By Ed Muna
The Financial Accounting Standards Board (FASB) recently issued an update (ASC 842) that will require businesses to rethink how they structure real estate leases going forward. The code change, which will be implemented in 2019 (2020 for private companies), requires companies to put the capitalized value of their lease obligations on the balance sheet as a liability and asset (“Lease Liability” and “Right of Use Asset”). As it currently stands, almost all lease costs are limited to the income statement and might only appear on the balance sheet as a footnote. Because there is no grandfathering for existing leases and financial statements include a two-year look back, the decisions being made today will impact the financial statements of the future. This has many decision-makers taking a closer look at leasing transactions to see how this liability can be reduced.
The renewal option in a lease is one area getting a lot of attention and causing confusion. The new standard requires the calculation of the lease liability to include rent payments over a future renewal option term if the tenant is reasonably certain to exercise the option. This could potentially double the lease liability for a tenant entering into a 5-year lease with a 5-year renewal option. As a result, companies are beginning to scrutinize and weigh the benefit of seeking a renewal option during lease negotiations against the impact it will have on the balance sheet. However, this exercise may be both unnecessary and risky if the inclusion of the option does not meet the threshold required to be included in the determination of the capitalized value.
The determination of whether the renewal option needs to be included on the balance sheet depends on several factors, but can mainly be directed at economic incentives and the businesses dependence on the location.
From a traditional sense, renewal options were negotiated to establish economic incentives (i.e. 95% of market) for the tenant on a future extension to take into consideration the benefits the landlord receives by avoiding future vacancy. This economic benefit is one of the benchmarks that could be used to determine if a capitalized value of the lease should include a renewal option term.
The reality is most renewal options are now tied to market rent, and those supposedly offering below market economic terms include burdensome processes that make them unlikely to be exercised since they put the landlord in a strong negotiating position by forcing the tenant to commit to the extension before the economic terms are determined. Instead of exercising what options they might have, smart tenants are retaining a real estate broker to help them negotiate and get the best terms possible. Knowing this, the question then becomes should the renewal option be avoided altogether so the liability does not need to appear on the companies balance sheet. Unless the economic incentive is clearly spelled out, such as stipulating the exact rent, the better approach might be to accept a fair market rent option and use the option as a fall-back if good faith negotiations fail.
Site Specific Factors
While the perceived economic incentive on the rental rate might be avoided by going with a fair market rent option, another factor that needs to be considered when determining if it is reasonably certain a tenant will exercise a renewal option is their investment and dependence on the location. While every business needs to properly evaluate their situation with the accounting and audit team, there are some general assumptions and considerations to be made based on the type of user.
Office Users: For traditional office users entering into 3 to 10-year leases, there is very little tying you to your current location at the expiration of the initial term other than the inconvenience of a move. Your clients likely will not mind if you move down the street, and your landlord probably provided most of the funds needed to get the premises ready for your initial occupancy. Because of this, it seems fair to say you truly do become a free agent at the end of each contract term, and there is not reasonable certainty you will renew. Office users are therefore the least likely to be required to include a renewal option term in the calculation of the lease liability. The decision still needs to be evaluated on a case-by-case basis. For example, if the option is represented to be below market or the tenant invested significant money in the initial improvements, they may be more likely to exercise the renewal option.
Manufacturing and Lab Users: For laboratory, industrial or manufacturing users, your investment in the facility will factor into the likelihood of renewing. If the facility is being used for warehousing and did not require an extraordinary investment, you may be likely to choose to relocate for better terms or location at the end of the lease term. The situation may become stickier if you have made an investment in the facility with the intent that they will last beyond your initial lease term. This is not always easy to predict, but if it is reasonable to say you will strongly favor a renewal because of the dollars spent, you are probably looking at including the renewal option term in the determination of the capitalized lease value. Of course, the initial term of the lease will come into play here. If your investment in the facility has a 10-year life, the likelihood of exercising a renewal option is greater on initial lease term of five years than if your initial term was 10 years, since the argument can be made that in 10 years the value of your investment has been received.
Retail Users: On the opposite end of the office user spectrum is the retail user. While many tenants in retail are mobile, most are dependent on the location for customer loyalty and have made a significant investment in the improvements. Given this, it is unlikely they will move down the street after the initial term to save a few dollars on the rent. For these users, it would be hard to argue there is not reasonable certainness they would renew, and therefore options are more likely to be factored into the calculation of lease liability.
It is important to note that extended terms only need to be included in the lease liability if you have an option to renew. If an option doesn’t exist and you are very likely to occupy the premises long term, you still only need to use the current term to determine the lease liability.
The Risk of Forgoing a Renewal Option
So why not forgo the renewal option all-together and what are the risks of doing so? While landlords are normally happy to accommodate tenant extensions, the future is unpredictable. We have seen landlords refuse to extend tenants for a number of reasons, from wanting to accommodate a larger adjacent tenant to desiring to reposition the space for better long-term success (i.e. remodel and/or combine spaces). Without a renewal option, the landlord will be able to boot the tenant at the end of the term.
The bottom line is the decision to pursue or avoid a renewal option is one that should be done carefully and with input from your real estate advisor, accounting team, and auditors. Short-term decisions can prove to be long-term disasters if not done properly. At Hughes Marino we are helping companies better understand this risk and the impact it has on their bottom line, and would love the chance to assist you during this complex decision.
Ed Muna is a senior vice president of Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices in San Diego, Orange County, Los Angeles, San Francisco, Silicon Valley and Seattle. Ed heads Hughes Marino’s Lease Administration and Audit Service divisions and helps tenants address issues that arise during their occupancy. Contact Ed at 1-844-NO-CONFLICT or firstname.lastname@example.org to learn more.