$4.5bn liability could impact commercial leases

9:57 AM Wednesday March 16, 2016 TrueCommercial

Anyone leasing office space, retail premises or industrial property needs to get to grips with a $4.5 billion liability that could affect their business.

That’s the advice from commercial real estate giants CBRE who say that, while IFRS 16 may not have the most exciting name, it is a new international accounting standard demanding attention from many New Zealand businesses.

Six years in the making, IFRS 16 will require leases to be carried on corporate balance sheets from January 2019. It is a material change in the way corporate occupiers will account for lease obligations, with most leases now coming ‘on balance sheet’.

Brent McGregor, senior managing director of CBRE, says the new standard is likely to bring significantly greater rigor around leasing decisions and reporting practices as most leases will move onto balance sheets as debt, in financial reporting terms.

McGregor says: “The current rent roll for commercial property in New Zealand’s main centres totals approximately $4.5 billion. Like it or not, for corporates required to report under IFRS, from 2019 a large part of this rent roll will be recorded on the liability side of corporate balance sheets.”

That will generate debate around a number of issues, including the market’s likely response, the potential for a swing towards property ownership over leasing and questions around optimal types of lease review and renewal provisions.

McGregor says physical need for leased accommodation isn’t likely to change significantly but, under the new regulations, banks and analysts will exert stronger influence on property leasing decisions.

Historically, long lease transactions in New Zealand have attracted tenant incentives which can substantially cover fit-out and other costs. With the pending rule change, there is speculation around what will become the ‘new normal’ in terms of lease length and the standard’s influence on future incentives.

Up until now, unless a particularly long lease was being contemplated, financial reporting considerations were not a driving factor in leasing decisions.

“How the rule change plays out in the property market will depend in large part on how banks classify rental liability in terms of corporate debt covenant ratios and in respect of listed companies,” says McGregor. “We expect analysts and bankers to ‘look through’ to the substance of the relevant transactions but it would be prudent for occupiers to engage with stakeholders early.”

Corporate occupiers should, if necessary, renegotiate debt covenants earlier rather than later to protect value.

He says there is “no need to panic” as the property market has three years to come to grips with the rule change – which has little impact on actual net cash flow in practical terms. However CBRE is advising lessees to be aware of the standard’s wider repercussions.

“On implementation the impact on net profit before tax (NPBT) depends on the mix of an entity’s existing lease portfolio and the transitioning option opted for under IFRS 16. However, in most instances, all else equal, NPBT won’t change significantly,” says John Schellekens, head of professional services at CBRE. “But EBITDA & EBIT will increase because rental expense will be replaced by interest, depreciation and amortisation.

“The more I think about IFRS, the more I think it could influence the market. The new standard is going to change the way companies balance their debt-equity ratios, and how they fund operations.”

John Holmes, director of structured transactions & advisory services with CBRE, says IFRS has the potential to change tenant behaviour because of the impact on balance sheets. When IFRS 16 comes in and lease costs are counted as a liability on the balance sheet, occupiers may seek shorter lease terms so balance sheet liability is lower than that from a longer lease.

“Generally, from a building occupier’s perspective, longer lease terms are more attractive, suggesting that, if we do see some shift to shorter lease terms driven by tenants, those buildings with existing long term leases in place will become more attractive from an investment perspective.”

“One trend we believe will emerge as a result of IFRS 16 relates to sale and leaseback transactions. In recent years we have seen a significant volume of these transactions. However, with the off-balance sheet motivation now removed, the low interest rate environment and the impact of capital gains, it is likely we will see fewer transactions of this sort.”

For those affected by IFRS 16, CBRE has a range of resources on the new standards and the implications and opportunities for property lessees, as well as a dedicated global task force on lease accounting in place.

McGregor says: “Start having the conversation, consider renegotiating debt covenants with your bank and, most critically, seek advice from property professionals and accountants about IFRS and how to balance lease economics and best use of capital in the new reporting environment.”