Aligning the numbers when comparing multiple leases during Lease Negotiation

In a previous Blog posting, we introduced our readers to the Lease Analysis component of iLeasePro, our comprehensive lease management technology solution specifically designed for lessees. We indicated that Lease Analysis is an invaluable tool that supports lease negotiations and lease reassessment by providing the user with the technology for evaluating all the financial terms and conditions associated with alternative leasing opportunities and facilitating an “apples to apples” comparison of those alternatives.

A narrative description can only do so much to explain the capabilities of Lease Analysis, therefore, in this whitepaper, we present an example of a proposed transaction and how Lease Analysis can be utilized in the decision making process.

Our example company, Acme Holdings (”Acme” or “the Lessee”) must expand its operations and is evaluating three office locations with 10,000 square feet of available space. Acme has decided on a seven year lease term with no options periods and has determined that it will require tenant improvements (“TIs”) of $30 per square (total of $300,000) to outfit the space to its needs.

Lease 1 rent payment is for $25 per square foot in the first year increasing $1 per square foot each year to $31 in the final year of the lease. The landlord will not provide any TI allowance and there are $50,000 of other lease costs that must be paid by the Lessee. Additionally, for Lease 1, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $82,813 over the seven year term of the lease based upon the base year costs and its 15% pro rata share of the property.

Lease 2 has twelve months of free rent in the first year of the lease with rent of $35 per square foot beginning in the second year and increasing $1 per square foot each year to $40 in the final year of the lease. The landlord for Lease 2 will provide a TI allowance of $150,000 with $10,000 in other lease costs that must be paid by the Lessee. For Lease 2, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $51,529 over the seven year term of the lease based upon the base year costs and its 10% pro rata share of the property.

Lease 3 has rent beginning at $30 per square foot in the first year and increasing $1 each year to $36 in the final year of the lease. The landlord here will fund a TI allowance of $300,000 and there are other lease costs of $20,000 to be borne by the Lessee. For Lease 3, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $99,376 over the seven year term of the lease based upon the base year costs and its 15% pro rata share of the property. Acme is using Lease Analysis to evaluate these alternatives and, in order to produce a comprehensive due diligence analysis, only certain basic information is required to be entered into iLeasePro, namely, property/unit description, square footage, lease term, rent payments, expense chargeback estimates, TI requirements, TI allowances, other lease costs, amortization period for TIs and other lease costs and a discount rate for present value calculations. Here Acme is using 6% as the discount since this is its cost of borrowing.

Lease Analysis produces the following report for the evaluation of the three alternatives.

Commencement Date

1/1/2014

Expiration Date

12/31/2020

Lease Term (Months)

84

Lease Term (Years)

7

Rentable Square Feet

10,000

Discount Rate

6.0%

 

 

 

Lease 1

Lease 2

Lease 3

Property Sq Ft

150,000

100,000

150,000

Lessee ProRata for CAM

15%

10%

15%

Base Rent PSF

$25

$35

$30

Base Rent Annual Amount

$250,000

$350,000

$300,000

Free Rent Months

0

12

0

Free Rent Amortization

0

12

0

Tenant Improvement Allowance PSF

$0

$15

$30

Tenant Improvement Allowance

$0

$150,000

$300,000

Tenant Improvement Total Cost

$300,000

$300,000

$300,000

Tenant Improvement Cost Amortization

84

84

84

Other Lease Total Cost

$50,000

$10,000

$20,000

Other Lease Total Cost Amortization

84

84

84

Rent Payments (PSF)
2014

$250,000

$0

$300,000

2015

$260,000

$350,000

$310,000

2016

$270,000

$360,000

$320,000

2017

$280,000

$370,000

$330,000

2018

$290,000

$380,000

$340,000

2019

$300,000

$390,000

$350,000

2020

$310,000

$400,000

$360,000

Base Rent

$1,750,000

$2,450,000

$2,100,000

Escalations

$210,000

$150,000

$210,000

Free Rent

$0

-$350,000

$0

Annual Rent Payment

$1,960,000

$2,250,000

$2,310,000

Present Value of Annual Rent Payment

$1,643,100

$1,835,657

$1,938,964

Average Annual Rent Payment

$280,000

$321,429

$330,000

Net Effective Annual Rent Payment

$277,676

$310,217

$327,676

Expense Chargebacks

$82,813

$51,529

$99,376

Tenant Improvements

$300,000

$150,000

$0

Other Lease Costs

$50,000

$10,000

$20,000

Total Costs

$432,813

$211,529

$119,376

Total Annual Rent Cost

$2,392,813

$2,461,528

$2,429,376

Present Value of Total Annual Rent Cost

$2,004,753

$2,011,845

$2,034,817

Average Total Annual Rent Cost

$341,830

$351,647

$347,054

Net Effective Total Annual Rent Cost

$338,794

$339,992

$343,875

 

Notice that the report displays all the critical information necessary to evaluate the lease alternatives.  The calculations of annual rent payments and annual rent costs include amortization of rental concessions, TIs and other lease costs over the term of the lease. Especially helpful are the present value and the net effective rent calculations to determine the true cost of the alternatives.  In evaluating the three alternatives, Acme has a number of variables to consider.

Lease 1 presents the lowest rent payments and notice that when other costs, such as outlays for TIs, other lease costs and expense chargebacks are considered, the total cost, average rent cost and net effective rent for this alternative are also the lowest on both an absolute and present value basis. However, with this option, Acme must make upfront cash payments of $350,000 for TI and other lease costs .  In Lease 2, Acme gets the benefit of free rent for the first year of the lease and a $150,000 TI allowance so the cash requirements in the first year are the lowest among the three alternatives. However, rent payments increase substantially over the term of the lease and total cost, average rent and net effective rent, on both an absolute and present value basis, are higher than Lease 1. Lease 3 presents the highest rent payments but also has the highest TI allowance and a rather modest amount for other leased costs. The resulting total cost, average cost and net effective rent are also higher than Lease 1.

Which lease options should Acme choose?  The answer may not be as obvious as it seems.  The initial choice might be Lease 1 because of the lowest cost results for most of the metrics. But cash payments early in the term of the lease may be a critical factor to an organization that has cash flow concerns. That might make Lease 2 or Lease 3 a more attractive alternative. Maybe Lease 2 is in a more prestigious location than Lease 1 and justifies the extra $1,198 per year effective rent.  Conversely, perhaps Acme has substantial cash at the beginning of the lease term and wants to have as low cash payments as possible over the term of the lease.  In addition, Acme may know that it will be likely to renew the lease after the seven year term and may want to enter into those negotiations with the lowest rent payments in the seventh year of the lease term. Once again, that might make Lease 1 a likely choice.

We are not here to draw a conclusion in this example. We cannot possibly know all of the considerations that would enter into a final conclusion. However, we have demonstrated that Lease Analysis can provide the user with an easy to evaluate, side by side comparison of all the relevant information necessary to draw a conclusion based on its business needs and situation. Too many times, lessees focus on only one aspect of a potential transaction when making a decision – the annual rent payments. But the other costs associated with the transaction should not be overlooked. For example, the negotiations involving the TI allowance or free rent are often critical issues for most office leases. A healthy TI allowance can mitigate much of the cost associated with setting up or moving an office. Free rent can be a critical factor for a start up entity.   Lease Analysis can be instrumental in helping the user determine how these aspects of the lease fit into the overall negotiations.

Too often lease management systems do not consider the need for a technology solution to assist in sorting out all the critical issues associated with evaluating lease alternatives and providing the user with the statistical tools for an effective negotiation. In fact, this is the most important part of the process – understanding all the aspects of the alternatives and getting the best deal. In planning iLeasePro, we were determined to develop an end to end technology solution that provided critical assistance to the user during the full life cycle of the lease. Our Lease Analysis component provides that type of critical assistance.

Lease Accounting Update January 2013: Lease Components in a Single Lease Contract

The FASB and the IASB (“The Boards”) met on January 30, 2013 to continue further deliberations on the Lease Accounting Project. The discussions were narrowly focused on the instances where multiple lease components are contained in a single lease contract. As examples, multiple pieces of equipment could be leased under a single lease contract, a single lease contract could contain both property and non-property components or land and building(s) could be leased under a single lease contract.  The central issue discussed revolves around whether individual lease components in a single lease contract must be accounted for separately. The Boards tentatively concluded that for components that are distinct from other goods and services in the lease contract and the components are not customized to meet the particular needs of the customer, those distinct components should be accounted for separately. A single lease that contains components (for example, property and non-property) that are customized and integrally related would be accounted for as a single lease contract. Land and building(s) contained in separate lease contract would be treated a single component and would not be allocated (a difference from current GAAP treatment).

For a lease contract that contains both property and non-property and must be accounted for as a single component, an additional issue deliberated was which lease classification test would apply in these circumstances. The Boards tentatively concluded that the lease classification of the primary (predominant) asset would determine the lease classification. Therefore, if the equipment was deemed to be the primary asset, the presumption would be that the accelerated amortization method would be used whereas if the property was deemed to be the primary asset, the straight-line method would be presumed to apply.

From the previous example, it is clear that any technology solution that a lessee chooses to employ to comply with the new lease accounting standard should be capable of tracking and accounting for both property and non-property (equipment) components. We at iLeasePro have anticipated this need and are developing our lease management and accounting technology product as an integrated solution for both property and equipment.

The Boards additionally indicated that they plan to issue a revised Exposure Draft (“ED”) by the end of March 2013 which will be open for comment for a period of time. Redeliberations and discussion of comments on the revised ED will begin in the second half of 2013.

Lease Management and Accounting Tool

We have some exciting news to share with all of our readers.  iLease Management LLC will soon launch a lease management and accounting tool that will meet the critical needs of lessees as they react to the new lease accounting standards and continuously try and gain efficiency in their day to day operations.  As we have emphasized a number of times in the past few months, an accounting change of the nature being proposed provides a perfect opportunity to review and improve operating procedures.  We are confident that we are developing a technology solution that will accomplish that objective.  Some of the features and capabilities of this tool are as follows:

  • Dashboard – provides the user with the capabilities to see a high level view of all lease portfolios and critical dates.
  • Property – provides key property metrics and details.
  • Unit – drills down another level to provide critical unit level details.
  • Lease– captures important lease information that will facilitate effective lease management.
  • Rent– provides all critical rent information including base rent, free rent and rent steps.
  • Insurance – captures key insurance information.
  • Lease options – allows the user to effectively monitor option terms and conditions.
  • Accounting – using the information that has been previously input, the accounting feature automatically generates the accounting entries that will be required under the new accounting standard, both by individual lease and in the aggregate.  The user can export these transactions and is then ready to post these entries to the general ledger.
  • Reporting – a full suite of Lease Management and accounting reports

Additionally, the user will have the capabilities to capture key information on retail leases, maintain critical contact information, define critical dates, add specific and customized information on unique lease options and clauses and attach images and key documents.

As you are aware, we are monitoring the FASB/IASB activities and developing the accounting solution to be consistent with the new standard. We expect the tool to be available as soon as possible after the new standard is released.  We have been working on this project for a number of months and will keep you updated on our progress.  Our product will make a significant improvement in your operations.

In the meantime, we are interested in your comments and feedback.  Please update the Blog with your questions, comments and needs for additional information. Additional information can be found on the iLeasePro homepage.

LEASE ACCOUNTING CHANGE EXAMPLE

LEASE ACCOUNTING CHANGE EXAMPLE

iLease Management LLC monitors and reports on the progress of the proposed changes to lease accounting.  The FASB and the IASB issued an Exposure Draft in 2010 which generated a significant amount of controversy among preparers and users of financial statements. The Boards continue to meet to evaluate the more contentious issues and are considering changes to the Boards’ original proposal, particularly in such areas as lease renewal options and contingent rents.  Included is a simplified example of how we expect the current changes to impact the accounting process and reporting for a basic real estate lease.  This example does not take into account many of the more complex and subjective areas of the original Exposure Draft dealing with subjects such as lease renewal options, contingent rents, residual value guarantees and term option penalties.    

To illustrate the impact of the proposed new lease accounting model for lessees, consider the following example:

Assumptions

  1. A four-year non-cancelable lease term:  48 months
  2. Minimum monthly lease payment:  $1,000
    1. Assuming there are no defined lease options, contingent rental payments or residual value guarantee
    2. Incremental borrowing rate:  7%

Calculated Amounts

Present Value (PV) of lease payments = $42,000

Total lease payments over the 48 month term = $48,000

Balance sheet analysis

Under current GAAP Accounting for an operating lease where rent is accounted for in the current period

Existing US GAAP
  At inception End of Yr 1 End of Yr 2 End of Yr 3 End of Lease Term
No asset $0 0 0 0 0
No liability $0 0 0 0 0

 

Under the proposed guidelines, there is an increase in assets and liabilities.

Proposed Model
  At inception End of Yr 1 End of Yr 2 End of Yr 3 End of Lease Term
Assets          
Right To Use Asset $42,000 31,500 21,000 10,500 0
Liabilities          
Rent Payable $42,000 32,600 22,450 11,600 0

 

Profit and loss statement expense analysis

Under the proposed model, the right to use asset is amortized to expense over the term of the lease and the rent payable liability decreases as rental payments are made. 

  Year 1 Year 2 Year 3 Year 4
Existing US GAAP        
Rental Expense                                       $12,000 12,000 12,000 12,000
         
Proposed model        
         
Amortization of Right To Use Asset $10,500 10,500 10,500 10,500
Interest Expense $2,600 1,850 1,150 400
Proposed Expense $13,100 12,350 11,650 10,900

 

Accounting entries under the proposed model would be as follows:

  Debit Credit
Accounting by lessee – at inception    
     
Right To Use Asset $42,000  
Rent Payable                                           $42,000
     
Accounting by lessee – year 1    
     
Amortization Expense $10,500  
Right To Use Asset   $10,500
     
Interest Expense $2,600  
Rent Payable   $2,600
     
Rent Payable $12,000  
Cash   $12,000

 

In the profit and loss statement, rental expense under existing US GAAP becomes a combination of amortization and interest expense under the proposed model. Expense under the proposed model is higher in the earlier years of the term of the lease due to interest expense calculated using the effective interest method applied to a declining outstanding balance of rent payable.

In addition to the reporting changes to the balance sheet and P&L report identified above, firms should evaluate the impact to;

  • Current accounting processes
    • Lease Accounting system/software
    • Income tax impact
    • Financial Ratios
      • Increase in EBITDA
      • Return on Assets
      • Debt-to-Equity
      • Interest Coverage
      • Operating Margins
      • Debt covenant compliance
      • Ability to secure financing
      • Integrity of lease information
      • Resources required  

iLease Management LLC will continue to closely monitor and report on the decisions of the FASB/IASB Board meetings on the lease accounting changes.

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