During the first quarter of 2016 FASB and the International Accounting Standards Board (IASB) promulgated new lease accounting standards that eliminate a key advantage leasing previously enjoyed over ownership of real estate and long-lived equipment. Commencing with the 2019 fiscal year of public companies, virtually all commercial leases will create a balance sheet lease liability and a corresponding right-of-use (ROU) asset. The liability generates charges for imputed interest, while the ROU asset generates charges for amortization, against earnings.
Problem. For “finance” leases, the category defined by FASB to encompass most equipment leases and certain real estate leases—e.g., those with very long terms or bargain options to purchase the building or extend the lease—these combined earnings charges are front-loaded in much the same way that interest on a mortgage decreases from year to year. For other leases (“operating leases” as defined by FASB) such charges are averaged over the lease term, with the company taking each year a combined level charge against earnings that approximates rent expense under current rules. IASB’s new lease standards omit this distinction, imposing on virtually all leases what FASB calls finance lease treatment. Even in the FASB version, however, operating lease treatment has become less certain and more difficult especially for single-tenant buildings, owing to FASB’s introduction of subjective criteria to determine when a tenant’s optional lease renewal periods are added to the primary term of its lease, often the decisive factor when distinguishing between operating and finance leases.
To put in perspective the impact on your company’s financial statement, a 2012 study published by Chang & Adams Consulting estimates that the new rules will increase balance sheet liabilities of U.S. public companies by $1.5 trillion.
Solution. Leasehold Equities LLC (LE) has developed and patented an innovative financing technique, ILPS Preferred® stock, with the FASB/IASB lease accounting changes in mind. By financing the purchase or construction of an office building or other commercial property (the Property) primarily through the issuance of preferred stock in a single-purpose finance subsidiary (the Issuer), an ILPS Preferred® financing allows a user (the User) that is part of a consolidated group with the Issuer to avoid the balance sheet liability and related earnings charges imputed by the new lease accounting standards. At the same time, the Preferred Stock dividend has a reliable source of funding in the form of rents paid by the User to the Issuer (Internal Rents). Because the Issuer and User are part of a consolidated group of corporations that report their results on a combined GAAP financial statement the obligation to pay Internal Rent is eliminated from the consolidated earnings statement and balance sheet of the group. The cost of outside capital (Preferred Dividends) is treated as an allocation of, rather than a charge against, the group's earnings. The following diagram illustrates the capital stack and cash flows involved in an ILPS Preferred® financing:
Our comprehensive example based on real world properties compares over a 15-year period the annual financial statement effect of a third party lease, a mortgage-financed purchase, and an ILPS Preferred® financing of the same building. When comparing ILPS Preferred® to a lease, the example demonstrates an overall savings in the present value of earnings charges against the user’s consolidated group of 75%, or 46% per-common-share of the group’s parent. Since all capital employed to purchase or construct the building is equity—consisting of the proceeds of common and preferred stock—an ILPS Preferred® financing also avoids a balance sheet liability of 70%-100% of the property’s value, depending primarily on whether the comparison is made to a mortgage-financed purchase or a long-term lease. The dividends are generally tax-advantaged by virtue of being either: (i) taxed at capital gains rates, in the case of an individual shareholder who meets certain holding period requirements; or (ii) eligible for the 50% dividends-received deduction, in the case of a shareholder that is a C corporation.
The ILPS Preferred® technique starts with LE's adaptable, long-term financial model that compares the earnings, balance sheet, and cash flow effects of such a financing to corresponding effects of a mortgage-financed purchase or third party lease of the same property, taking into account the new FASB rules. Besides generating such comparisons and sensitivity runs, our model serves to set key terms of the ILPS Preferred® structure, such as the rate of internal rent and the targeted schedule for preferred stock redemptions.
Company. Leasehold Equities is a joint venture formed by principals of Impost Research LLC, a respected tax consulting firm specializing in commercial real estate, and Jackson Cross Partners LLC, a nationally recognized leader in commercial tenant representation.
For further information contact Glenn Madere at 610-574-3296 or Lou Battagliese at 610-265-7700.