Most U.S. companies lease equipment or real estate for their operations, the study asserts. Generally, it says the changes would depress company profits, retard economic growth and add to financial instability. U.S. companies would add an estimated $2 trillion to their balance sheets, increasing overall debt by 11%. This added debt would affect companies’ ability to gain financing. And elevated debt-to-equity ratios will affect corporate earnings. The study says the proposed changes could result in a $96 billion reduction in the equity of U.S. firms overall.

Front loading, which recognizes greater lease payment expenses earlier on, will reduce companies’ earnings and capital. Balance sheets will reflect more assets (the capitalized leases) more debt, and less equity.

Additionally, companies will need to pay for professional guidance to make the adjustments.
Companies in industries that rely more heavily on operating leases, such as retail, transportation, banking and telecommunications, are likely to bear more of the impact.

A wave of uncertainty will roll over the financial world as key metrics change that are useful for financial analyses such as company valuations, peer to peer performance comparisons, credit worthiness and capital requirements.

“Perhaps the most significant unintended consequence of the new regime could be a shift in the lessor-lessee dynamic,” the report points out. Lessees, seeing a loss of advantage in long term leasing, are likely to seek shorter leases or choose to buy outright instead of continuing their leasing strategies, all creating risk for owner/lessors, and possibly inflating the cost of leasing generally.

Exemplifying these points, the study analyzed the impact that the proposed changes would have had, if they had been implemented in 2010. It found that $2 trillion in assets and a corresponding level of debt would have been added to company balance sheets, and that income for U.S. corporations would have declined by $32 billion, or 2.4% as a result of front loaded recognition of lease payment expenses.

Contributed by:
Chris Campbell
Managing Director
Net Lease Capital Advisors
ccampbell@netleasecapital.com

http://www.areadevelopment.com/AssetManagement/April2012/corporate-sale-leasebacks-low-financing-26262511.shtml

In her Nov. 16, 2011 CFO Journal article “Firms Resist Accounting Plan,” Emily Chasan cites analyst estimates to say that the accounting change would add a total of $1.7 trillion in current liabilities to corporate balance sheets.

Moreover, the proposed measures to equate leasing with buying for accounting would require companies to use “front loaded” accounting, which recognizes greater portions of each lease payment as expense in the earlier years of the lease, just as the interest component of loan payments are greater in the earlier years of a loan.  (By contrast, straight line accounting spreads the expense costs evenly over the lifetime of a lease, like rent payments.)  So companies’ income statements will reflect less net income in the earlier years of a lease.  According to Chasan, front loading also raises lease expenses, over all.  While frontloading can be seen as beneficial for tax purposes, since it results in greater deductions earlier, it might be seen as problematic for companies trying to show higher returns and profitability to shareholders.

Front loading especially affects retailers who rely heavily on leasing property, since they require numerous properties as outlets for their businesses.  (CVS drugstore, for instance, leases 95% of its retail stores according to its own December 2011 report to FASB as sited by Chasan.)  Chasan explains that for retailers, the greater value of a lease is actually found in its later years, since retailers require time to build name recognition and clientele.  So the expensing method does not accurately reflect the way many retailers value their leases.  Chasan cites Bill Bosco, a member of the IASB’s working group on lease accounting.  He estimates that Walgreens, which leases 79% of its locations, would see an increase of 23% in lease expenses in the first lease year, alone, as a result of the front loaded accounting.

Another side effect of the changes is likely to be that companies may seek to reduce lease terms to keep costs down and to reduce the liability they must record, according to Brett Hardy, Colliers International’s head of corporate finance, as cited by Chasan.  This could be disruptive for retailers who need long term presence and could add to their exposure to market uncertainty whenever they look to extend their presence in a given location.  In its white paper, “The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP,” dated Sept. 15, 2010, KBA Lease Services explains that the incentive created for companies to use shorter lease terms will also conflict with lender and investor preferences for long term commitments.

KBA points out additional costs of these changes for companies:  They will need to continually reassess lease renewals and contingent rents.  They will also need new systems and processes in place by the time the changes take effect, especially since leases that are already in existence will still be subject to the changes.

Also, KBA points out that the changes may be unfair in their blanket equation of leasing and buying, with harm to companies for whom leasing is a deliberate part of operations strategy.  Many companies need only limited presence in many locations, and prefer not to own real estate but to keep capital in their operations.  Such companies use leases as a cost-effective way to pay for limited space during particular times, rather than having to own and maintain space, even when it is not functional for their businesses.  In their case, it seems appropriate that lease payments be considered operating expenses, not mortgage payments.

Assessment

KBA’s position is that in spite of their negative impacts, the changes make overall sense in that they put all companies on an even playing field.  They create consistent treatment, for companies which make long term financial obligations for the right to use things, regardless of whether those companies buy with financing, or lease with long term rent commitments.  The changes also create consistent treatment regardless of what kind of asset is being leased, be it widgets or property.  So they do help in making comparisons among different companies, and in making analysis more straightforward.

Continued.

Contributed by Chris Campbell
Managing Director
Net Lease Capital Advisors
ccampbell@netleasecapital.com

Reviewed by Jim McCartney
Managing Director
Net Lease Capital Advisors

According to KBA Lease Services, the logic sees leasing as akin to buying – for a few reasons: Like a financed purchase, a long term lease is a commitment to make periodic payments over a fixed period for the use of something, often over the entirety of its economic life; For a large subset of capital leases, the lease payments total to an amount close to the purchase price of a property; And many capital leases end up becoming acquisitions because they come with a bargain option to purchase at the end of the lease.

In the Boards’ reasoning, if a tenant leases a building for 30 years which would likely be torn down at the end of that period, that tenant effectively enjoys the control and use of the property for its entire economic life, and might as well be considered to own the property for the amount of the lease payments.

In order to eliminate the different treatment of capital and operating leases, and the apparent false distinction between leasing, generally, and buying, the Boards are proposing that all leases should be classified as a new kind of asset – the right to use something, offset by the liability of an obligation to pay over time for that right, and treated as capital leases now are, as loans for the acquisition of property.

But disagreements persist between the members of the Boards and they have continued to solicit input through exposure drafts on possible unintended consequences of proposed changes.

Continued.

Contributed by Chris Campbell
Managing Director
Net Lease Capital Advisors
ccampbell@netleasecapital.com

Reviewed by Jim McCartney
Managing Director
Net Lease Capital Advisors

Capital leases vs. operating leases
For accounting purposes, a capital lease is treated similarly to a loan to buy something. The property on a capital lease appears on a company’s balance sheet as an asset, with the capital lease as an offsetting liability. The leased object incurs depreciation expense on the income statement which is tax deductible, just as an acquired object would. Rent payments on a capital lease are treated like principal and interest payments on a loan, with the interest portion of each considered an additional tax deductible expense on the income statement.

By contrast, operating leases do not appear on the balance sheet at all, but are classified under operating expenses on the income statement. Since it is considered an expense of operation, rent for an operating lease is an expense that is deductible in full, not just for the component of the payment that would be equal to the interest component of a loan payment.

Implications of the distinction
The different treatment of capital and operating leases for accounting may present a false distinction with unintended consequences. According to Emily Chasan of CFO Journal in her article: “Firms Resist Accounting Plan,” Nov. 16, 2011, an operating lease offers at least a couple of advantages: By not appearing as a liability on the company’s balance sheet, the operating lease may help a company to appear to be in better financial condition; Secondly, the lessor deducts the full amount of lease payments from income for taxes, rather than just the portion of lease payments which correspond to interest payment, as with a capital lease.

Also, a problem arises that since operating leases are not represented on the balance sheet, the financial obligations they represent may go undetected by investors and analysts. A KBA Lease Services white paper entitled: The Impact on Corporate Real Estate of Lease Accounting Changes under GAAP, Sept. 15, 2010, explains that, in order to compare companies apples to apples, analysts often feel the need to reclassify operating leases as capital leases based on estimates from the operating statements of a company. This allows the analyst to observe the obligations of both companies, regardless of whether the companies have capital or operating leases.

So while capital and operating leases often seem, functionally, like taking a loan for the purchase of a property, operating leases receive very different treatment under GAAP accounting. The Interational Accounting Standards Board and the Financial Accounting Standards Board are proposing changes to address the apparent false distinction. The next part of this article will identify changes they have proposed and the possible implications of these changes.

Continued.

Contributed by Chris Campbell
Managing Director
Net Lease Capital Advisors
ccampbell@netleasecapital.com

Reviewed by Jim McCartney
Managing Director
Net Lease Capital Advisors

For 1031 exchange, strict requirements present a daunting prospect of failure. The seller must acquire replacement property of at least the same value as the relinquished property, and must reinvest all equity derived from the sale.  Additionally, the seller must identify replacement property within 45 days of sale, and must acquire it with 180 days.  It is no wonder that many 1031 exchanges fail.

Net lease properties are frequently used as replacement properties for sellers of all property type, because net lease properties remove the uncertainty of buying replacement property in a market that is in flux, and because net lease properties eliminate the uncertainty of financing contingencies.

A steady market for net lease property exists around the country, in good economic climates and bad, making these assets accessible with reliability. This market is fed by corporate sale leaseback property. Roughly, we think of the supply of investment grade credit tenant property resulting from corporate sale leasebacks as around $2 billion at any given time, depending on market conditions. (The current market shows significantly fewer such properties available, but we expect a rebound of supply.)  So the taxpayer under deadline can feel some assurance that it will be possible to identify a net lease property – somewhere - to acquire as an exchange property.

But doesn’t it matter where?

Continued.

Contributed by Chris Campbell
Managing Director
Net Lease Capital Advisors
ccampbell@netleasecapital.com

The American Recovery and Reinvestment Act, enacted in Feb, 2009, encouraged investment by allowing businesses to take depreciation expenses more rapidly than before, to offset income. By taking these additional expenses, businesses would be able to reduce their taxable income and save more in taxes, sooner. The additional depreciation expenses were called “bonus depreciation”. Since then, the Tax Relief Act of 2010 and the Small Business Jobs Act of 2010 have extended and increased the bonus depreciation available for filers in 2010 and 2011.

As the Tax Policy Center explains in its fact sheet, “Quick Facts: Bonus Depreciation and 100 Percent Expensing,” taxable income for a business is the amount of income it produces minus the expenses it incurs. The depreciation of assets needed to conduct business is one kind of deductible expense. Some assets depreciate entirely in a single year, but durable assets, like tractors or computers, depreciate over multiple years on a on a graduated schedule.

Bonus depreciation is added to the depreciation expense available from a year’s worth of an asset’s depreciation according to a standard depreciation schedule. Bonus depreciation is always applied in the first year a property is put into service. The amount of additional depreciation expense allowed with bonus depreciation has varied in different years. Under the American Recovery and Reinvestment Act in 2009, businesses could deduct an additional 50% of the property’s depreciable basis in the first year of ownership for qualified properties.

This amount of bonus depreciation allowable was increased under the Tax Relief Act of 2010 and under the Small Business Jobs Act of 2010. For properties with up to 20 years of depreciation period and subject to the Modified Accelerated Cost Recovery System of depreciation (MACRS), businesses can deduct 100% of a property’s depreciable basis during its first year of ownership. (Later, when an asset is sold, the total amount of depreciation taken is subject to recapture tax as ordinary income.)

For example, if a newly developed property is placed in service and acquired in October, 2011, any component of that property which can be depreciated under MACRS in a period of 20 years or less – perhaps the property’s parking lot – can be depreciated entirely in the first year, rather than in smaller, annual increments. The owner saves income tax on the depreciated value up front, and derives the benefit of putting that saved money to work, early on.

For a $20 million building, for instance, if $5 million of the property qualified for depreciation in 15 years, $5 million could be depreciated in the first year. Assuming a 40% combined income tax rate, that amounts to savings of $2 million in taxes up front – savings which might then be invested in other productive assets for added return.

The expenses from bonus depreciation may be applied against income from prior years to generate immediate tax savings.

According to Net Lease Capital Managing Director, Jim McCartney, bonus depreciation is a powerful tool for the property owner who has a productive use for capital in the immediate near-term.”

For more on bonus depreciation or to discuss how it may be applied in your tax planning this year, contact Jim McCartney at 603-546-2556, or at jmccartney@netleasecapital.com.

Contributed by Chris Campbell
Managing Director
Net Lease Capital Advisors

Debt and inflation – No one knows exactly how the unprecedented US debt will affect the country’s economic future, but U.S. indebtedness creates a lag on federal dollars going into the economy, puts upward pressure on interest rates – which will slow reinvestment – and generates conditions ripe for inflation. We have seen prices inflating. According to a CFO Magazine poll (The Deep Dive That Rising Feeling, Sept., 2011, http://www.cfo.com/article.cfm/14596346?f=search ) 59% of respondents felt inflation has already had impact on their business, with about half of them absorbing elevated costs (a temporary measure for most) and almost as many beginning to raise their prices.

Technology – has made it increasingly possible for companies to distribute work without hiring new full time employees, according to the McKinsey report. Jobs are being “disaggregated” into tasks which can be assigned to existing workers in diverse locations, and the internet allows increasing reliance on at-home employees who use shared office space when required to come into the main office.

Labor unpreparedness – Beside an insufficient number of college graduates, numerous studies have identified that American education is not providing students with the skills required by employers. The McKinsey report’s survey indicates that “40 percent of executives whose companies plan to hire next year said they’ve had unfilled openings for six months or longer because they cannot find qualified applicants.”

Combination of recession with financial crisis – In a McKinsey Quarterly interview, Harvard economist and coauthor of This Time is Different: Eight Centuries of Financial Folly, Kenneth Rogoff, asserts that when recession is combined with financial crisis (banks failing, credit evaporating), as we have recently experienced, the effects are amplified and protracted. In fact, he feels this recession has not ended, and that we are actually facing a long-term contraction. 

…So, you’re the employer… You’re afraid to hire if you don’t know whether your company can withstand the combined macro forces of international economic crises, changing tax laws and domestic stagnation. You won’t hire if you can get the work done cheaper by redistributing it internally. And you can’t hire if you can’t find qualified personnel to do the job.

In commercial real estate, the uncertainty and economy-retarding forces translate into heightened demand and rising prices in a few “gateway“ locations like Washington DC and New York, perceived to offer security to fearful investors, and a slogging stagnation in most other places.

Changes that are needed to propel employment and promote recovery are likely to be structural in nature, and so, will require real time to develop and implement, weakening the inertia of this recovery.  Immediately ahead, we will need to find ways through political gridlock in Washington to develop definitive tax and economic policies.  But deep additional changes will be required, including:

As recommended by McKinsey:
• Revamping education to provide job-ready labor
• Deregulation to allow new businesses to start and grow

As recommended by Rogoff:
• In the short term: writing down and forgiving mortgage debt and structural reform, and then further out, more fundamental changes such as:
• Stripping the Code of subsidies for debt – both for corporate tax law that favors debt, and for home mortgage tax deductions
• Indexing debt instruments to other economic indicators (e.g. indexing mortgage loans to regional housing prices) in order to put a leash on debt levels and make debt less affected by systemic risk
• Regulating financial lobbyists, who Rogoff cites as having fallen out of touch with the risks of the financial innovations they had promoted.

Contributor: Chris Campbell
Managing Director
Net Lease Capital Advisors
Email: ccampbell@netleasecapital.com

Others agree. In Real Estate Forum’s July/August article: Fighting Headwinds, (http://www.reforum-digital.com/reforum/20110708/#pg54) Rod Vogel, Managing Director of Equity Production, Principal Global Investors, forecasts six years for a return to unemployment rates between 5 and 6 %, and Mark Higgins, CIO of Cigna Investment Management, characterizes the next five years as ones of slow growth.

Indeed the current recovery has been called jobless. Corporations have record amounts of capital to invest. And with the Federal Reserve’s promise to keep rates down for at least the next two years, there is capital available, but employers and investors are still cautiously waiting to invest and hire. So what’s holding them back?

Uncertainty paralyzes corporations from taking risks. Against the backdrop of an economy which is “close to faltering” according to Fed Chair Bernanke, some of the big what if’s that CFO’s face now include:

- Uncertainty over international conditions – Capital is unsure of the degree of American exposure to a Greek default, and to the potential domino effect on Portugal, Spain, Italy, and the Euro in general. If Greece defaults, Italian and Spanish companies and banks already awash in debt, could be forced closed, affecting other companies which trade with them or hold their stock and other banks exposed to their debt. It is not over reaching to fear a dissolution of the European Union itself, given the lack of economic regulation that the political union has over its own member economies. Stronger European states demonstrate less and less willingness to picking up the tabs of their weaker sisters. A unified Eurobond is being considered, which would give confidence in European ability to repay debt, but would require unprecedented cooperation from the disputing member states.

- Uncertainty over tax reform – A national debate remains unresolved over whether taxes should be used to stimulate the economy and redistribute wealth, or be contained to cover a spare list of government functions and reduced to reduce the debt.

- Uncertainty over FASB lease accounting standards – According to a February 2011 Deloitte survey of real estate professionals, FASB accounting standards changes, which would eliminate operating leases and bring off-balance sheet leases onto the balance sheet, would have significant impact on corporations. These include: changes to debt and equity ratios, changing existing debt covenants, making it more difficult to obtain financing, making shorter lease terms preferable, and encouraging lessees to purchase rather than lease their space. Corporations will have to adapt their business processes and technology to implement the new standards properly, but 90% of companies were not well prepared to do so, and 68% of survey respondents did not know the tax consequences of the proposed new standards.

- Uncertainty over policy due to Washington gridlock – Among the reasons for S&P’s recent unprecedented downgrade of the US credit rating was the inability of the American Congress to agree on an elevation of the debt ceiling, which raised serious questions about the country’s ability to react swiftly to changing economic conditions and to create effective policy going forward.

More

Contributor: Chris Campbell
Managing Director
Net Lease Capital Advisors
email: ccampbell@netleasecapital.com

Net Lease Capital has closed on the $237 million sale of 49 CVS drugstores to an undisclosed client.

Net Lease Capital provided the portfolio as replacement properties to be used in a 1031 exchange transaction.  The portfolio consisted of CVS properties located across the country, which were desirable because of the corporate guarantee of rent payments offered by CVS Caremark Corporation (NYSE: CVS), which carries an investment grade credit rating (S&P BBB+).  The corporate guarantee means that rent payments for all the properties are guaranteed over the entire life of their long-term leases, regardless of how well the individual properties perform.

Additionally, because of the triple net leases on each of the properties, CVS Caremark Corp. maintains responsibility for all of the operating and capital expenses of the properties, including upkeep, property taxes and insurance expenses, as well as expenses for roof and structure, so that the buyer will enjoy passive ownership of the properties.

Net Lease Capital has closed over $500 million in transactions in 2011.

Net Lease Capital Advisors (www.netleasecapital.com) is a specialized investment and advisory firm that offers a broad array of services in the net lease arena, and has closed over $6 billion in net lease transactions.  The Acquisitions Group at Net Lease Capital has bought over $1 billion of net lease assets.  The Advisory Group at Net Lease Capital uses net lease property and credit tenant finance in specialized tax strategies for owners of all property type.   For more information, please contact Chris Campbell.

Chris Campbell

Managing Director

Net Lease Capital Advisors

Ph. 603-598-8560

ccampbell@netleasecapital.com

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