Underwriting Net Lease Credit: The Impact of New Accounting Rules

By John DeCouto, Senior Partner, Lee & Associates

Beginning in 2013, under the proposed FAS 13 changes, operating leases are to be reported on the balance sheet (capitalized). The new lease accounting rules will capitalize operating lease obligations differently than the process credit rating agencies and lenders currently use. While these agencies are aware of the differences and prepared for the changes, many parties in a net lease transaction may not be aware of how the new rules could affect credit analysis.

Agencies such as Standard & Poor’s use only the minimum lease payments disclosed by companies in their current capitalization mythology. They do not include recognition of renewal options and contingent rent payments, both of which are included in the new accounting model. Standard & Poor’s doesn’t consider renewal options and contingent rent because they are generally not included in the current disclosure of minimum lease payments.

The new lease accounting model will require contingent rent payments and renewal options (that are more likely than not to occur) to be included in the capitalization process. Because these amounts are generally not included in the current disclosure of minimum lease payments, which is the basis for S & P’s adjustment, the addition of the intended occupancy period (options) and contingent rent payments could result in a materially higher amount capitalized under the new model. The net effect of the new rules will most likely increase EBITDA and operating income. This will change financial ratios which can affect debt covenants and other capital requirements.

Companies will have to micro model capitalization on all leases which may reveal lease liabilities previously undisclosed or could create material changes in business practice that could affect their risk profile assessments. While many underwriters don’t expect a significant change in credit ratings, the amount of new information required under the proposed rules could create debt covenant compliance issues or compliance with other technical benchmarks could limit borrowing capacity and raise liquidity issues. The additional scrutiny could have an adverse affect on a company’s credit standing! If not managed properly, the risk premium on some net leases can increase affecting market value and cap rates.