The new lease accounting standard, IFRS 16, is set to radically change the way real estate leases are recognised in financial statements and could fundamentally change the leasing market going forwards.
What’s at the epicentre of this shift?
Under the new standard all real estate leases will be brought on to the Balance Sheet as an Asset and Liability. The resulting changes to financial statements are likely to be share price sensitive.
Individual lease terms can have a significant impact on the scale of the Asset and Liability recognised on the Balance Sheet. Leasing decisions are therefore expected to come under greater scrutiny than ever before.
How will this impact the leasing market?
Put simply, the longer the lease term, the greater the impact on financial statements. For the lessee, negotiating a lease will become a delicate balancing act between the accounting impacts and operational requirements.
For assets that are critical to business operations, the benefits of a long-term lease may outweigh the negative accounting impacts. However, for properties used for non-business critical operations, it may be a very different story!
For landlords it’s not all bad news; in some cases lessees may be willing to ‘pay’ for shorter lease terms with higher rents.
I want my incentives NOW?
Upfront incentives, in the form of rent-free periods / rent reductions, have a strong mitigating effect on the accounting treatment of leases. In comparison, an equivalent rent reduction over the full lease term, or rent-free periods taken part of the way through a lease, will produce a less favourable outcome from an accounting perspective.
In this respect, it is likely that lessee and lessor objectives will be neatly aligned, with lessors generally preferring to grant upfront rent-free periods and agree a higher headline rent.
The impact of uncertainty?
Everyone knows uncertainty is bad for business, right? In accounting terms, it’s quite the opposite; being unable to predict future changes in rental income will help occupiers to mitigate the accounting impacts of their leases at lease start.
Leases with fixed uplifts provide the lessee with the ability to forecast rental outgoings over the lease term. However, they produce a significantly worse accounting impact than those leases with variable rent review mechanisms, e.g. indexation or market rent reviews.
In comparison, leases with variable rent review mechanisms offer an accounting benefit for the lessee. However, the lessee is less able to predict future changes in cash flows and the Asset and Liability that are created will have to be updated each time the rent changes.
As a result of changes to the accounting standard, infrequent variable reviews, such as the UK’s traditional 5-yearly market review, look rather appealing under IFRS 16, while index-linked rents with a collar offer the worst of both worlds; they require frequent updating and, as with fixed uplifts, produce a higher accounting impact.
For investors such as pension funds, who seek to match future outgoings with long-term index-linked income, this could spell trouble.
Seismic shift or minor tremor?
Today’s leasing decisions will have a direct impact on lessees’ financial statements from 2019. It is crucial that lessees make informed leasing decisions, in full knowledge of the accounting implications. Nonetheless, the fundamentals of supply and demand remain unchanged and it will be these that continue to drive the terms agreed rather than purely the accounting treatment.
So, seismic shift or minor tremor? While the changes are likely to rank relatively low on the Richter Scale, small aftershocks are anticipated…
Paul Fry is a Partner in Strategic Consulting EMEA at Cushman & Wakefield.
Paul specialises in supporting corporate occupiers with IFRS 16 implementation, strategic cost reduction and capital raising.
Our Strategic Consulting experts provide innovative real estate solutions to organisations with specialised requirements. Bringing together experts from finance, property and accounting, we support clients in the areas of Occupier Finance, Business Location & Incentives Advisory, Portfolio & Metro Strategy, Workplace Strategy & Change Management, Occupier Development, Centre of Excellence for Real Estate Analytics.