Accounting Rules Will Drive Companies to Look at Shorter-Term Leases

If a fast-growing, growth-stage startup, desperate to find great office space, signs a 7-year lease at an average of $1 million per year in rent, nothing changes to the long-term liabilities in their financials. Now, the company is on the hook for a million dollars per year. What if they downsize? What if they need more space? It seems strange that the same company, whether they have seven years left on an office lease or one year left, doesn’t reflect that huge liability somewhere, encouraging companies to sign longer leases since they’ll get lower rates and more tenant improvement allowance at the beginning, and thus making the company look better in the short-term.

Well, the Financial Standards Accounting Board is five years into a project to change the standards around accounting for leases. While it isn’t finalized yet, the net effect is that companies are going to have to recognize assets and liabilities that come from lease transactions.

Here are a few ideas on how more transparent recognizing of leases will affect the market:

  • Lease terms will be shorter on average
  • Companies that can commit to longer terms, and the corresponding liability, will be given more concessions by landlords
  • Furnished, short-term office environments, like the Atlanta Tech Village, will see increased demand
  • Subleases will be more aggressively reviewed (and the flip side is that companies will look to get out of their liabilities more aggressively by subleasing space)

The amount of liabilities out there for companies with long, expensive commercial real estate leases is staggering. While a FASB change won’t cause the market to correct overnight, it will have a fundamental change on commercial real estate leases.

What else? What are some more thoughts on accounting rule changes that will drive more companies to look at shorter-term leases?

5 thoughts on “Accounting Rules Will Drive Companies to Look at Shorter-Term Leases

  1. I think this is just window dressing by the accountants, nothing changes from a cash perspective. I would guess that office space is becoming more competitive and forcing companies into longer term leases.

  2. How will landlord and banks react to shorter term leases though? If your major tenant won’t or can’t sign a longer term lease, won’t lenders penalize the owner in either a shorter amortization or a higher interest rate?

  3. As a commercial real estate professional, I have been following this process for many years. I have talked to many bankers and the bottom line is although the balance sheet will have to reflect the lease obligation, lenders will note the portion that is a lease liability but will not impact the company on financing. This accounting change is more for transparency.

  4. I always thought this was odd and agree with the changes in the accounting rules. Over time this should help companies and put pressure on traditional long term leases, at least the ones that focus on SMB clients. In a way the previous rules were made to benefit the commercial real estate interests and inflate the market by helping to hide collective liabilities. Acquirers of businesses already focus on lease length as a form of liability but now it can be formally part of the valuation process.

  5. David, great article! One thing to note though is your last point about subleases. The boards have decided that the assets from subleases cannot be netted against the liabilities from head leases. So companies will not be able to get out of their liabilities by subleasing space. As I said though, great article.

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