Property managers will have to think hard about the terms on which they occupy property, following proposals announced last December that promise to bring the UK into line with accounting practices elsewhere in the world.
The change, which essentially removes the current distinction between accounting for finance leases and operating leases, comes from a discussion paper –Leases: implementation of a new approach – issued under the auspices of a group called G4+1, comprising New Zealand, Australia, Canada, the USA and the UK, plus the International Accounting Standards Board. It was not simply dreamed up in the UK.
Basically, landlords are going to need to show a distinction in their financial statements between the value of receivables under their leases, and the residual value of the assets. At the same time, tenants are going to have to report a liability for the minimum payments due under the lease, and a balancing asset. Their subsequent income statements will have to provide for depreciation of the asset, while payments under the lease will be treated as debt, with costs allocated between costs of finance, and repayment of the debt by the end of the term.
While the changes will force most organisations to think hard about the terms on which they occupy property, the proposals should have the side effect of widening occupier choice, and should more equitably spread the risk between the landlord and the tenant.
At the operational level, occupiers will face some interesting dilemmas. Some will decide that since all their competitors are in the same boat, they do not have to do anything. They will find some support for this view in the discussion paper itself, which points out that many analysts already recast the financial statements of companies to establish the exposure to risks in leasehold property, and compare organisational performance on a like-for-like basis. I suspect that few companies will be able to ignore stark, relative, differences in property risks between themselves and their competitors, and that for some there will be no choice. The implications on the debt side will put pressure on their borrowing covenants, the retail sector being an area where this may become an issue.
For many occupiers, the first and most obvious suggestion is that ownership, as opposed to leasing, becomes relatively more attractive, despite the capital lock-up involved. If leases – entirely fictitious assets – have to be shown on balance sheets, why not exchange a fictitious asset for a real one?
For many properties, and even more so when portfolios of property can be considered, occupiers may well find that banks can deliver the money to buy the freeholds at lower costs than they would have to show for full repairing and insuring (FRI) leases in their financial statements. The sale-and-leaseback expedient is likely to be very hard hit. The number of organisations deciding that this is an appropriate way to raise capital may become very small indeed.
On the other hand, organisations that will continue to lease their operational property are going to try even harder to make the lease as short as possible. The trend towards shorter leases and break clauses in longer ones is already quite well established in the current economic cycle. In previous cycles the balance has tended to ebb and flow according to the relative bargaining positions of landlord and tenant, but tenants now face a different situation entirely. A new approach to risk-sharing in property tenure is the most likely outcome.
While the changes will force most organisations to think hard about the terms on which they occupy property, the proposals should also widen occupier choice, and more equitably spread the risk between the landlord and the tenant.
While the main pressures will be on the way property is owned rather than the way it is run, a renewed stimulus for property and facilities partnering is likely.
For those organisations keen to retain the current off-balance sheet advantages of the operational lease, a partnering contract becomes the only option. That involves the marriage of traditional property management, the management of life-cycle investment and traditional facilities management.
A property and facilities partnering contract – where property appears on the balance sheets of the provider, not the occupier – is getting increasingly difficult to draft. The accounting standards authorities see the idea as a device rather than a legitimate sharing of risks. Furthermore, there are structural difficulties to be overcome for many occupiers. Property and facilities management decisions are often handled by quite different teams and in different places, which tends to reduce access to one of the great features of the facilities management market – that prices are sensitive to volume. The more dispersed the purchasing decision, the higher the cost.
Having said this, the era of the large scale service provider is now here, created by the government’s private finance initiative contracts, growth in the serviced office market and the growing investment appetite for stakes in this kind of operation. Larger suppliers can purchase facilities management services much more efficiently than most occupiers, and this will add to their competitive advantage.
More importantly, the ethos that underlies the provision of a fully serviced environment is the perfect antidote for the occupier constantly challenged by inflexible traditional leases.
Pressures already exist for large facilities management contractors and property companies to provide serviced facilities. What after all is a company like Trillium, the PFI contractor to the Department of Social Security, other than a huge supplier of serviced offices? One can see that when a company like this adds new clients, with the accompanying boost to profitability and reduction of overheads and risk, all occupiers get a better bargain. The greater the spread of risk, the better the quality of the income.
Generally, the results from these changes ought to be positive, despite the disruption and unhappiness that they will cause to some companies, and the surprises they will reveal to some shareholders. They should have the side effect of widening occupier choice, and should lead to a much more equitable spread of risk between landlord and tenant.
The concept of fully serviced environments, the way in which both facilities management costs and business risks reduce with volume and variety of covenant, and the emergence of a real business need for enhanced flexibility, are all important features of the emerging scene.
Source
The Facilities Business
