The Impacts of Accounting Standard ASC Topic 842 on NTR Balance Sheets

June 5, 2019

The Impacts of Accounting Standard ASC Topic 842 on NTR Balance Sheets

June 5, 2019 | James Sprow | Blue Vault

On January 1, 2019, nontraded REITs adopted Financial Accounting Standards Board, or FASB, Accounting Standards Codification, or ASC Topic 842. The change in accounting standards potentially impacts both the assets and the liabilities of the nontraded REITs.  In this brief article, Blue Vault examines the impacts on both assets and liabilities due to the adoption of this new standard, and the potential impacts on reported debt ratios resulting from it.  In the financial reports of the 67 nontraded REITs that filed 10-Qs for the first quarter of 2019, Blue Vault finds 28 that have recognized a liability for lease obligations under the new standard. The average impact on the debt ratios of those REITs with the new liability, if it were to be included in long-term debt, is an increase of 1.48%. However, the new standard also requires a REIT to report an asset called “Right-of-Use” (“ROU”) that represents the lessee’s right to use, or control the use of, a specified asset for the lease term.  Of the 67 nontraded REITs filing 10-Qs in the first quarter of 2019, 29 reported this ROU asset. The impact on the total assets of the REITs reporting the ROU averaged an increase of 1.79%, with a median impact of +0.60%.  

Explaining the New Accounting Standard

Pursuant to ASC Topic 842, lessees are required to recognize the following for all leases with terms greater than 12 months at the commencement date: (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease; and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The lease liability is calculated by using either the implicit rate of the lease or the incremental borrowing rate. That is, the lease liability is reported as a present value of future lease payments, using a discount rate that is based upon the features of the lease or the REIT’s incremental cost of borrowing.

Related: The True Cost of Borrowing for Nontraded REITs

The new standard allows the REIT to recognize the cumulative effect of adoption as of the adoption date without restating prior periods.  Many REITs adopted ASC Topic 842 using the modified retrospective approach whereby the cumulative effect of adoption was recognized on the adoption date and prior periods were not restated. A REIT may report information under the new standard for the first quarter of 2019 and under the former standard (ASC Topic 840) for the year ended December 31, 2018.

The REIT determines if a contract is a lease upon inception of the lease. The REIT maintains a distinction between finance and operating leases, which is substantially similar to the classification criteria for distinguishing between capital leases and operating leases in the previous lease guidance.

An Example of the Impact of the New Standard

For example, as a result of the adoption of ASC Topic 842 on January 1, 2019, Griffin-American Healthcare REIT IV recognized an initial amount of operating lease liability of $5,334,000 in its condensed consolidated balance sheet for all of its ground leases. In addition, it recorded a corresponding right-of-use asset of $11,239,000, which is “the lease liability, net of the existing accrued straight-line rent liability balance and adjusted for unamortized above/below market ground lease intangibles.” According to the REIT’s Q1 2019 10-Q, the accretion of lease liability and amortization expense on right-of-use assets for operating leases are included in rental expenses in the condensed consolidated statements of operations. The operating lease liability was calculated using its incremental borrowing rate based on the information available as of the adoption date. Blue Vault estimates that including both the Lease Obligations liability and the Right-of-Use asset under the new standard had a net effect of reducing the REIT’s Debt/Assets ratio by 0.23%, assuming the Lease Obligations are included in the REIT’s debt for the purpose of the calculation.  The decrease in the ratio was due, in simple terms, to the ROU increasing assets more than the Lease Obligations increased liabilities.   

Blue Vault does not currently include the new Lease Obligations liability in calculations of REIT debt ratios, but if the REIT includes the Right-of-Use asset in its assets (usually in the account titled “Other Assets”), it will have the effect of reducing the calculated debt-to-assets ratio reported by Blue Vault. For most REITs, the impacts on reported debt ratios will be small.  The effects on the consolidated statements of operations for nontraded REITs going forward will be the net impacts of accretion of the lease liability and amortization expense of the right-of-use assets.  As data becomes available, Blue Vault will also examine these net effects on REIT net income, FFO and MFFO.

Sources:  SEC, Blue Vault, S&P Global

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Gregory De Jong, CFP, Co-Founder of Paragon Advisors, LLC.
July 7, 2015

Blue Vault is just what advisors need to size up the different offerings in the nontraded REIT market. Just as importantly, it’s what the industry needs to encourage best practices among REITs.