Founder and CEO, Visual Lease.
It’s been just over a year since the U.S. experienced a series of lockdowns in response to the Covid-19 pandemic. Lessees and lessors have had to quickly adjust their strategies to adapt to unforeseen circumstances such as office closures, restaurant shutdowns and low foot traffic at retail locations. Today, both parties are looking for added assurance when updating existing lease agreements or entering into new ones.
As a result, the very stability of leases has changed — a great example being that pre-pandemic, a typical commercial real estate lease in a major city like New York was rock-solid with an average length of nearly 10 years. Today, businesses and their landlords are prioritizing their ability to remain agile and are taking a long, hard look at how their leases support their long-term business needs. In doing so, they must also look at downstream financial implications, because any changes they make must accurately be reflected on their balance sheets to comply with the new lease accounting standards.
New Clauses Brought On By The Pandemic
In 2020, we all saw how a lack of flexibility can negatively impact both lessors and lessees. Many large retailers were unable to meet their lease obligations due to the unforeseen circumstances brought on by the pandemic. Under pressure to continue to make mortgage payments, affected commercial landlords responded by taking legal action against their tenants. In this scenario, both parties would have greatly benefited from added protective measures within their agreements.
Having learned from the past year, today’s business owners want to know that they have options. Similarly, property owners want to know that they’ll be afforded an added level of protection, despite some of the uncertainty that lies ahead. Many are leveraging lease clauses to achieve the flexibility that they desire:
• Shorter-term and pop-up leases: Contracts are now trending toward three years or less, as compared to the standard 10 to 20 years that have been typical for CRE leases in major cities. This shift will allow landlords to change terms, conditions and rental property location more frequently and will offer tenants the ability to grow their companies while also reserving capital for other business expenses.
• Flexible termination: Options are a critical part of flexibility. Having a prenegotiated clause that gives a tenant the ability to terminate its lease early or give up space, or conversely, to extend the term or expand into other space, gives it peace of mind knowing that it does not need to enter into protracted negotiations if it needs to respond to changes in the market.
• More specific force majeure clauses: Typically, this clause protects tenants and landlords against unforeseen events that are categorized as “acts of God.” However pre-Covid, this clause didn’t necessarily cover pandemics. Now, CRE attorneys are altering force majeure clauses (registration required) to include pandemic-specific language for added protection for all lease stakeholders.
• Cleaning and sanitizing specifications: Going forward, many businesses will have significantly different cleaning requirements for their premises. Detailed cleaning clauses should also be included in future lease agreements to outline procedures and their requirements — and who is responsible for what — and to also provide the ability for affected parties to opt-out should cleaning requirements change.
Implications For Lease Accounting Reporting
While using specific lease language and clauses can provide businesses with peace of mind, it also directly impacts their lease accounting.
The new lease accounting standards — ASC 842, GASB 87 and IFRS 16 — require that all leases are disclosed on a company’s balance sheet. The rules also require revision (“remeasurement”) of the lease accounting calculations anytime there are changes in lease length, added or altered options or, in some cases, changes in operating expense pass-through structures. Failing to properly capture these changes can result in a lot of remedial activity by an organization’s accounting department and can also result in higher audit fees, damage to a company’s credibility and a drain on internal resources. And because leases are so dynamic, businesses can incur additional soft-dollar costs as they prepare for their audits if they don’t have a way to properly track any and all movement across their portfolio.
As landlords and tenants continue to embrace different opportunities to gain control over their portfolios, they should create and maintain one source of truth — a centralized place where all leases and related data are managed (potentially thousands of pages of material). This will empower an organization’s accounting and operational teams to more easily collaborate, creating accountability on both ends of the spectrum. It will also ensure accurate financial reporting, which will give companies greater visibility into their financial state and the insight required to enter into new lease agreements.
The benefit of this level of control isn’t just for today. Rather, it will continue to help companies deal with the aftershocks of the pandemic as they continue to ripple through the commercial real estate industry.
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