New Accounting Reg Will Lead to Shorter Lease Terms

A new accounting regulation could have a major impact on office lease terms. ASC 842 is now in effect for public companies, as of December 15, 2018, and will come into effect for private companies on December 15, 2019, and it sets a new standard for leases. According to Veronica Bulman of RSM, the new standard will require lessees, or tenants, to recognize assets and liabilities associated with most leases. This new requirement could encourage companies to sign shorter-term leases.

“While the bookkeeping requirements of long-term leases under the rule require significant data tracking, companies can avoid the issue entirely by moving to short-term leases, which can continue to be recognized over the term of the lease on a straight-line basis,” Bulman, a senior real estate manager at RSM, tells GlobeSt.com. “ASC 842 permits lessees to make an accounting policy election by class of underlying asset for leases with lease terms of 12 months or shorter.”

While ASC 842 could expedite a transition to short-term leases, the industry is trending in the direction of shorter lease terms regardless. This trend has emerged alongside more flexible office space options. “For years, our industry has been experiencing a pullback from long-term leases as companies increasingly demand flexible space to accommodate quickly changing business needs,” Bulman says. “This is how pop-up, experimental models and shared spaces have gained popularity.”

For tenants, this could potentially be a benefit and allow for more flexibility. For landlords, however, shorter lease terms will increase uncertainty at a property. “ It introduces greater uncertainty into the budgeting and planning process for landlords and real estate investors,” explains Bulman. “The commercial real estate industry has historically preferred to use discounted cash flow models to value buildings, which could become an issue if there’s a significant increase in short-term leases.”

One benefit for landlords could be charging higher rents for short leases, however, those rents will likely offset higher expenses that come with more frequent lease rollover. This could mean shifting the valuation of a property. “Short-term leases command higher rents, yet they also come with more expenses, including leasing commissions, legal and marketing costs and, potentially, a change in the vacancy assumptions in the cash-flow analysis,” adds Bulman. “If those rental premiums don’t offset the added expenses, the value of the building could fall. Asset managers and appraisers may have to consider weighting other methods, such as replacement building costs or comparable sales more heavily, or prepare for lower valuations.”

The regulation won’t start until the end of the year for private companies, so it could be some time before we see this trend emerge. “As their leases come up for renewal, companies may choose to enter into short-term leases and annually reassess whether traditional office space or brick-and-mortar storefronts make sense for their business,” says Bulman. “To remain competitive, landlords may need to begin accepting more tenants on a short-term basis or providing other incentives to encourage them to commit to a longer-term agreement.”

It isn’t only shorter lease terms that come with this new accounting regulation. It could also lower liquidity metrics, lower performance metrics and increase leverage metrics. The added noncurrent assets and noncurrent liabilities from the leases could seriously compromise a borrower’s ability to satisfy their debt covenants,” says Bulman. “Even borrowers without significant debt should consider how their revised balance sheets could affect their future ability to access credit.  As mentioned, changes to the building valuations and potentially how building valuations are performed. Both tenants and landlords will be affected by changes to non-lease components and non-components with regards to the initial direct costs and the disclosures required.”