Article

Eight things to know when drawing up leases

Asia Pacific / Portfolio strategy

By this time, you should be well-aware of the new accounting requirements guidelines and standards. All data needs to be tracked and recorded from 2017 and companies have to present existing real estate or equipment leases directly on their balance sheets instead of in the footnotes of their financial statements.

The implications of the change will affect the way you draw up leases for their organizations going forward. Here are eight things to know:

1. Standard lease terms in APAC to remain unaffected

Unless your organization is after a large, strategic requirement that warrants a longer lease term, leases in Asia Pacific are generally between three to five years. Therefore, using shorter lease term as a strategy to mitigate the impact of lease accounting changes is not likely to be a viable option in the region. A shorter than normal lease term will also increase tenure risk and will likely be disadvantaged in the deal terms in the form of lower incentives and/or higher unit rent.

2. Weighing your renewal clause options

Leases that are automatically renewed unless otherwise notified (such as the traditional leases in Japan) will be considered as perpetual leases and you will need to determine how many years your organization is reasonably certain to remain in occupation of the space and account for it accordingly.

3. Demanding for “clean” rent

The definition of “rent” in Asia Pacific varies from market to market. In some cases, it is akin to the triple net rent used in the United States; in other cases, it is a gross figure that includes service and other charges.  In the case of a gross rent, if the landlord is not willing or not able to strip out the non-rent component in the lease agreement, the full amount will have to be accounted for. Therefore, where possible, you should negotiate for “clean” rent in leases.

4. Accurate articulation of risks and obligations in lease contracts

The impending accounting changes are only applicable to contracts that fulfill the definition of leases as stipulated in the accounting boards. While the majority of contracts that CREs deal with are leases where accounting standards will apply, there will be some contracts that have opportunities to be framed in a way that could exclude it from being accounted for as leases. Some examples include contract for data centers, warehouses and other arrangements where the counter party provides services. Make sure the contract correctly reflects the financial position your organization is taking.

5. Reconsidering the entities signing the lease

It is not uncommon for multi-national companies to have multiple legal entities even within a single country. In Asia, many of these legal entities exist for regulatory purposes. In light of the lease accounting standards, it’s important to consider the appropriate legal entity to sign leases to minimize the financial impact to the signing legal entity, subject to regulatory requirements. It may be worthwhile to consider signing leases by using holding companies and then charge back business units for the cost of the lease.

A possible structure for a holding company will be via the setup of a real estate company (or property company) to hold all property leases and assets. However, this is not a simple undertaking due to the myriad of issues relating to tax and legal considerations, especially if the holding company is meant to work across different countries.  Should your organization have large asset and lease holdings in a single country, you might have greater success creating such a structure for a specific country instead.

The implications of the change will affect the way you draw up leases for their organizations going forward.

6. Exploring alternative arrangements

“Coworking” is probably the biggest buzzword in the real estate industry besides technology and data these days. If companies truly use co-working spaces in the traditional form (that is, membership based, non-dedicated space), such arrangements are unlikely to be considered a lease, and therefore excluded from lease accounting requirements. However, there may be some coworking arrangements that might still end up being construed as a lease, where the coworking provider is in effect a sub-lessor and the tenant a sub-lessee.  The same applies to service office contracts.

Weigh their options—whether a coworking, service office or any other type of alternative accommodation arrangements best meets your business operational requirements—before deciding to take on such spaces.

7. A move towards ownership

The accounting rule changes will eliminate some of the capital efficiency benefits of leasing. It’s already driving large corporations to re-examine the fundamental question of whether they have more to gain by leasing or owning properties. With both hitting the balance sheet as a liability, the financial difference between a lease and an owned property will become less significant. That said, capital allocation strategy, economics, portfolio flexibility and operational requirements should still be the primary drivers for a lease versus ownership decision.

8. New implications for sub-leasing

The new accounting standards will no longer allow companies who are sub-leasing their excess space to deduct their sub-lease incomes from total lease costs associated with the site. The income from sub-leasing income will need to be reported as “Other Operating Income” while the full lease costs of the site are recognized under lease accounting standards. This means that sub-leasing will continue to be beneficial from a cash flow perspective, but it will have different tax implication and require more administrative efforts to account for it.

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Interested to learn about the new leasing standards? Read this insight paper.