On today’s show we are talking about a new rule under the generally accepted accounting principles that could profoundly affect the way commercial real estate leases are written in the future. If you’re a property owner where your commercial tenants sign multi-year leases, you need to pay close attention.
There is a new rule under GAAP that requires companies to disclose long term lease obligations on their financial statements.
For all leases with terms of more than 12 months, the revised standard requires a right-to-use asset to be added to the asset section of the balance sheet and the present value of the related lease obligations to be included as liabilities.
So let’s say you have just signed a 10 year lease with lease payments of $100,000 a month, of which there are, say 9 years remaining. You would be required to add a right of use asset on your balance sheet in the value of 9 x 1.2M or 10.8M. You would also have a liability added to your balance sheet in the amount of $10.8M. Next month that liability would be 10.7M, 10.6M and so on as you draw down the residual balance of the lease.
You might argue that there is no change really since the you’re adding an asset and a liability to the balance sheet and they fully offset each other.
However, not everyone looks at liabilities the same way. These changes could make lessees appear significantly more leveraged and cause unprepared entities to violate their loan covenants.
Remember, just because the generally excepted accounting principles have changed, doesn’t mean that banks and lenders are going to change their underwriting rules to accommodate the changes in GAAP. Many bank underwriting rules compare the loan amount to the total liabilities. If these long term liabilities now appear on the company balance sheet, it can change the way a bank looks at a borrower.