Bad national forecast; better news for landlords

Chris Stephens

This column covers two topics: a pessimistic outlook for commercial real estate nationally, and an update on the proposed change in accounting rules for leases, a subject I wrote about earlier this year.

First, the outlook on national market conditions. The Real Estate Roundtable, a nonprofit public policy organization, recently announced a drop in its fourth quarter "Sentiment Index" to the lowest level since 2009.

The "Sentiment Index" measures perceptions of commercial real estate executives on a range of market, financial and political issues.

The members of the Roundtable are leaders of national real estate companies and major real estate trade associations, so they know what they are talking about.

Roundtable chairman Daniel M. Neidich said, "Today's report confirms that U.S. commercial real estate markets remain under significant pressure, and are highly sensitive to political and economic developments, both here and abroad.

"Fostering a broader recovery in commercial real estate markets still depends on an improved jobs picture, but we won't see significant improvement in this area until confidence is restored and there's a more positive climate for job creation -- and that means reducing some of the tremendous uncertainty weighing on businesses and consumers."

The Roundtable also reported that 26 percent of its members thought the availability of loan money was getting somewhat worse; that compares with 2 percent in the third quarter. They expect commercial property prices over the next year to remain flat at best.

At the same time, the national economic newsletter FedView, which is distributed locally by First National Bank Alaska, reported in its October issue better-than-expected national economic data.

This somewhat eases concerns that the economic recovery is faltering. Still, the national economy will have growth that will result in only a modest decline in unemployment.

This negative forecast for employment mirrors the concerns of Neidich. The commercial real estate market recovery depends on job growth, but the forecast for only slight improvement in jobs means little improvement in the national real estate market.

Now some good news: Last spring I reported that the accounting rules for releases were being changed, and the proposed changes were going to have a significant and negative impact on commercial real estate.

But in response to industry outcry, the U.S. Financial Accounting Board (FASB), which sets accounting rules for the nation, has dropped the changes proposed for landlords.

The proposed changes for tenants still apply; however, they, too, are being reconsidered.

The proposed landlord changes created an incentive to write shorter-term leases. Shorter leases are less secure and could affect the landlord's financing and property values, as well as slow new development and increase operating costs. This change in the rules, fortunately, was dropped.

However, the proposed tenant changes are more significant. FASB is attempting to eliminate what is called off-balance-sheet accounting so that financial reports more accurately show the true financial condition of companies.

Most leases are recorded as operating leases, where rent payments are recorded as expenses, similar to other expenses of operating a business.

But this accounting doesn't show the entire picture. Neither the benefit of the lease, nor the future obligation of the company under the lease, is shown on the company's financial statements.

The proposed tenant rule changes require that all leases be recorded as capital leases, where the lease is recorded on the balance sheet as both an asset and liability for future rent obligations. Instead of recording the rent as an expense, depreciation of the lease asset is recorded.

This change in the accounting method will have a significant impact. The Securities and Exchange Commission estimates that under the proposed rule changes, public companies will add a trillion dollars of assets and liabilities to their financial statements.

The rule change will affect how companies structure debt, evaluate leasing versus owning, and determine the length of leases, renewal options and much more. They will upset many of the traditional financial measures used to evaluate companies.

FASB has a legitimate point in wanting tenant lease obligations to show on the balance sheet. At the same time, the industry has equally legitimate concerns about unintended consequences of the proposed rule changes. This is not yet settled, as the proposed tenant rules receive further review and elicit continued industry alarm.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His column appears monthly in the Sunday Daily News.