December 27, 2010

Renewal options under the new FASB

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses renewal options under the new FASB.

This is the fourth in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.
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December 13, 2010

Letter to FASB on the Proposed Lease Accounting changes

The following is a letter on behalf of Lucernex, Jim Duport, our in-house real estate finance expert, sent on December 7th, 2010 to FASB in response to the proposed changes to the lease accounting standards.

Re: Proposed Account Standards Update – Leases (Topic 840)

Technical Director
Financial Accounting Standards Board
File Reference 1850-100, FASB
401 Merritt7
PO Box 5116
Norwalk, CT 06856-5116
sent via email to:
Director@FASB.org
Subject: File Reference 1850-100, FASB
Dear FASB,This letter is being written relative to two questions:
Question 8: Lease term
Question 9: Lease payments

In addition, I would like to offer FASB/IFRS a complimentary copy of our software, Lx LseMod Corporate v15. It was prepared with the assistance of our CPAs and reflects our interpretation of the proposed changes for leases. Since our software also includes a comparison of Current GAAP to the Proposed GAAP, you can easily see the impact of different scenarios.

In particular, Lx LseMod Corporate v15 includes exact day Transaction Date, exact day Lease Commencement and End Dates, and a 30-year initial lease term. You can include Percentage Rents, up to 30 additional years of renewal options, and exclude Executory Costs. All calculations are done on a monthly basis. To my knowledge Lx LseMod is the only commercially available real estate lease analysis product that includes all the features listed above.

My Background:
I was a corporate real estate manger for 18 years for two Fortune 500 companies. In 1996 I started selling a lease & scenario analysis software program called LseMod designed to do site selection financial analysis to ensure tenants were making an informed decision prior to executing a lease. Over the years, LseMod has been enhanced to be compliant with current GAAP, even to the point of incorporating GAAP accounting for subleasing.

With the proposed change to GAAP, we have completed a major upgrade to include the new proposed changes to GAAP and can quickly make changes as needed when the new GAAP is finalized. Since LseMod incorporates all the proposed changes, I am, in a sense, indifferent to the changes. Please view my comments as those of a corporate real estate manager, not as a software developer.

Question 8: Lease term
I am opposed to the inclusion of Renewal Options in the lease term. My reasons are as follows:

(1) In a 20-year retail lease with two “more likely than not to be exercised” 20-year renewal options, the total charge to the P&L for Right-to-Use and Interest Expense would include a discounted value of the year 60 rent. This year 60 timeline does not seem reasonable to me.

If the final document must include Renewal Options in the Right to Use calculation, consider capping the renewal term at 5 or 10 years maximum at the time of the Transaction Date, i.e. not a rolling 5 or 10 years since that would require a recalculation monthly and an adjusting entry to the balance sheet and the P&L.

(2) When is a Renewal Option actually exercised? Did the tenant exercise the renewal option as drafted, or was there a renegotiation including rent or lease term (as I believe is the case in many renewals) and although the lease was renewed, what really occurred was the term was extended and possibly the renewal rent and concessions changed from what the lease initially provided. How does a tenant determine if “past practices” include exercising the renewal option as written in the lease, or a renegotiation?

(3) In the real world, since having renewal options written into the lease will now adversely impact a tenant’s P&L, tenants will no longer negotiate for renewal options. A renewal option is a significant advantage to a tenant, a valuable intangible asset, and by not having the ability to include renewal options in a lease, the tenant is at a disadvantage in any renewal negotiation and the landlord has an advantage, Bottom line, including renewal options in the current lease Right-To-Use significantly weakens the tenant’s ability to get the best deal at the time of the renewal and ultimately will serve to adversely affect the value of the enterprise.

It seems to me the inclusion of Renewal Options is an attempt to reconcile U.S. leases with some international leases. For example, some international leases may be for 10 years with a right to terminate the lease after 5 years, a break clause. There is a significant difference between a right to terminate early and a renewal option. A work-around would be to apply the renewal concept as currently proposed, but only to leases with early termination/cancellation options so that the term and associated rents includes the term most likely to occur, i.e. exercise the break clause or lease the space for the full term.

Question 9 – Lease Payments
I am opposed to the inclusion of ALL contingent rental payments, in particular, percentage rent (typical in retail leases). My reasons are as follows:

(1) In my opinion, percentage rent is a Cost of Goods Sold. Just like Sales Commissions, percentage rent is a Variable Cost based on sales. If there are no sales, there is no percentage rent.

(2) Inclusion of percentage rent will require massive recalculation and reconciliation on a monthly basis, “the no accountant left behind act.” Not only will there be a monthly balance sheet reconciliation, but the P&L will need to be adjusted monthly based on a probable different forecast of sales and associated rents.

(3) If renewal options are included, then the percentage rent calculation is truly a wild ass guess since how does one forecast sales in 20 years? In 60 years?

Note: In the case of rent adjustments (increases) based on CPI or some other inflation factor, I agree that the inflation factor must be estimated and included in the Right-To-Use calculation. For example, if rent is at $30/sf/year and increases at 75% of the CPI, then the tenant should estimate the annual increase.

Thank you for taking the time to read my comments. Again, if FASB/IFRS would like a complimentary copy of our software, Lx LseMod Corporate v15, please contact me at jduport@Lucernex.com or 408-253-4067. Also, please note, the opinions expressed herein reflect my personal options and are not meant to reflect the opinions of Lucernex Technologies.

Sincerely,

James R. Duport
Lucernex Technologies
Plano, Texas

Past Blogs by Jim Duport

Thoughts on the proposed FASB GAAP lease accounting changes
5 GAAP Rules you need to know
GAAP in Commercial Real Estate Sublease Accounting
Go Beyond a simple and potentially misleading Cash Flow analysis
What is GAAP rent and how does it impact SOX?
Sale Leaseback transactions
The proposed FASB changes and the impact on the lease vs. buy decision
When is the Proposed NEW FASB / GAAP Cheaper in Year 1 vs. Old GAAP?
Renewal probability and the New FASB Rules

November 29, 2010

Renewal probability and the New FASB Rules

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses questions surrounding how renewal option probability will be calculated under the new FASB rules.

This is the third in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.

Under the proposed FASB rules tenants are required to estimate the probability of exercising their renewal taking into account past practices which includes assigning “more likely than not to occur renewal probability”. For example, assume a tenant has 30 offices with similar leases and renewed 20 of them and allowed the other 10 to lapse; then the past practice is to renew for 2/3rd of the portfolio of similar leases (66% probability of exercising). (more…)

November 15, 2010

Probability in New FASB Lease Accounting Explained

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses how probability used to be used with the new FASB rules.

This is the second in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.

In my previous life I was a math major (actually also a high school math teacher), but, more importantly, I have a friend who is a PhD in Math. I figured if I didn’t understand the probability in the multiple examples I have seen of the new PROPOSED FASB Lease Accounting, then others might also be having issues understanding it. (more…)

November 1, 2010

When is the Proposed NEW FASB / GAAP Cheaper in Year 1 vs. Old GAAP?

Lucernex real estate finance expert Jim Duport, after completing an upgrade to our core financial engine to support the new proposed FASB / GAAP rules, discusses an interesting finding – in certain circumstances, the new GAAP can be cheaper.

This is the first in a series of Blogs by Jim describing his findings during the process of developing the architecture within the core Lucernex financial engine to handle the new proposed FASB rules.

I started the substantial upgrade of Lx LseMod version 15, including changes to the core Lucernex financial engine, in July. After over 500 hours, it is virtually done. Since it includes a Transaction Date that can be different from the Lease Commencement Date (even exact days such as the lease starting on the 12th of the month), and Renewal Option Rent Calculations, I have been able to “test” a variety of real world scenarios under the Proposed New GAAP. Note: Lx LseMod provides for a 30-year lease term and 5 renewal options for a total of another 30 years. (more…)

October 4, 2010

The proposed FASB changes and the impact on the lease vs. buy decision

Lucernex expert Jim Duport discusses the potential impact of the FASB GAAP lease accounting changes on the lease versus buy decision.

The law of unintended consequences

A FASB goal is transparency and to match revenue and expenses including commitments of future expenses. Towards this goal, the PROPOSED FASB change in the GAAP lease accounting would require that the Rent Calculated (or estimated in the case of percentage rents) would be booked as an expense to the P&L and shown as an asset on the balance sheet taking into account “probable” renewal periods.
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September 20, 2010

Thoughts on the proposed FASB GAAP lease accounting changes

Lucernex expert Jim Duport discusses the proposed FASB GAAP lease accounting changes.

So, the GAAP rules for lease accounting are changing with the dual goals of increased transparency and full disclosure. Don’t panic yet. There are still a number of unanswered questions. FASB (the Financial Accounting Standards Board) released a DRAFT on August 17, 2010 with a request for comments by December 15, 2010. The implementation date has not even been set. I have heard dates ranging from 2012 through 2015.
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March 15, 2010

5 GAAP/SOX Rules You Need to Know

Lucernex expert Jim Duport discusses the 5 rules you need to know about GAAP/SOX. Learn more about Lx LseMod Corporate for lease analysis including GAAP impact.

1. Rent straight-lined over the term if rent increases are known.

Impact: First Fiscal year cost will increase

 

2. Landlord Tenant Improvement Dollars are shown as a net rent credit, and Total construction cost including Landlord’s TI Dollars are depreciated.

Assume: Construction cost is $30/sf, Landlord paying $21/sf
Old Days: Depreciate $9/sf (part paid by tenant)
Now: Depreciate $30/sf (tenant and landlord cost) Landlord cost shown as credit to rent spread over term Tenant’s capital stays at $9/sf ($30 – $21)
Why? Rationale – base rent includes landlord’s amortization of TI$
Impact: Reduces “rent” charged to the P&L
Increases depreciation
Changes EBITDA

 

3. GAAP rent starts with “beneficial use” GAAP rent starts earlier of when construction starts or lease commences

Assume: Lease starts March 2007, construction starts January 2007
Old days: Start paying costs in March 2007
Now: GAAP rent starts when you “use” the space e.g. January 2007
Why? Tenant, in essence, controls space since construction is for Tenant’s use
Impact: Potential double rent on financial statements during construction (if relocating)
First Fiscal year cost will increase
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4. Restoration amortized over term

aka – “make good” or in UK, called “dilapidations”
Old days: Adjust Cash Flow at the end of term to include Restoration cost
Now: FASB 143 requires the accrual of future liabilities, in this case Restoration / Dilapidations. The following applies if you choose to Apply GAAP Accounting.The methodology used is to estimate the cost now, then apply an inflation factor to estimate the cost at the end of the term, the Future Cost.

The Future Cost is then discounted to a Present Value. The Discounted Present Value of the Future Cost is straight-lined over the lease term AND an accretion expense is applied to the increasing liability. The accrual starts with the GAAP lease term since it represents a liability. Cash Flow needs to be adjusted to reflect the P&L liability and the payment of the actual cost at the end of the lease term

Impact: Increases average annual occupancy cost on P&L

 

5. Rules for sublease analysis write-offs have been further defined

  • Cost written off when decision made. When vacate space or if vacant, when decide to sublease
  • Costs include NPV of rental costs, depreciation write-off, estimated subleasing costs and sublease income
  • Income Statement (P&L) charged the NPV of write-off
  • Monthly, interest expense on declining balance of the NPV Write-Off charged to P&L
  • Declining balance determined by taking net monthly costs and
    interest expense, deducting that from the NPV write-off

 

GAAP Accounting

GAAP Comparison

Shameless Plug

Lx LseMod Corporate Lease Analysis is the market leading application for Corporate lease analysis, providing GAAP impact analysis within detailed P&L and Cash Flow projections. Companies like GE, MetLife, American Express and Robert Half use Lx LseMod Corporate for lease analysis making it the most trusted name in corporate lease analysis.

February 21, 2010

GAAP in Commercial Real Estate Sublease Accounting

Lucernex expert Jim Duport discusses GAAP sublease accounting.

GAAP Sublease Accounting

Summary of GAAP/FASB Accounting for a Loss Associated with a Sublease

Our interpretation of GAAP sublease analysis according to FASB accounting rules is as follows:
Overview: Start by determining the net present value of all rental costs including write-offs of depreciation and subleasing costs, offset by the sublease income (the NPV write-off). The Income Statement (Profit & Loss statement) is then charged the NPV write-off and it is charged an interest expense based on a declining balance of the NPV write-off, the accretion interest expense. The declining balance is determined by taking the net monthly costs (including sublease income) and the interest expense and deducting that cost from the NPV write-off.

Steps are as follows:

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February 14, 2010

Go beyond a simple and potentially misleading Cash Flow analysis

Lucernex expert Jim Duport describes the important of the P&L statement and compares use of Cash flow analysis vs P&L analysis.

Intended for Corporate Real Estate Managers and Tenant Rep Brokers.

 

Importance of P&L?

First and foremost, in a corporation the cost charged to a manager’s budget is the PreTax P&L, not the Cash Flow. Since performance evaluations and bonuses are based on budgets, it is important to know how the impact of an action (e.g. leasing space) impacts the budget.

Profit & Loss (P&L) is what companies use when reporting financial results. A company’s P&L is perhaps more important than its Cash Flow. It shows whether or not a business has achieved its primary objective – earning a profit.

You have probably heard people say, “Profitability is key.” Profitability is different from Cash Flow. Profitability is the number reported to Wall Street and quoted in newspapers in earnings per share (EPS).
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