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November 17, 2016
Roughly seventy percent of all leases have amendments. Whether those amendments take the form of a “blend and extend”, extension, expansion, contraction, early termination or some combination of all of these, amendments don’t just change the cash flows from a lease, they dramatically change how that lease is accounted for on the tenant’s balance sheet and income statement.
In simple terms, you cannot treat the amendment as a separate lease for accounting or analysis purposes. The pre-existing balance sheet and income statement values affect how the amendment impacts the tenant’s financials, and what you thought was a good deal can quickly turn out to be a very bad deal where it matters most: net income and EBITDA results. Yet virtually nobody gets this right when analyzing lease amendments – brokers and tenants alike. This is precisely why LeaseCalcs automatically handles the analysis and accounting for lease amendments – in just minutes.
Recently, LeaseCalcs ran over 50 “blend and extend” (“B&E”), amendments through our patent-pending lease accounting + analysis application. While 100% of them achieved the objective of reducing the tenant’s cash rent expense, over two-thirds immediately reduced profits. Amazingly, there were remedies, but neither the tenants nor their brokers knew the impact or how to fix it before signing the amendments. Take, for example, the case of a tenant in San Diego who executed a B&E amendment at the end of the sixth year of their ten-year lease term. The amendment effectively added four more years of lease term onto the existing term, meaning from the date of the amendment the tenant would then have eight years of lease term remaining. The amendment also served to reduce the rental rates they would have been obligated to pay in the final four years of the initial lease term. In other words, a classic “blend and extend” deal.
When the amendment was being negotiated by the tenant and its broker, however, all of the analyses were based on discounted cash flow alone, with a focus on the amount by which the tenant was able to immediately reduce its cash rent expense. In fact, the amendment did serve to reduce the tenant’s rent expense by $350,000 per year in for the first two years of the new term, and by $400,000 per year for the next two years of the new lease term.
Unfortunately, this is where the tenant’s and its broker’s analyses stopped. Their analyses never considered the impact the amendment would have on the tenant’s financials, most importantly including its net income and EBITDA results.
May 5, 2016
Now it really counts. For years, companies could negotiate leases with minimal thought of how it would impact their financials beyond doing their best to minimize the actual costs. That is no longer the case. The FASB & IASB lease accounting changes are set to commence as of January 1, 2019 and all leases with a term greater than 12 months will formally hit the balance sheet. For the S&P 500 alone, the estimated lease value that will hit those company’s balance sheets is in excess of $1.75 trillion.
Portfolio optimization has never been more important for companies. Excess and inefficient lease portfolios will of course continue to cost companies but once the changes take effect company balance sheets will also experience negative and unnecessary financial impacts due to inefficient lease portfolios.
The below graph represents a Cresa client’s balance sheet for their entire lease portfolio. Cresa’s portfolio optimization team reduced this client’s balance sheet liability from $950,000,000 (blue bar) down to $810,000,000 (pink bar) through a myriad of recommendations. That equates to a balance sheet liability reduction of $140,000,000 just by optimizing the lease portfolio.
Cresa will assist companies not only with optimizing their lease portfolios to reduce the lease accounting impacts but we will also assist companies with the entire lease accounting transition. Contact us to find out how.
Not only are the new Lease Accounting rules complicated... they are also illogical!
February 26, 2016
How can two leases that have the exact same underlying costs have two dramatically different impacts to a company’s balance sheet? The below balance sheet impacts are different because the FASB & IASB have formally stated in the final lease accounting changes that gross leases (any lease with operating expenses / real estate taxes & insurance imbedded in the base rental amount) will now have to capitalize the real estate taxes and insurance onto their balance sheets. By comparison, net leases will not capitalize real estate taxes or insurance on to their balance sheets.
We agree that this doesn’t exactly make sense but these are the types of surprise unintended consequences that companies will be facing if they don’t get their arms around these new lease accounting changes immediately.
The below table demonstrates the dramatic difference between a gross lease and a net lease to a company’s balance sheet.
Assumptions utilized for above lease calculations - (50,000 SF lease; 10 year term; $40/SF “all in” of which OPEX equates to $4/SF; RE taxes $5/SF; $1/SF for insurance and $2.50/SF for utilities).
The above lease comparisons have an “all in” cost of $40 per square foot on a gross basis but one is structured as a “gross” lease and the other is structured as a “triple net” (NNN) lease. According to the new rules the gross lease structure must capitalize the embedded taxes and insurance onto the balance sheet whereas the NNN lease structure does not. Therefore, there is now a difference in the net based rental amounts being capitalized which creates a much higher balance sheet impact for the gross lease than the triple net lease. The gross lease is capitalizing $33.50/SF onto the balance sheet and the triple net lease is only capitalizing $27.50/SF onto the balance sheet which accounts for the $1,435,368.00 balance sheet difference.
It is worth noting that these two scenarios do have different impacts on balance sheet and shareholder equity, but it’s also possible that a company that cares about EBITDA would prefer the gross lease structure if it could achieve Type A / "finance" lease classification, as that would shift taxes and insurance below the line for EBITDA purposes, while a net lease would leave them "above the line."
Find out more at www.fasb.org
October 20, 2014 – FASB / IASB Update
The FASB & IASB will meet three times in the next 60 days to finish voting and finalize the new lease accounting standards! This means in 60 days we will all know the details of what will be included in the final standards.
A member of Cresa’s lease accounting task force continues to speak with representatives from the FASB & IASB who are directly involved in establishing the new lease accounting standards. Our detailed financial analyses have even been used in support of the various decisions the boards have already reached this year. One of the many benefits of these interactions is we have a clear picture of the path that lies ahead … and it’s now a very short path.
Earlier this week we learned that the Boards are scheduled to finalize their voting on the leases project over the next 60 days. The key dates and agenda items are as follows:
October 22 – 23: Definition of a Lease: The Boards will discuss and vote on some “fine tuning” of the definition of a lease to provide clarifications based upon feedback they have received for unique circumstances. The clarifications are unlikely to have any meaningful impact on real estate leases.
November 17 – 21: Disclosures: The Boards previously voted on many of the disclosure requirements for the new standards (i.e., what information companies will need to include in the notes to their financial statements related to their lease obligations). During the prior votes on disclosures there were a few items left undecided, and it is these loose ends that will be the focus of the November meetings.
December 15 – 17: Transition Methodologies: The Boards will establish the options available for companies to convert their lease accounting balances and calculations from the existing rules to the new standards. The Boards have previously proposed what are referred to as “Fully Retrospective” (i.e., going back to the lease commencement date to run the calculations) and “Modified Retrospective” (i.e., essentially capitalizing remaining obligations), approaches. This meeting will focus on ways to simplify transition and resolving inherent flaws in the Modified Retrospective approach (which a member from Cresa’s lease accounting task force first brought to the Boards’ attention many months ago).
National Banking Company
Over 2,500 Office and Retail Locations
Client had acquired several bank chains which had never performed lease audits. Even though the acquired chains were not yet integrated into the Client’s lease administration software and database, Client required a lease audit firm that could immediately launch an audit plan to maximize recoveries to improve performance against the current year budget. To perform a preliminary risk assessment of all locations, we first had to obtain all the relevant documents, which required contacting landlords for missing information. We then proposed a lease audit plan that included on-site full-scope audits for 102 locations deemed high risk, and limited scope desk audits for 141 locations. In our first year, we completed 100% of the audit plan, and negotiated recoveries with landlords exceeding $1.2 million. In the subsequent five years, we performed audit procedures on more than 100 locations per year.
National Retail Clothing Company
Our client’s portfolio included up to 760 retail locations, mostly in high-end malls. Initially, client selected three lease audit firms to conduct audits in a competitive situation. Client engaged us on
63 locations, and we recovered more than $92,000, which was far more successful than our two competitors. We won the right to be the sole lease auditor and have performed lease audits for the client over the past 18 years. Each year, we prepare an action plan to ensure that all locations are examined on a rotational basis. In order to maximize recoveries with streamlined effort, we conducted audits on a “landlord-basis” rather than only performing individual audits. Each year, we would audit up to seven major landlords, some with close to 100 locations. We discovered that landlords had made many errors with respect to capital expenditures, depreciation, marketing charges, and vacancy. We successfully perform up to 200 audits each year and have recovered millions in savings. In addition to performing the audits, we were also able to help our client by including more effective and clear lease language regarding various additional rent charges.
Education Solutions Firm
The client is an education solutions company dedicated to helping educators, administrators, students and families maximize success through every stage of the learning lifecycle. In 2009, Cresa was engaged to assist the client through every stage of the real estate lifecycle. The client was given a 2011 base year for expense pass-throughs. At this time, the annual expense totals were laid out in a trend analysis which showed operating expenses increasing 9% from 2011 to 2012, then another 22% from 2012 to 2013. Furthermore, real estate taxes increased 39% from 2011 to 2012, then 5% from 2012 to 2013. It was quickly determined that the base year was not accurately reflective of a 95% occupied building, per the lease. After working with the property manager on the oversight, the total bill for 2012 and 2013 was reduced and the higher base year will protect the client throughout the full term of the lease.
Estimated Savings: $894,000
National Restaurant Chain
Our client had intermediate plans to launch an Initial Public Offering, and was extremely focused on streamlining operations and saving money. Our client was able to hire us as third-party consultants and reduce headcount, with the goal of reducing its pass-through charges. During the first month of work, we were able to recover $200,000 in landlord overcharges. We performed extensive procedures on all locations in the portfolio, and averaged nearly $100,000 of recoveries per month during the first year. We discovered that landlords had made many errors with respect to denominator exclusions, taxes, and CPI miscalculations.
Regional Engineering Firm
Our client began questioning some of the annual reconciliation charges they were receiving from their landlord. Cresa Lease Compliance was asked to review the annual reconciliation statement for one office in particular in the Mid-Atlantic region of their lease portfolio. The office contained 25,000 SF. Cresa Lease Compliance Services uncovered over $200,000.00 in charges in operating expenses just in one year alone. Of course this finding led to the review of previous year’s reconciliation statements in which an additional $125,000.00 in overcharges were found because the landlord was passing through expenses that were not permitted via the lease agreement. Needless to say, the client was thrilled with the findings and believe it or not the landlord made the same mistake the following year after the audit was completed. Of course, that mistake was rectified immediately by Cresa Lease Compliance Services.
Our four Cresa Lease Compliance service line principals have nearly a century of combined experience in saving tenants capital via lease audits and related services. Their diverse backgrounds contribute to comprehensive solutions that are custom-tailored to each individual client. Select clients of the group include FedEx, Walgreen's, GlaxoSmithKline, American Express, Eddie Bauer, Universal Studios, Lockheed Martin, Washington Mutual, and many more.