In today’s economic climate, financial leaders across America have much to consider when right-sizing their real estate portfolios. One critical factor is the ever changing rules related to accounting for real estate dispositions.
Basic financial choices and their consequences need to be continually reviewed: Are their leases operating leases or capital leases? Do they currently own the buildings they’re in? Are they looking for reduced expenses on the P&L or a near-term reduction in cash burn?
Knowing whether they should sublease, terminate or even abandon space, directly relates to knowing how these actions are affected by current accounting guidance and how that guidance effects their financial reporting.
In recent years, Generally Accepted Accounting Principles have come to play an increasingly important role in corporate real estate strategy. As FAS 13, Accounting for Leases, came into focus with relation to lease terminations and dispositions, various accounting rules and regulations appeared. This led to the latest guidance on lease accounting for space dispositions titled FAS 146 or Accounting for the Costs Associated with Exit or Disposal Activities.
The impact of accounting changes involving vacant space in the Massachusetts market can be profound. According to Richards Barry Joyce & Partners, overall office vacancy in Eastern Massachusetts reached 15 percent in the first quarter of 2003. Nearly 28 percent – over 7 million square feet – of this vacant space is sublease space. These numbers do not include “shadow” space, defined as excess space within a corporate portfolio that is either being held for future use or no longer needed, but not put on the market for sublease.
A fourth quarter 2002 survey of real estate managers by CoreNet Global stated that nearly 30 percent of respondents believed that 10 to 30 percent of their portfolios consisted of shadow space. Applying that ratio to the overall Eastern Massachusetts market would result in an additional 5 million to 30 million square feet of vacant space in an already saturated market.
In another alarming statistic, 56 percent of respondents from the same CoreNet survey indicate they are planning to decrease the amount of office space kept in their portfolios.
Over the past two years, skyrocketing vacancy rates translated into big write-offs in corporate America. In 2001, Merrill Lynch took nearly $300 million in facilities-related charges, while Sun Microsystems wrote off more than $350 million and Inktomi $75 million in 2002. While these and many companies took restructuring charges at a time when accounting rules were less stringent and so called “one-time events” were in vogue throughout corporate America, others avoided charges by taking a liberal interpretation of the then current accounting guidance.
The EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit, also gave guidance to executives by declaring that charges related to exit or disposal activities did not need to be taken until a commitment to an exit plan had been made. With the release of FAS 146, being effective Dec. 31, 2002, those companies who formerly avoided charges are now asked to reevaluate and to “recognize and measure” costs at fair value on the earlier of a lease termination or a “cease-use” date. To calculate the write-off for a block of vacant space, take the present value of the remaining lease liability and deduct the present value of the likely sublease income from a theoretical sublease done at current market rates.
In Practice
Even with more stringent guidance in place, many of those in corporate finance and public accounting have found that these new rules have some leeway in their interpretation. Companies have been known to leave a handful of employees at largely vacant locations to make it appear as if the space is currently being used.
While others claim that the likelihood that they may reoccupy vacant space prevents them from taking a charge. This “shadow” space is not put on the market for sublease due to a fear that current standards require such space to be written off once it is marketed. In fact some large suburban Massachusetts tenants have so much shadow space, they can control market pricing by deciding how much or how little of their vacancy to put on the market. It is hard to imagine the difficulty any such company would encounter in calculating a write-off when fair market rates might be severely reduced should they put all of their shadow space on the market.
In light of recent accounting scandals throughout corporate America, a consistent liberal interpretation of accounting rules has become worrisome to those who fear a tightening or a reigning in of these rules by organizations such as the Financial Accounting Standards Board and the SEC. Putting a limit on how management currently construes FAS 146 could have a material effect on many companies’ quarterly and annual financial filings. In Eastern Massachusetts alone, potential write-offs for unused space could total more than $1 billion. New accounting guidance forcing those write-offs to the forefront would cause numerous struggling companies to miss already reduced earnings guidance and send recently recovering stock prices back on a downward spiral.
After more then two years of corporate restructuring, it’s possible that many companies may have missed a window where one-time charges were accepted by Wall Street with little to no effect on shareholder value. If this window closes, those spaces now appearing to be available for sublease may not be available at all. These corporations would no longer be able to take a disposition-related charge without serious financial ramifications to shareholders.
Some larger corporations will choose to avoid facilities-related restructurings rather than take a one-time hit that would cause them to miss earnings. They would be making a conscious decision to maintain higher than necessary ongoing facility costs, a choice that current accounting guidance apparently does not prevent them from making.
