Lease Accounting Update: Key Considerations for Real Estate

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Transwestern's chief financial officer discusses the potential impact of the proposed lease accounting update on commercial real estate.

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Lease Accounting Update: Key Considerations for Real Estate

  1. 1. LEASE ACCOUNTINGUPDATE:KEY CONSIDERATIONSFOR REAL ESTATEOctober 11, 2012 | Houston, Texas
  2. 2. LEASES PROJECT STATUS Re-deliberations substantially complete in July 2012 Exposure draft expected to be issued in early 2013 120 day comment period Final standard to be issued in late 2013 Effective date not expected to be earlier than January 1, 2016However………………Alternative views continue to exist, which could further delay the process fromthe timetable above LEASE ACCOUNTING UPDATE 2
  3. 3. SIGNIFICANT PROPOSED CHANGESIN LEASE ACCOUNTING Separate treatment for real estate and equipment leases Lessees will place all leased assets on the balance sheet, with a corresponding liability. Lease asset and corresponding liability measured at present value and adjusted throughout lease termThese changes will impact real estate assets differently LEASE ACCOUNTING UPDATE 3
  4. 4. ACCOUNTING TREATMENT FORREAL ESTATE LEASES Separate treatment for real estate and equipment leases – A “Real Estate” lease is defined as a lease of an asset that doesn’t consume a significant portion of the asset’s useful life or the rental payments do not amount to a substantial portion of the fair value of the asset – Most traditional real estate leases meet this criteria. However, there could be exceptions: » Long-term leases (i.e. 25+ year leases) » Medium-term leases (10-20 year) with inordinately high rents – No guidance currently included in expected exposure draft on what “significant portion “ of assets useful life or “substantial portion” of fair value of the asset » Accountants are expected to default to current guidance of 75% of useful life and 90% of fair value when assessing this criteria LEASE ACCOUNTING UPDATE 4
  5. 5. ACCOUNTING TREATMENT FORREAL ESTATE LEASES Separate treatment for real estate and equipment leases – If the asset qualifies as a “Real Estate” lease: » Lessees will recognize expense as a single line item (“lease expense”) generally straight-line over the life of the lease. » Lessors will continue to recognize income as they currently do. – Assets that do not qualify as a “Real Estate” lease have different accounting » Interest expense component in all lease transactions » Expense is generally higher and front-end loaded » Lessors would be required to “de-recognize” leased assets at outset of transaction and accrete to a “residual asset” value at the end of lease term LEASE ACCOUNTING UPDATE 5
  6. 6. ACCOUNTING TREATMENT FORREAL ESTATE LEASES Lessees will place all leased assets on the balance sheet, with a corresponding liability. – For real estate leases, the value of the “right of use” asset and corresponding liability is calculated based on the present value of expected future lease payments » Need to consider future lease options, lease incentives, variable lease payments, and other cash flow impact lease terms in assessing present value » Present value is determined using a discount rate. For lessees, this will almost always be their incremental borrowing rate. This is defined as the rate the lessee would pay to borrow similar money over a similar term to purchase the asset LEASE ACCOUNTING UPDATE 6
  7. 7. ACCOUNTING TREATMENT FORREAL ESTATE LEASES Simple Example 1 – 3 year real estate lease, $1,000 per month over the life of the lease – Lessee’s incremental borrowing rate is 10% – Present Value of this lease is $30,991, which would be recorded as a right of use asset and lease liability on the lessee’s balance sheet Simple Example 2 – Same 3 year lease, but rent payments accelerate to $1,250 in year 2 and $1,500 in year 3 – Lessee’s incremental borrowing rate is 10% – Present Value of this lease is $45,625, which would be recorded as a right of use asset and lease liability on the lessee’s balance sheet LEASE ACCOUNTING UPDATE 7
  8. 8. ACCOUNTING TREATMENT FORREAL ESTATE LEASES Subsequent Accounting Treatment – Lease expense would be still be recognized straight-line over the lease term, as is done today – Right of Use Asset and corresponding Lease Liability are “amortized” using effective interest method, not straight-line In short, the biggest change most tenants will experience is the additional bookkeeping required to maintain the Right of Use Assets and related Lease Liabilities. LEASE ACCOUNTING UPDATE 8
  9. 9. WHAT SHOULD REAL ESTATELESSEES BE THINKING ABOUT Impact of adding assets and liabilities to balance sheet – Impact on loan covenants – Additional bookkeeping requirements/impact on systems Lease term structure LEASE ACCOUNTING UPDATE 9
  10. 10. WHAT SHOULD REAL ESTATELESSORS BE THINKING ABOUT Understanding the needs of their tenants and potential issues that may arise from the changes in accounting that have been proposedLessors were largely spared any significant accounting changes as it relates toreal estate assets LEASE ACCOUNTING UPDATE 10
  11. 11. QUESTIONS?STEVE HARDINGChief Financial OfficerSteve.Harding@transwestern.net713.272.1205www.transwestern.net

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