COVER STORY, FEBRUARY 2011

A SHIFT IN POLICY
The commercial real estate market is preparing for the FASB’s proposed policy changes, which will have a significant affect on the market.
Amy Bigley

For the commercial real estate industry, 2011 will be a year of anticipation and adjustment as the Financial Accounting Standard Board (FASB) is expected to release its revisions and changes to current commercial real estate policies and literature.

Although the changed policies will not go into effect in 2011, the commercial real estate industry is still perking its ears to any comments or drafts released by FASB, including the lease exposure draft and the proposed change in investment properties and investment companies.

FASB has proposed a new approach to lease accounting that will address perceived shortcomings of the current policy. The proposal, the lease exposure draft, will eliminate operating lease accounting and record an asset and liability for future payments of rents on the balance sheet, explains Nick Antonopoulos, managing director at McGladrey’s real estate practice office in Chicago.

“The biggest impact for the lease exposure draft is that it’s going to completely change the way accountants record leases,” says Antonopoulos. “It’s basically going to record an asset and liability on the books and records of both the lessee and lessor.”

The new lease literature will require tenants to record a right-to-use asset and liability for the rent obligation on its books. Under the changes, rent expense will be eliminated and the lessee will record the interest expense associated with the liability, which will be measured at the present value of future lease payments, including option periods and contingent rents. Additionally, the future lease payments will be discounted at the lessee’s incremental borrowing rate. The rented asset will be valued at cost, which is the amount of liability plus the initial direct costs. Finally, the right-of-use asset will amortize over a shorter period of the lease term, or life of the asset, and is subject to impairment while the obligation will amortize using the effective interest method, with cash payments recorded as an interest expense and a reduction of the obligation.

Property owners will have two options for handling the lease exposure changes — the derecognition approach or the performance obligation approach. To determine which method to use, Antonopoulos suggests asking “Does the lessor retain exposure to significant risks or benefits with the underlying asset?”

If an owner falls into the first category — derecognition approach — underlying assets are partially derecognized. Landlords derecognize the portion of the rights that have been transferred to the tenant while reclassifying the non-transferred portion as a residual. Additionally in this method, income and expense is recognized at the commencement of a lease while interest income is recognized during the lease term. Owners utilizing this method will make a reassessment of lease receivable when changes in lease terms equal adjustments to the residual asset, while a change in uncertain payments will be recognized as income.

For owners using the performance obligation approach, the lessor retains the leased asset on the balance sheet and recognizes a liability for the obligation to allow use of the underlying asset. The lessors will record the asset and obligation equal to the present value of lease payments to be collected during the lease term, which is similar to how a lessee records its lease. Also, the revenue is recognized as the lease is satisfied, while interest income is recorded by the interest method. The owner will continue to reassess the lease receivable when changes made to the lease term equals adjustments of lease liability or changes uncertain payments, i.e. contingent rents.

These proposed changes are going to have a significant impact on the real estate market, notes Antonopoulos. With the lease exposure changes, long-term leases may become a thing of the past. Lessees may insist on short-term leases or avoid the lease market by acquiring properties, while property owners may increase rents on short-term leases. Additionally, leasing commissions and management fees may increase if shorter leases become the norm. Possible shorter leases could negatively impact property valuation due to occupancy stability and continuity issues, as well.

The second major issue on the table is guidance for investment properties and investment companies. FASB is in the process of developing new guidelines on what is considered investment properties and what types of entities should be classified as investment companies.

“These changes are going to have a drastic impact,” says Antonopoulos. “Currently, all owners of real estate who record investments in real estate on their books are recording at historical costs. Now it’s going to change.”

FASB’s proposed changes will force all real estate companies to record their real estate investments on a fair value basis. Since there will be no exception to this policy, it will affect any entities that investment in real estate.

Beyond these proposed changes, real estate owners should have a few tools in their toolbox to continue to weather the sluggish economy. Owners should be aware of impairments, which could still take place due to the slow recovery. Impairments occur when the carrying amount of a long-lived asset exceeds its fair value. With possible tenant relocations, loan maturities and deficit cash flows, owners should keep impairments on their radar screen. Additionally, owners should be aware of the “going concern” part of an auditor’s process. Strong communication and cooperation between property management teams and auditors ensure that properties and companies receive proper assessments regarding their businesses and stability. Finally, and most importantly according to Antonopoulos, owners should receive appropriate appraisals for their properties.

“My biggest recommendation is to get an appropriate appraisal,” says Antonopoulos. “There’s a lot of subjective treatment [in the market]. An appropriate appraisal will save owners tons of time when dealing with auditors.”

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