A Peek into the Shifting Leasing Landscape

By John Salustri

The leasing landscape is changing. Not so much in the transaction itself as much as what comes after (in the reporting) and, as a result, what comes before (in the preparation to remain in compliance). For the majority of industrial assets, the triple net deal is still the industry darling. How we report those deals, however, is now transitioning, thanks to the Financial Accounting Standards Board (FASB). And that implies a new measure of caution in how we approach certain deals and how they turn up on our books. We’ll get back to that shortly.

First, let’s explore the popularity of the net lease deal compared to other types. Kapil Kohli, Industrial Real Estate manager, North America, for Air Liquide, says the joy of the triple net comes in the “control it gives us.” With operational expenditures in the tenant’s hands (along with property taxes and, of course, rent), “I don’t have to rely on the landlord to provide vendor services,” and by choosing his own consultants, the Houston-based Kohli explains, he can make his own cost/benefit analysis.

But triple net deals are not universal, although they are by far the most prominent in the industrial space. Modified gross leases, for instance, aren’t totally foreign to industrial, but by no means are they in the majority of transactions.

“It’s a function of the custom and the culture of the local market,” says Carl Quesinberry, senior director of Avison Young Consulting Group in Cincinnati. “In most markets, office leases are gross and virtually all industrial leases are some form of net,” he says, and few tenants will enter an area with the intention of going against that local market expectation. “At the end of the day, the conversation comes down to who will be fronting the expense.”

What are the exceptions? Signing for a facility that isn’t built-to-suit could be one, where the tenant is taking on the landlord’s maintenance and structural headaches. “In an existing building, the tenant has to be careful about taking on the risk of such issues as roof repairs,” says AJ Magner, CBRE’s Cleveland-based EVP of Global Portfolio Services, “simply because the tenant wasn't there when it was built.”

In an absolute triple net, the tenant is responsible for such structural upkeep, and in the case of sale/leasebacks, “that’s pretty much the standard,” says Kyle Sals, first vice president of Corporate Capital Markets for CBRE. The Chicago-based Sals explains that this would make sense since “the occupiers are the most familiar with the building, and they’ll know what capital will be needed. Besides, if the risk is passed onto the investors, “they’ll want it priced into the deal for a net rate that’s more attractive to them.”

Coming to Terms

No surprise here, but we’re in the midst of a record-breaking landlord’s industrial market, and the numbers tell the tale: In large part to keep up with e-commerce demand, 432.1 million square feet of assets were absorbed in 2021, according to CBRE research. Neither is it surprising that “Asking rents rose to a record $9.10 per foot a year, 11 percent higher than a year ago. Rent growth is expected to remain at double-digits for the foreseeable future."

Compare that to the current, rather bumpy post-COVID office environment, where many office landlords can only hope for a long-term deal. If they get them, those leases are laden with termination clauses, put there by an as-of-yet unsure tenancy. The industrial dynamic is very different.

“Tenants aren’t thinking about termination,” says Sals. Just the opposite. “With such a scarcity of supply, organizations are trying to lock down those spaces.” He tells of one recent project where “the tenant sought a 10-year lease and the landlord countered with a seven in order to get to that renewal negotiation and mark-to-market sooner.”

The reality is that, “If you’re leasing a $50-million building in a good location, and you have $100 million in equipment invested in it, you’re less concerned about the flexibility of a short-term lease,” says Sals. “The priority is on locking up space long-term, and operational requirements are driving decisions more than the new lease accounting standards.”

Welcome to FASB 842

Ahhh, yes . . . the new lease accounting standards. After what has been a long-promised, longer-delayed change in methodologies, FASB has finally dropped what is now called Accounting Standards Codification, or ASC, 842. The gist of the new standard is to reflect all leases–even if they aren’t called leases, such as equipment rentals–onto your corporate balance sheet. Finding yourself on the wrong side of the new standard will also put you on the wrong side of Generally Accepted Accounting Principles (GAAP) and those who look for the presence of those standards in their financing. Think banks and investors.

Obviously, 842 not only deserves its own in-depth feature treatment. But here are some takeaways from IAMC members:

First, a closer relationship with your Finance department, or as Kohli puts it, “Corporate Treasury,” is key, as are greater communications with Legal and Procurement. This is especially true as companies review their leases for the transition in reporting. Holdings that were “once considered an expense will now be looked at as an asset.”

Not only will 842 alter your balance sheet reporting, but it will also likely work changes in your organizational reporting as well. As Kohli implies, formerly siloed departments will have to get to know each other and work together to comb through current in-place leases and contracts to develop an accurate reporting methodology.

In Kohli’s view, by the way, sale/leasebacks will demand particular attention, especially before a company pulls the trigger on a deal. A careful “buy-vs-lease analysis is critical,” he says. Treasury (or Finance) now needs the results of what Kohli calls this litmus test. “It’s always been a part of our methodology,” he says. “Now it’s even more critical to all of our decisions.”

According to Claudia Bassett, CPA, director in National Assurance at CohnReznick, there are a number of changes that will impact sale/leaseback accounting. First, “both the seller-lessee and buyer-lessor must assess whether the buyer-lessor has obtained control of the asset and a sale has occurred. Under ASC 842, most leases will be recognized on the balance sheet of lessees.” That being true, operating leases can’t be used as a source of off-balance sheet financing.

“Also,” she continues, “the seller-lessee and buyer-lessor separately determine whether control of the underlying asset is transferred to the buyer-lessor. Even though the same guidance is being followed, each party could reach different conclusions about the transfer of control of the asset.”

She provides a for-instance: “Lease classification could be impacted by differences in assumptions like economic life, the discount rate used and the fair value of the asset. Based on assumptions used, one entity could conclude that the lease is a finance or a sales-type lease while the other entity does not.” She notes that other changes can include “the removal of real estate industry-specific guidance and consideration if there’s a repurchase option.”

No matter the lease type, Magner emphasizes the need for inter-departmental collaboration: “Collaborate with the internal teams to achieve alignment on the accounting treatment as well as on deal negotiations to avoid accounting obstacles. We suggest that you start early to determine your accounting objective.”

Keep in mind as well that every company’s methodology for addressing the new standard, as well as any anticipated outcomes, are going to be different. “A customized strategy that best aligns with the owner’s and the tenant’s strategic plan is an essential part of managing FASB,” says Quesinberry. “This is not a one-size-fits-all situation.”