The Financial Accounting Standards Board’s (FASB) new lease accounting standard took effect for publicly traded companies, including REITs, at the beginning of 2019. REITs will now have to report on their balance sheets certain assets and liabilities implicit in leases with terms of more than 12 months. George Yungmann, Nareit’s senior vice president for financial standards, takes a closer look.
What will be the most obvious impact of the new standard?
The financial statements of REITs as lessors will not be significantly impacted. REITs as lessees will be required to recognize a liability representing the obligations under the lease agreement.
At the same time, the REIT will recognize a right-of-use asset representing the right of the lessee to use the leased asset. In addition, the new standard restricts the capitalization of leasing costs to only those leasing costs that are incremental in connection with executed leases.
This treatment of leasing costs will generally increase leasing costs that must be expensed, which will have a negative impact on performance metrics, including funds from operations.
How far along are REITs in adopting the new standard?
REITs have made substantial progress in analyzing the impact of the new standard and preparing to implement it. As REITs planned the implementation of the new standard, several issues arose. These issues were discussed with Nareit and communicated to the FASB both in letters and meetings with board members and FASB staff. After considering the issues, the FASB modified the standard to resolve a number of the issues.
What is the most challenging aspect in terms of making the change?
The standard requires that the lessee’s lease liability (and corresponding right-of-use asset) be measured as the present value of future lease payments. The discount rate to be used is required to represent the lessee’s incremental rate for a similar borrowing.
This requirement presented a significant challenge to REITs that are lessee’s under very long-term ground leases. The complexity around determining the required rate lies in the fact that the instrument for which the lessee is trying to determine an incremental borrowing rate, e.g. a 99-year ground lease, may not exist.
Do you anticipate the new standard could have a knock-on effect on the number and type of leases that companies enter into going forward?
We have not identified any knock-on effects of the new standard. As the new leases standard was being developed, lessors expressed concern that lessees may modify their leasing strategy to press for shorter-term leases in order to reduce the lease liability that is required to be recognized on their balance sheets. There has been no indication at this time that lessees will attempt to negotiate shorter lease terms.