Some surprises – like a birthday party or two friends’ engagement – can be good. But suddenly finding out your company’s income statement is going to take a dramatic hit this quarter is never one of them.
This surprise hit to earnings can happen when a company ends up booking “double rent” charges when the “possession date” of a new lease occurs before the expiration date of the old lease. Although it is simple enough to avoid physically taking leased space or paying cash rent before the old lease expires, the rent for accounting purposes can begin prematurely for a variety of reasons including deal structuring, lease language, and even the single action of a tenant employee.
So what is “double rent” and how can real estate professionals structure and implement deals to avoid it?
None of this information is really new. But with the roll out of new FASB accounting rules, these double charges will soon be showing up directly on companies’ balance sheets too – not just their P&Ls.
The spotlight will be on real estate organizations and their policies and procedures around lease administration. What might have been ignored in the past may become revealed in an environment of heightened scrutiny.
When Lease Obligations Need To Be Booked
Regardless of when the actual occupancy or cash rent commencement date of the space may occur, rent commencement (based on the lease possession date) for accounting purposes is deemed to happen when “a lessee has the right to use or control physical access to the leased property prior to opening for business (e.g., during the leasehold improvement construction period)1”.
That may sound straightforward, but there are numerous shades of gray in terms of how different companies may interpret that guidance internally.
Clearly, if the tenant gets the keys, hires its own contractor and directly oversees the build out of the space, the possession date will likely be deemed to have occurred when the tenant picked up the keys, accessed the premises, or starts their work.
At the other end of the spectrum, if the improvements are performed 100% by the landlord, based on plans included in the lease, with no intervention or management of the project by the tenant, the possession date will likely be the day the tenant picked up the keys and first enters the premises.
In between those two extremes, there are other possible accounting outcomes that depend on:
- actions of the tenant;
- company policy;
- the lease contract.
The combination of these three elements are lovingly called the “Facts and Circumstances” by auditors and accounting professionals. All three of those factors need to be coordinated to ensure all parties are on the same page with each transaction.
Lease contracts need to be worded specifically to avoid overlapping lease liabilities as much as possible. And regardless of what is written in the contract, tenant’s actions need to follow through as well. All it takes are a few employees going over to a new space to supervise construction or install wiring in order to force a lease onto the balance sheet early.
But strong internal controls and company policy are the biggest factor in avoiding surprises in how leases are accounted for.
We have one client that tends to start their new leases as soon as they become involved in the design of the space that the landlord is building for them. While this maximizes lease overlap across their portfolio, it also removes any uncertainty from the equation.
The Financial Pain of Double Rent Charges
For an illustration of how double rent charges can impact a company’s balance sheet, consider the following scenarios:
A tenant’s lease for their headquarters is expiring at the end of 2019 and they need to relocate as of January 1, 2020. For their 10-year lease, their rents will be increasing from $40.00/SF to $50.00/SF. In Scenario A, the tenant will control the build out of their new space and in Scenario B, the landlord will provide a turnkey build out. For simplicity with this example, we’ll assume that regardless of which route they choose, the build out will take a full 12 months to complete and all rental rates, incentives and other deal terms are constant.
In Scenario A (red), the tenant triggers the lease commencement for accounting purposes as soon as they entered the space to start work because they had the “right of use or control” and physically accessed the premises a year before the cash rent commencement.
In Scenario B (blue), the tenant deferred the “right of use or control of physical access” by structuring a turnkey build out within the lease. Therefore, they don’t have to start recognizing their rent until the official commencement (and occupancy) date a year later.
The cash rent doesn’t change. But overlapping the rents for a full year (Scenario A) means that for the final year of the old lease, the company will book rent charges of over $85.00 PSF during the last year of the old lease.
But after that first year, the accounting rent in Scenario A is actually 9% lower ($45.45/SF) than Scenario B ($50.00/PSF) due to the fact that the lease term started a year earlier and the total rent ($500.00/SF) is averaged over a longer period (11 years instead of 10).
So this is, in fact, a double-edged sword. If the tenant can stomach the initial hit on their balance sheet and EBITDA, they reduce their straight-line rent expense by more than 9% for the remaining 10 years of the lease.
Again, the concepts laid out there are nothing new. But with the new FASB accounting rules ramping up, charges will also move onto the company’s balance sheets – where a new level of scrutiny awaits.
Accounting for leases is going to get more challenging as the new lease rules come into play, and there are still plenty of complications in the existing rules that needs to be properly managed including the sometimes elusive concept of the lease possession date.
Companies need to ensure they have strong internal controls in place to properly recognize lease data, and understand what the impact of overlapping lease terms might be.
After all, financial statement surprises are rarely greeted with balloons and cake.
1From EY Financial Reporting Developments Revised December 2016 (Page 101) – To read the full guidance, you can register and download here.