From the IFRS Institute – March 5, 2021
COVID-19 has presented no shortage of challenges to the real estate sector. While much of the focus has been on the difficulties faced by tenants unable to pay rent, landlords have also faced profound business challenges with significant financial reporting implications under IFRS® Standards. In this article, we summarize four immediate financial reporting considerations for landlords relating to tenant lease payments, construction delays, debt, fair value and impairment. In addition, we discuss considerations and the related accounting consequences for landlords moving forward.
Changes in lease payments
Across the country, many cities and states implemented orders requiring businesses to operate at reduced capacity or to close entirely. As a result of these economic pressures, many tenants, particularly those in the retail and services industries, have made rent payments that are less than the amount that was contractually owed. The accounting for these reduced lease payments depends on whether the lessee was contractually permitted to withhold or defer rent.
Many landlords have provided commercial tenants with rent concessions, including rent-free periods, decreased rent and interest-free rent deferrals. Most commonly, landlords have permitted tenants to either:
- defer rental payments for a specified number of months with the deferred amounts added to the remaining rent payments within the existing lease term; or
- forgo rent for a specified number of months in return for extending the non-cancellable term of the lease by the same number of months at the same rent.
Landlords have also accepted decreased rent from tenants, such as by changing rent payments from fixed to variable (e.g. a landlord may accept variable rent based on sales in lieu of base rent), or waiving variable rent payment minimums.
If a landlord did not have an obligation under the original lease contract to grant a rent concession, and the concession results in a change to the scope of or consideration for the lease, then the lessor’s agreement to grant a concession is accounted for as a lease modification. Concessions that change the consideration for the lease – e.g. grant the lessee free or reduced rent – and are not modifications are generally accounted for as negative variable lease payments.
Certain concessions do not change the scope of or consideration for a lease and are therefore not accounted for as lease modifications. For example, a concession that permits a tenant to forgo rent for three months with the forgone payments added to the following three months does not meet the definition of a lease modification; this is because neither the scope (i.e. term) of, nor consideration for, the lease has changed. In this case, the landlord would continue to recognize rent on a straight-line basis.
The International Accounting Standards Board (the IASB® Board) has amended IFRS 161 to simplify how lessees account for rent concessions arising as a direct consequence of COVID-19. However, no such relief exists for lessors, who are still required to assess whether a rent concession is a lease modification. This assessment can be burdensome for landlords, particularly when granting a large number of concessions within a short timeframe.
If a rent concession is a lease modification, the accounting depends on the classification of the lease (i.e. operating or finance lease). The following diagram illustrates this evaluation and its result on a lessor’s accounting.
|Original lease is a finance lease.
||Original lease is an
Increase in scope of lease by adding right of use
for one or more underlying assets and at stand-alone price for increase.
All the contract modifications.
Classifications at inception if
modification had been in
effect then as:
|Seperate lease||New lease||Apply IFRS 9||New lease|
Landlords account for modifications to operating leases as a new lease, with any prepaid or accrued rent payments from the original lease treated as part of the lease payments in accounting for the new lease. As a consequence of treating the modified lease as a new lease, any incremental initial direct costs incurred in the modification are eligible for capitalization.
When a finance lease is modified, determining the appropriate accounting can be complex. For increases in scope (e.g. adding the right to use an underlying asset), landlords have to assess if the increase is at stand-alone selling price. Otherwise, landlords evaluate whether the lease would have been an operating or finance lease if the modification had been in effect at inception.
Unlike the IASB Board, the FASB provided relief to both lessees and lessors by permitting them to apply the lease modification guidance for concessions related to COVID-19 that do not result in a substantial increase to the rights of the lessor or the obligations of the lessee. Therefore, landlords reporting under IFRS Standards may have different accounting outcomes than landlords reporting under US GAAP.
While many tenants have negotiated with landlords to receive concessions, other tenants have simply ceased making rent payments. When a tenant fails to pay amounts due under a lease contract with no agreement from the lessor, such short payments are not considered a lease modification (i.e. the lease agreement has not been modified), and landlords are required to continue accounting for the lease under its original terms and conditions. Therefore, it will generally be appropriate for landlords applying operating lease accounting to continue recognizing operating lease income on a straight-line basis, and lessors applying finance lease accounting to continue recognizing decreases to the net investment in the lease regardless of the negative effects of COVID-19 on tenants. In addition, a tenant’s failure to pay amounts due under a lease agreement may raise a range of other issues for landlords to consider, including the following.
- Operating and finance lease landlords will need to consider potential impairment to operating lease receivables and the net investment in the lease, respectively, under IFRS 9.2
- Operating lease landlords will also need to evaluate the appropriateness of the underlying asset’s measurement. Fair value estimates of investment property under IAS 403 will need to incorporate current market participant expectations. Property measured at historical cost may need to be evaluated for impairment (see below).
KPMG recently released Real Estate Leases: The landlord perspective, an in-depth discussion of the key accounting issues facing landlords when applying IFRS 16 and IAS 40.
Landlords acting as developers are also facing difficult decisions on how to proceed with construction and development projects. At the onset of COVID-19, certain projects were put on hold due to local restrictions or shortages of labor or supplies. Additionally, some developers with flexible deadlines voluntarily placed projects on hold to obtain better information about COVID-19’s effects on the economy; some of these projects have not yet resumed.
For developers that have not yet resumed projects, or that resumed projects after an extended period, questions may arise about the accounting for borrowing costs.
IAS 234 requires capitalization of borrowing costs directly attributable to qualifying assets – i.e. assets that necessarily take a substantial period of time to be made ready for their intended use or sale, such as assets subject to major development or construction projects. However, capitalization must be suspended during extended periods in which active development is interrupted. IAS 23 does not provide guidance on what constitutes an ‘extended period’ and judgment may be required. Our article further discusses the impacts of project delays and suspensions, and how the capitalization of borrowing costs may be affected in the recent environment.
IAS 23 and US GAAP are broadly converged in regard to the underlying principles. Read our article, IFRS Perspectives: Borrowing Costs: Top 10 differences between IFRS Standards and US GAAP to learn more.
While many have offered rent concessions to their tenants, landlords themselves are generally expected to continue to service outstanding mortgage and construction loans. This is compounded by the fact that certain governors or local officials have issued executive orders imposing moratoria on evictions without granting mortgage payment or tax (e.g. property tax) relief to landlords. As a result, many landlords have sought to modify the terms of their existing financing arrangements or enter into alternative financing arrangements.
Real estate lenders have generally been willing to work with landlords to restructure or modify the terms of outstanding debt to avoid foreclosure during the pandemic. Common modifications include changes in interest rates, extension of maturity dates, renegotiation or waiver of covenants, or waiving of default interest (particularly on construction projects).
Landlords are required to assess whether such changes to the terms of existing financial liabilities constitute a ‘substantial modification’ under IFRS 9. Substantial modifications are accounted for as an extinguishment and derecognition of the original loan, whereas other modifications result in recognition of a modification gain or loss. Generally, terms are considered to have been ‘substantially modified’ if the net present value of the cash flows under the new terms – including any fees paid, net of any fees received, discounted using the original effective interest rate of the original liability – differs by at least 10% from the present value of the remaining cash flows under the original terms.
Like IFRS Standards, under US GAAP, a substantial modification of the terms of an existing financial liability results in extinguishment accounting. However, unlike IFRS Standards, US GAAP includes specific requirements for troubled debt restructurings.
In addition to negotiating modifications, landlords may explore obtaining additional financing in the market. Recently, there has been a trend toward mezzanine financing, which blends characteristics of debt and equity. Mezzanine financing can be structured as either subordinated debt or preferred stock; in one form of mezzanine financing common in commercial real estate, debt is secured with an equity conversion option rather than the underlying property. These arrangements need to be analyzed closely to determine their classification under IFRS Standards – i.e. equity or liability.
Additionally, certain other forms of financing (e.g. preferred stock redeemable at the option of the holder) will often be liability-classified under IFRS Standards, but meet the criteria for (temporary) equity-classification under US GAAP. The initial classification as a liability under IFRS Standards drives subsequent measurement and presentation in the statement of comprehensive income; there is no effect on classification as (temporary) equity under US GAAP.
While such financing can be attractive to property owners seeking to avoid taking out a second mortgage, landlords need to carefully evaluate the desired capital structure. Further, the favorable financing effects from these financing transactions may be offset by increased accounting complexity.
Default and covenant breach
Separately, the deterioration of operating results may lead to breaches to debt covenants or triggering subjective debt covenant clauses, ultimately resulting in debt being callable on demand. Companies may need to classify such liabilities as current under IAS 15, an evaluation that may be complex and require significant judgment. Our article, IFRS Perspectives: Current/noncurrent debt classification (IAS 1 vs. ASC 4706) discusses the differences between IFRS Standards and US GAAP for debt classification.
Under IFRS Standards, investment property measured at historical cost rather than fair value is tested for impairment if there is a triggering event. An impairment loss on a real estate asset is recognized if the asset’s carrying amount exceeds its recoverable amount, which is the higher of fair value less cost of disposal and value in use. The impairment loss is then measured as the difference between the asset’s carrying amount and its recoverable amount.
The changes to the business climate, anticipated future cash flows, and market prices of real estate have increased the likelihood that a triggering event for impairment testing occurred in 2020. While many landlords have robust impairment testing processes in place, COVID-19 introduced an additional layer of complexity and underscored the need for carefully reasoned and well documented judgments. Considerations may vary significantly by class of real estate. For example, those with significant retail and hospitality holdings may be more likely to identify a triggering event and record an impairment loss, given continued vacancies and shifting real estate preferences.
Like IFRS Standards, under US GAAP a real estate asset is impaired only if its carrying amount exceeds its ‘recoverable amount’. However, that term is used differently. Under US GAAP, the recoverable amount is the undiscounted cash flows expected to result from the use and ultimate disposition of the asset. If the carrying amount is less than the recoverable amount, the impairment loss is the difference between the carrying amount of the asset and its fair value.
Further, the unit of account for identifying and measuring an impairment loss may be larger than the individual asset, but the determination of the larger unit – the cash-generating unit under IFRS Standards and the asset group under US GAAP – is different under the two GAAPs.
Under IFRS Standards, certain real estate assets (e.g. condominiums developed or held for sale in the ordinary course of business) may be accounted for as inventory and declines in value are evaluated under the inventory guidance, rather than the general impairment guidance. Under this model, the cost of inventory is written down to net realizable value when net realizable value is less than cost. If the net realizable value subsequently increases, the writedown is reversed. IFRS Standards and US GAAP differ with respect to inventory impairment considerations. US GAAP prohibits reversal of a writedown of inventory for subsequent recoveries in value unless it relates to changes in exchange rates.
For further discussion on the differences between IFRS Standards and US GAAP, see our publication IFRS Compared to US GAAP.
Looking to the future
COVID-19 will likely have lasting effects on landlords’ business models, liquidity management strategies and capital investment practices. Landlords should consider the following accounting implications of these changes.
- Impacted tenants are likely to continue to request rent concessions and changes to their lease agreements, including adding force majeure or similar clauses that consider events like the COVID-19 pandemic. Further, tenants may increasingly prefer leasing smaller areas for shorter terms. Landlords and tenants are both likely to structure leases more carefully, including provisions like tenant improvements to obtain optimal financial results. Landlords should consider how key accounting judgments such as the determination of lease term might be affected. Tenants may also express a preference for variable over fixed payments, and landlords should consider the potential volatility to profit and loss and cash flows.
- Landlords should consider whether changes to lease agreements with tenants will affect their liquidity profiles and proactively negotiate with lenders in advance. The accounting for any modifications to outstanding debt agreements will depend on whether those modifications are ‘substantial’ (see above).
- Landlords with sufficient capital and risk appetite may consider acquiring distressed real estate assets (via below-market leases or direct ownership) to diversify their real estate holdings and increase presence in real estate sub-sectors and geographic areas that show strong prospects for recovery. Landlords considering acquiring finance leases through an asset purchase will need to consider whether the asset is credit-impaired on initial recognition because this will affect the initial measurement of expected credit losses.
- Landlords acquiring real estate assets also need to determine whether the transaction should be accounted for as an asset acquisition or a business combination. It is not always clear whether acquired real estate portfolios meet the definition of a business under IFRS 37 – i.e. have inputs and substantive processes that together contribute to the ability to create outputs. As a result, some landlords may elect to simplify this assessment by applying the optional concentration test under IFRS 3. This test indicates that if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset (or group of similar identifiable assets), then the transaction should be accounted for as an asset acquisition instead of a business combination and no goodwill will be recognized. For further discussion, see our article IFRS Perspectives: New definition of a business: IFRS compared to US GAAP.
- IFRS 16, Leases
- IFRS 9, Financial Instruments
- IAS 40, Investment Property
- IAS 23, Borrowing Costs
- IAS 1, Presentation of Financial Statements
- ASC 470, Debt
- IFRS 3, Business Combinations, defines a business as an integrated set of activities and assets capable of being conducted and managed to provide goods or services customers, generate investment income, or generate other income from ordinary activities.