycle, bringing less stability and more uncertainty to the market. This is certainly an issue for landlords.

So the changes are going to be just as unwelcome to landlords as to tenants. "Landlords don't want shorter leases," says Mark Long, director of Three Delta. "The virtue of a longer lease is you can compare it to a bond-like income stream and it will be priced like that. If we have shorter leases, yields will probably rise, values will fall in the market as a whole and the ultimate effect of that will be a lower supply of new accommodation until the market again reaches equilibrium."

Rachel MsIsaac, director, asset management, AEW UK, says that lease lengths will not just be affected by considerations over accounting standards. "My long experience as an institutional investor is that tenant profitability influences supply and demand more than any legislation. In retail, for example, locations with high spending footfall and resulting competition from other occupiers are the drivers of market rents and lease lengths."

The decision over whether to buy or rent is likewise driven by more than just the effect of accounting standards. "A lot of people decide they like the flexibility of a lease," says Ion Fletcher, finance officer at the BPF. "Or they don't have the capital to buy a building. In the retail context a particularly desirable location may only be available for lease, so retailers sometimes have very little choice. While the accounting proposals might make leasing less attractive because you have to recognise liabilities on the balance sheet, you ultimately have to make a decision to buy or rent based on commercial factors."

Currently, operational leases are an off-balance-sheet debt, so do not affect a company's financial ratios, which has been a major attraction for lessees. With the demise of this benefit the decision comes down to a simple comparison of the debt needed to buy a property and the amount of rental payments under a lease.

It is a debt versus rent play, says Jones. "Clearly you will still have companies saying we want to use the cash in some other way, and don't want to tie it up, but borrowing in the majority of cases is likely to be lower than rental payments. It would make more sense economically if you could borrow 100% of value of the asset to buy it rather than rent. Both debts would go on the balance sheet."

Mark Beddy, real estate partner at Deloitte, says the decision on leasing or buying will become more finely balanced. "Why lease an asset and have an asset and liability on your balance sheet when you could buy it and have a similar effect? If you buy it you have complete control."

The effect of the new standards on sale-and-leaseback transactions has received a lot of attention. But just as in the buy or lease and the lease length decisions, other considerations will play a large part. Sale-and-leaseback arrangements allow companies to use cash that would otherwise be tied up in property to generate profits. That will still be the case, but sale and leaseback has also been used as an accounting ploy.

"Deloitte's research a few years ago suggested about a third of sale and leaseback had some element of seeking an accounting result, ie, taking assets and liabilities off balance sheets," says Beddy. "If that's not possible any more clearly the attractiveness to those types of users of sale and leaseback will disappear."

For investors the ideal type of sale and leaseback is on a long lease with a guaranteed uplift built in. Not only do they have tenants for a long period of time, but rental income is increasing in line with RPI, at yearly or five-yearly intervals.

"More investors out there are looking for that type of income," says Jones. "A pension fund would be keen for a secure 20-year income effectively going up at a known rate. But those types of transactions will undoubtedly have a bigger hit on balance sheets than standard leases, so fewer companies might be doing sale and leasebacks because of this."

The consequences of the changes will vary: retailers, for example, with extensive property portfolios are in the frontline of companies facing a massive blow, as are logistics companies leasing substantial warehousing facilities. The European Public Real Estate Association conducted a survey last year into how major retail operators viewed the new rules. Major findings were that they viewed leases not as financing arrangements but as a means to secure selling space and cost and operational flexibility; and they objected both to including renewal options as part of the valuation of assets and liabilities and to including contingent rents (where performance of the business affects the value of leases).

But any company with a substantial portfolio of leased properties will be faced with a huge data collection and management exercise to keep track of all their leasing. Information about all leases must be gathered together in one place - information on the number of leases, length of leases, rents, expected rental growth, expiry dates and so on. Leases must be valued and revalued annually and the accounts signed off by auditors.

Company financing is also likely to be hit by the new rules. Additional liabilities on balance sheets increase a company's debt to equity ratio and could cause them to breach their banking covenants. And, as ratings agencies use company accounts as part of their assessment process, the new rules are likely to affect ratings, and in turn future financing arrangements.

One of the most controversial impacts for companies could be the effect on their profit and loss account of a change in valuation of the rental liability to give so-called front loading of the charges. Where previously the rental expenditure has been recognised as constant for the whole term of the lease (straightlined), it would in future be recognised as being higher in the early years, decreasing over the term. This would hit profits hard in the early years and has been a source of a great deal of objection in industry feedback.

But it looks as if the standards boards have had a change of heart on this. This would mean a partial retreat from abolishing the difference between finance and operational leases.

Paul Nash, head of the asset finance and leasing group at PwC, says: "[Accounting standards boards] have introduced what they call ‘financing leases', and ‘other than financing' leases. In a financing lease the profit and loss recognition might end up front loading the expense. Where you have something that is other than a financing lease it looks like they might be heading back to straight-line accounting."

Property owners and investors as well as tenants seem united in their opposition, and the consultation process has attracted much negative feedback. Jochen Schaefer-Suren, a partner at Internos Real Investors, is forthright in his criticism: "It's going to be very detrimental to a lot of people. It's going to blow up the size of balance sheet for a lot of tenants, and increase the apparent asset value of those companies, which is a good thing, but it makes that very volatile. It creates volatility in earnings when there isn't really any. It will be quite dramatic, which is one of the reasons why everybody is resisting it so strongly."

But this is not the universal view. Accountants think differently: having two types of leases, one of which appears on the balance sheet, when the other does not, is not logical, particularly as the two can be very similar. Beddy thinks the change will correct an anomaly.

"Generally," Beddy says, "there has been a view that having a debt off balance sheet - which is what an operating lease is - is a bad thing. Transparency is achieved by having all liabilities on the balance sheet. Liabilities don't appear on the balance sheet and there is a view they should. In principle most people find it difficult to argue coherently against that."