This Land Is Your Land

Changes afoot in lease accounting will have dramatic effects on retail and REIT balance sheets.

Imagine a world in which AMB Property Corp., which owns more than 100 million square feet of real estate, appears to lose all of the property on its balance sheet overnight. Or where Walgreen Co., the giant drugstore chain, suddenly sees $26 billion in operating leases weighing down its ledger.

This through-the-looking-glass world is just two years away from becoming reality. The Financial Accounting Standards Board, along with the International Accounting Standards Board (IASB), is hard at work revising accounting rules that currently allow companies to keep most of what they lease off their balance sheets. For real estate firms and the companies that lease from them, the outcome will be, on paper, dramatic inversions in property ownership. “You won’t see a rental company anymore,” predicts Tom Olinger, CFO of AMB, a San Francisco–based real estate investment trust (REIT). “You’ll basically see a finance company.”

FASB is scuttling FAS 13, the 31-year-old standard that defines capital and operating leases and spells out their accounting treatment. Unlike capital leases, which are generally used to finance assets, operating leases need not be recorded on the balance sheet, and often appear only in the footnotes of company reports. FAS 13 set the bar for operating leases relatively low, requiring them to last less than three-quarters of a property’s economic life, with future payments adding up to less than 90 percent of its value. Even so, companies have long been accused of using creative measures to ensure that their leases qualify as operating leases.

Two years ago, the Securities and Exchange Commission estimated that 63 percent of public companies used operating leases, compared with 22 percent for capital leases. Aswath Damodaran, a finance professor at New York University’s Stern School of Business, estimates that capital leases now account for just 10 percent of all leases. The SEC, which called for lease accounting to be revised in the wake of Sarbanes-Oxley, estimates that $1.25 trillion of (undiscounted) future cash obligations resides off the books.

Ratings agency Standard and Poor’s notes that if operating leases were converted to capital leases, hundreds of billions of dollars in assets and obligations would instantly hit balance sheets — potentially rattling capital markets. According to a 2006 research note from investment bank Bear Stearns, the aggregate debt of nonfinancial S&P 500 companies would rise by 17 percent if all leases were capitalized.

Some sectors will really feel the pain. “The order of magnitude would be greatest for large retailers,” says Mindy Berman, managing director of Jones Lang LaSalle, a real estate services firm. According to an analysis by Bill Bosco, head of consultancy Leasing 101 and a member of the international working group for lease accounting, 13 of the 20 companies with the largest holdings of operating leases are retailers. Home-improvement stores, big-box retailers, and drugstores are high on Bosco’s list.

Given Walgreens’s total current assets of $9.7 billion, adding $26 billion in operating leases to the company’s balance sheet would throw its ratios seriously out of whack. The drugstore chain is reluctant to speculate on that prospect. “We’ll have to see what happens,” says Michael Polzin, a spokesman. “The information [on operating leases] is already in our annual report. Whatever the regulations are, we’ll follow.”


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