Copyright: David Lawson - Property Week Feb 2001
A chink of light emerged last month from a gathering cloud that threatens to throw the property industry into turmoil and force occupiers to reassess the cost of vast amounts of space. New rules were anticipated by the end of next year which force tenants to include the true cost of premises in their accounts. This could turn the traditional UK long lease into an albatross and drag seemingly healthy concerns into dangerous waters. The bad news is that these changes are still on the agenda. The slightly better news is that they could be pushed back by at least another couple of years. This provides extra breathing space for occupiers and investors to assess the potential impact. Whether they take that opportunity is another matter.
The threat has been known for at least two years but the response so far has been muted. Whenever the matter arises at conferences and seminars, many delegates act as if it is the first time they have heard about the changes. ‘But there is some evidence that people are thinking about the implications,’ according to Mike Ringer of Fraser Corporate Real Estate. ‘Occupiers have been complaining about long leases since the recession but they now have something tangible to focus on.’
The proposed changes stem from attempts to unify the way companies in different countries record property in their accounts. This has become more urgent with widespread globalisation, forcing occupiers to draw up different sets of figures for various countries. Pressure for a more vigorous approach to non-core assets has also contributed to the need for change, as a range of techniques are being tested for handling property.
Accountants want to eliminate the distinction between operational leases for real estate lease and the finance leases for things like cars and photocopiers. That means bringing both benefits and future discounted costs onto the balance sheet. It might seem insignificant when benefits balance out costs but this would have a substantial impact on factors such as gearing, dragging down the credit rating of some companies. It would also put heavy pressure on landlords to shorten leases far below the traditional UK standard.
A group called G4+1, which represents accounting bodies in the UK, US, Canada, New Zealand and Australia, has been mulling over the implications since publishing a discussion document drawn up by the UK’s Accounting Standards Board in late 1999. But after a meeting in London last month, it appears that a lot more mulling is required. ‘There are a lot of complex issues to be considered,’ says Kimberley Crook, project director at the ASB.
Administrative changes are also intervening, with a new chairman at the ASB and a reorganisation of the International Accounting Standards Committee in the pipeline. The first step of publishing an ‘exposure draft’ – commonly nicknamed a FRED - is unlikely until late this year. This would need widespread discussion and even if new rules were implemented, there would be a long period for implementation.
The IASC is even less committed to an early change. Spokesman Jim Saloman says: ‘There has been no decision to proceed on the development of a new standard. It is, therefore, almost certain that there will not be a new one in place by the end of 2002.
‘If the IASC decides to work on the development of a new standard, the material in the G4+1 document and comments received on it would be considered. Our board would, though, also consider alternatives. A final standard may or may not contain recommendations similar to those in the G4+1 document.’
Accountants want to eliminate the distinction between property and other assets. Bricks and mortar are virtually hidden from sight because they are considered operational leases, which get scant mention in the accounts. Finance leases are shown as both assets and liabilities.
The ASB reports that it has had ‘considerable support’ for removing the differences. ‘It does seem ridiculous that the BMW in your car park goes in the balance sheet but not the far more costly building you are sitting in,’ says Mike Ringer of consultants Fraser CRE.
The impact on occupiers could be far-reaching as property comes back on the balance sheet and impacts on gearing, possibly breaching banking covenants A simplified balance sheet constructed by Alex Ward of Chesterton Structured Finance and Lynette Lackey of BDO Stoy Hayward at the Henry Stewart conference Corporate Real Estate 2001 last month[FEB] shows how important this could be.
Rent £100,000 pa for 20 yrs (NPV £936,000 at 10% discount)
Current assets £500,000 Current Liabilities £400,000
Fixed assets £500,000 Long-term liabilities
(bank debt) £100,000
Net assets £500,000
------------ ----------
£1,000,000 £1,000,000
Gearing 20%
Solvency 50%
Leverage x 2
Current assets £500,000 Current Liabilities £400,000
Fixed assets £1,436,000 Long-term liabilities
(bank debt) £100,000
Lease liabilities £936,000
Net assets £500,000
------------ ----------
£1,000,000 £1,000,000
Gearing 207%
Solvency 26%
Leverage x 3.9
Companies will have to re-assess the benefits of sale-and-leaseback as deals done today will come back to affect their financial standing, says Ward. He is particularly worried about high-profile activity such as Sainsbury’s efforts to move property off the balance sheet.
Break clauses:
These will be more attractive than sale-and-leaseback, says a study by Ringer and Jeffrey Unerman, an accountancy lecturer at King’s College, London.
Rents:
But they will not come cheaply in areas where supply is tight, so rents will rise. In less active markets, occupiers will aim to defer their rights rather than losing the chance of breaks.
Owner-occupation:
May become more popular but may not overcome all the disadvantages of accounting changes.
‘Synthetic’ leases:
These have been created in the US to minimise the impact on balance sheets but Jones Lang LaSalle has warned that it could be dangerous consider them before even draft rules have been prepared
PFI:
Another danger area. Contracts which include packages of services have been touted as a loophole but JLL warns that the rules could change again in future and these were not recommended ‘until there is greater clarity’.
This illustrates the dilemma faced by occupiers: they should be acting now to minimise potential impact because even though changes may be some years away, they will be retrospective But so many uncertainties remain that no one course of action appears a cast-iron solution.
The one thing everyone agrees is that the impending changes will increase pressure for shorter, more flexible leases so occupiers have room for manoeuvre. But they will have to pay a price in premium rents.