Lease under February 2016 Lease Accounting Standards
Versus Mortgage versus ILPS Preferred®

Lease. Assume Company C leases a warehouse for 15 years at annual net rent of $800,000 initially, escalating 10% every 5 years. The present value (NPV) of monthly rents, discounted at C’s incremental borrowing rate of 4%, is approximately $9.8M. Under the lease accounting standards issued in February 2016 C would record a right-of-use (ROU) asset of $9.8M and a lease liability $9.7M, the difference being first month’s rent. If the lease is classified as a finance lease (e.g., because it gives C a bargain option to purchase the building), then in Year 1 C reports an imputed interest expense of $382,000 on the lease liability and a $651,000 level amortization expense on the ROU asset, for a total charge against earnings of $1,033,000 (rounding to the nearest $1000). In Year 2 interest decreases to $365,000, which combined with the $651,000 ROU amortization expense generates total earnings charges of $1,016,000, an amount that continues to decline each year. The new rules work as if the landlord loaned C $9.7M to buy the right to use the warehouse for 15 years, and C repaid the loan monthly over 15 years.

If instead operating lease treatment applies, total imputed interest and ROU amortization are averaged over the 15 year lease term, generating each year a combined lease expense of $883,000 that is allocated first to accrued interest (which decreases over time) and then to ROU amortization (which increases over time). Over a 15-year period the NPV of earnings charges would approximate $9.9M applying finance lease treatment and $9.8M applying operating lease treatment. The new rules eliminate an advantage that leasing traditionally had over ownership, namely, avoiding the “gross up” that occurs when a building is added to the asset side, and a mortgage to the liability side, of C’s balance sheet.

Leveraged Purchase. Both the balance sheet and earnings effect of a lease under the new rules are less desirable than the effects of a traditional mortgage-financed purchase. Suppose C purchases the warehouse for $10M inclusive of transaction costs, financing 70% of its purchase with a 15-year mortgage bearing 4.5% interest and using a 25 year schedule to amortize principal. Annual charges to earnings, consisting of depreciation of the warehouse, amortization of financing fees, and interest would approximate $602,000 and $595,000 in year one and two, respectively. Eventually C’s gain on sale of the warehouse serves as a partial offset to even those expenses. For example, assuming a conservative sale price in Year 15 equal to 60% of original cost C generates a $1,548,000 gain under GAAP in Year 15. The resulting 15-year NPV of earnings charges and gain on sale approximates $5.2M, while the present value of monthly net cash flows approximates $7.1M.

Key factors contributing to these savings of 46.4% and 26.8% in the NPV of earnings charges and net cash flow, respectively, when compared to an operating lease are: (i) the lower cost of capital that C enjoys as an investment grade company vis-a-vis a market cost of capital embedded in market rents; (ii) 15-year amortization of the ROU asset versus depreciation based on a remaining useful life of 30 years for C’s warehouse; (iii) interest expense decreasing over time while rents increase; and (iv) the GAAP gain and positive cash flow from selling the building in Year 15. In the new lease accounting environment, these advantages significantly tilt the scale toward ownership of core real estate assets such as headquarters, data centers, manufacturing facilities, and major distribution centers.

ILPS Preferred®. In the years between FASB’s initial proposal and the issuance of final lease accounting standards Leasehold Equities LLC (LE) developed and patented an innovative financing technique, ILPS Preferred® stock, that offers companies like C an alternative to the new balance sheet liability. The ILPS Preferred® structure also provides C substantial savings in earnings charges. In a representative ILPS Preferred® financing, parent company C establishes finance subsidiary F and operating subsidiary O. F is capitalized with $3M of common stock (the Common) funded by C and $7M of preferred stock (the Preferred) funded by third party investors. F uses its $10M to purchase the warehouse and pay transaction costs. F then leases the warehouse to sister company O on a 15 year lease (Internal Lease) guaranteed by C, which has an A credit rating. The Preferred enjoys a Preferred Dividend of 4.5%, reset every 5 years to achieve a spread of 2% over the yield on ten year Treasury bonds, as well as a distribution preference over the Common with respect to proceeds of any sale or refinancing of the building or release of F’s cash reserves. F has the option of redeeming the Preferred in whole or part on dividend reset dates and after Year 15. Annual rent on the Internal Lease (Internal Rent) is set initially at $808,000 and adjusts on each dividend reset date if necessary to maintain Internal Rent at a level equal to at least 120% of the annual Preferred Dividend. F uses Internal Rent, first, to pay Preferred Dividends, then to pay a targeted 5% dividend on the Common, and then to add to F’s cash reserves for future redemption of the Preferred. If the Preferred is not fully redeemed by the end of Year 15, the Preferred Dividend resets to a significantly higher rate—e.g., 3.5% over Treasuries—and the Internal Lease renews for an additional 10 years at a rate set to cover this increased Preferred Dividend.

In the patented ILPS Preferred® structure, Internal Rents backed by the investment-grade credit of C provide Preferred shareholders a reliable source of funding for their Preferred Dividends and eventual redemption of their shares. Our flow chart under Why ILPS? illustrates these cash flows. Since C, F, and O are part of a consolidated group of corporations (the Group) reporting results on a combined financial statement, the obligation to pay Internal Rent is eliminated from the earnings statement and balance sheet of the Group, thereby avoiding a balance sheet liability under the new rules. Moreover, ILPS Preferred® Dividends are not charges against earnings; rather, C reports such dividends as an allocation of Group earnings to Preferred shareholders. The only charges to Group earnings are depreciation of the warehouse, amortization of financing fees, and the nominal cost of administering the Preferred. As in the case of a mortgage-financed purchase C’s gain on sale of the warehouse eventually serves as a partial offset to even those expenses. Preferred Dividends reflect C’s cost of capital as an investment grade company—not the market cost of capital embedded in market rents.

Using the example of C above, LE’s proprietary long-term financial model demonstrates 15-year NPV savings in earnings charges and net cash flow of 74.6% and 28.4%, respectively, vis-à-vis a third party operating lease. If—in order to isolate C’s earnings improvement to its effect on C’s common shareholders—we treat Preferred Dividends as though they were earnings charges, ILPS Preferred® still achieves a 46.2% earnings advantage (NPV) over an operating lease. LE’s model demonstrates the following balance sheet and earnings advantages of ILPS under the new rules:

Example Chart

Notes to chart:

  1. In order to isolate the earnings improvement realized by C’s common shareholders, ILPS-Effect on Parent Comm. S/H treats Preferred Dividends as though they were charges against earnings.
  2. The chart shows gain on sale of the warehouse in Year 15, net of Year 15 annual expenses, as a negative charge.

The 28.4% NPV cash flow advantage of ILPS Preferred® over a third party lease demonstrates that much of the earnings improvement achieved reflects not just recent changes in accounting rules but underlying economic savings. In particular, NPV cash flow analysis accounts for the cost of parent company capital (i.e., the parent’s 30% capital contribution toward purchase of the building) by including all cash flows and discounting them at the parent’s incremental borrowing rate. Even taking this cost into account, and using the above conservative assumptions, an ILPS financing generates occupancy cost savings of over 28%.