The Boston commercial real estate market is in for some interesting discussions during the next few years, as new FASB accounting rules will quite literally change how leases are done worldwide.
By now, most of the real estate industry knows the basics. Starting in 2019, public companies will need to include all lease obligations with terms of at least a year on their corporate balance sheets (with private companies following suit the next year).
While the rules are quite different for domestic and international companies, the basic idea is that all the commercial lease commitments in the world will soon start flowing onto corporate balance sheets like a tidal wave.
There are a lot of accounting nuances to the new rules – far too many to cover in one blog post. But one of the big new rules means that Boston tenants and landlords are likely to be signing a lot more triple net (NNN) leases than they ever have before.
In Boston, the status quo has generally been Gross leases – where a tenant’s rent payment covers their rent, but also includes taxes, insurance, utility costs, maintenance and repairs, security, cleaning and pretty much everything related to owning and operating the real estate.
The other end of the spectrum is a NNN Lease. In this case, the rent payment covers ONLY the rent, and each tenant pays their own share of operating expenses, including taxes and insurance for the space.
Historically there were also single net, double net, triple net, and absolutely net leases. These terms are less common today and as with all contracts, the 4 Corners rules applies (i.e., only the words in between the 4 corners of the page count).
So how do the new lease accounting rules come into play? Why will tenants start asking for triple net (NNN) leases? What changes will this bring to the lease transaction process?
The new accounting rules will require lessee (tenant) companies to report the present value of the total remaining lease obligation on their balance sheets. But if the taxes and insurance are included in the rent, then they are part of the present value calculation and will raise the size of the liability that gets booked on the balance sheet.
When taxes and insurance are paid separately (i.e., NNN) and aren’t part of the rent, they generally won’t be reported on the company’s balance sheet. In major metropolitan areas where taxes exceed $10.00/SF, the additional lease liability could be more than $100.00 per square foot!
Here’s how this plays out.
In a hypothetical deal using very simplified numbers, let’s assume that Company XYZ signs a 10-year, 100,000 SF lease at $50.00 PSF Gross, which includes $10.00 PSF in taxes and insurance and $8.00 PSF for other operating costs.
To determine the balance sheet liability, the operating expenses of $8.00 PSF are deducted from the rent before the present value is calculated. (Technically the operating expenses are a “non-lease component” with an “observable” market price so they can be deducted.)
If we assume a 5% discount rate, the present value of the $42.00/SF ($50.00 – $8.00 = $42.00) rental obligation is $32.4M – which is the amount that would show up on the balance sheet.
If the same deal was structured with the rent net of taxes and insurance, the resulting rental obligation would drop to $32.00/SF and the PV would fall to $24.7M, a difference of $7.7M.
That means the liabilities from a Gross Lease are approximately 31% higher.
From a cash perspective, the costs are the same. But it’s very obvious which of those numbers companies will want showing up on their balance sheets.
Landlords and tenants in Boston are used to negotiating Gross deals, so managing a NNN lease may be unusual – and maybe even uncomfortable – for some companies used to the status quo.
Certainly some language in the leases will need to change, but the final economics for both sides don’t need to be very different.
This may be a rare case where tenants and landlords can agree to agree.