Thought Leadership
Lease Accounting 101
Classifying leases as finance or operating is fundamental to how companies manage leased assets and report them under today’s U.S. GAAP standards. Regardless of whether a company is entering into a traditional lease or a sale-leaseback, understanding the distinctions is essential for accurate financial reporting and decision-making. What is a finance lease? Leases are classified as ‘finance’ when they have characteristics that make them similar to financing the purchase of the underlying asset. To qualify as a finance lease, one or more of the following criteria must be met: Transfer of Ownership: Ownership transfers to the lessee at the end of the lease Lease Purchase Option: The lessee has an option to buy the asset (and likely will) Lease Term: The lease term represents most of the asset’s remaining economic life (typically 75% or more) Present Value: The present value of the lease payments (and any residual value guarantee) is equal to or exceeds substantially all of the asset’s fair market value (typically 90% or more) Under a finance lease, the lessee is deemed to have control over the asset. As such, finance leases are accounted for as if the lessee has ownership of the asset. Accordingly, the lessee recognizes the rent expense as a bifurcated expense between interest expense and depreciation on the income statement as well as a right-of-use asset and lease liability on the balance sheet. Given the nature of the arrangement, finance leases require careful consideration due to the impact on said financial statements. What is an operating lease? An operating lease is much more like a typical lease arrangement, where the lessor permits the lessee to utilize an asset for a set period of time. Under older accounting standards, these assets and related liabilities were not recorded on balance sheet, but that changed in 2016 with ASC 842, in which lessees are now required to bring operating leases on their balance sheet. Leases are categorized as operating if none of the four criteria for finance leases listed above are met. With an operating lease, ownership is not transferred at the end of the lease period. This carries with it the risk that when the lease term ends, a company may be asked to leave or offered unfavorable terms to renew the lease. However, this could also be a plus if the company is looking to move locations. On financial statements, operating leases are accounted for as a right-of-use asset and a lease liability, with all rent expense being recorded as an operating cost. Special considerations for sale-leasebacks Sale-leasebacks have an added layer to consider. For the transaction to qualify as a true sale under ASC 842, the sale-leaseback must be classified as an operating lease. If it is classified as a finance lease for any of the reasons above, it is treated as a ‘failed sale.’ When the sale fails, the seller/lessee: Does not derecognize the asset on its balance sheet and instead records the proceeds as a loan Pays down the loan through lease payments, which are split into principal and interest expense. The interest rate is based on the seller’s incremental borrowing rate W. P. Carey can help Understanding the differences between finance and operating leases is crucial for businesses, especially those considering a sale-leaseback. With both lease types now displayed on balance sheet, it’s important for companies to understand the nuances of each so they can best adhere to accounting standards and make well-informed decisions about their lease agreements. For a deeper breakdown into lease accounting, take a look at Lease Accounting: IFRS vs. US GAAP. In this article, we explore the key differences in lease classification, measurement and presentation under IFRS 16 and ASC 842 and go into more detail on the implications of failed sale accounting for buyers and sellers. W. P. Carey has more than 50 years of experience executing sale-leasebacks and helping companies structure customized leases that make the most sense for their business. While W. P. Carey can help, lessees should consult their accounting professional to address their specific needs.
What’s Next for Commercial Real Estate?
After several challenging years contending with the impacts of a global pandemic, the commercial real estate market finally seems to be healing. As noted in the latest Emerging Trends in Real Estate report from PwC and the Urban Land Institute, the Fed's 50-basis-point cut in September and subsequent 25-basis-point cut in November have generated some optimism in the CRE community that we are entering a new expansionary phase in the real estate cycle. Here are four of the top emerging trends taking shape as a result. 1. Interest Rates and Capital Cost Concerns Have Eased, but Still Remain In the aftermath of the global financial crisis of 2007-2008, the Fed attempted to revive the economy by lowering the federal funds rate to near zero. What followed was nearly a decade in which cheap debt became a way of life. However, starting in the spring of 2022, with inflation surging, the federal funds rate was increased 11 times, pushing the rate from zero to over 5 percent, bringing real estate investment activity to a near standstill. Reflecting on the market today, interest rates and cost of capital remain among the top concerns of respondents to the PwC Emerging Trends in Real Estate survey, but those concerns have eased since last year. While respondents largely agree that the rate cuts so far are not enough to alter deal economics fundamentally, the monetary policy movements have still injected optimism into the market. In addition, more than 80% believe that commercial mortgage rates will decrease in 2025, with 75% believing those rates will continue to decrease over the next five years. As an industry that relies heavily on leverage to get deals done, signs of lower-costing debt bode well for the future and will support more robust deal volume. That said, the Fed’s future decisions on rate cuts will depend on how inflation and the overall economic outlook evolve. 2. Acquisitions, Refinancing and Development Markets Improving The acquisitions, refinancing and development markets are slowly starting to heal, the Emerging Trends report noted, pointing to steady improvement in liquidity and more bids in the market, as well as tighter prices and debt spreads. Industry participants are also optimistic about debt conditions ahead, with lending expected to grow by 24% in 2025, indicating a full recovery to pre-pandemic levels and further signaling that normalization and stability are on the horizon. Another key factor market participants are looking at is the stabilization of recent real estate price declines. Cap rates began rising when prices peaked in mid-2022 and continued increasing until plateauing in early 2024. The most recent figures suggest prices might be turning positive again, although this may simply reflect that higher-quality real estate is accounting for a larger share of transactions. 3. Occupied Space Now Exceeds Pre-Pandemic Levels in Most Sectors The pandemic created significant changes in how tenants use space, and where. There are fewer office workers commuting to the workplace, more consumers shopping online and more goods being stored in warehouses. However, despite these changes, overall demand for space has more than recovered from the pandemic and remains robust across most property types, with the exception of office. When looking at the future of the retail market, survey respondents indicated that location is key. While newness is a significant priority for some property types like office, retail spaces tend to derive much of their value and demand based on their location. Frequently, older retail centers command the best locations, preventing newer entrants from gaining a foothold and making them more attractive to investors. In the industrial sector, net absorption has been positive, meaning more space is occupied than ever before. Yet demand has not kept pace with new supply, leading to an increase in vacant space. This has given more negotiating power to tenants, who are increasingly seeking spaces with more modern features such as high energy efficiency, LED lighting and higher clear heights. However, this “flight to quality” trend should abate slightly as the pipeline for new product slows and the supply/demand dynamics balance out. 4. There Is Less Movement Due to the High Costs of Relocation The pandemic not only created a shift in the demand for commercial property, but also shifted where people want to live and work. After years of increasing interstate migration, many areas are experiencing slower population growth or even outright population losses due to soaring home prices, fewer renters having the ability to transition to home ownership, and fewer households relocating for new jobs. The report notes that climate change is also becoming a greater factor in location decisions. The report points to a Freddie Mac analysis that shows natural disaster concerns have prompted one in seven households to consider other places to live. Many commercial properties are also at risk of damage from natural disasters and commercial property owners are facing increasing insurance premiums as a result. Conclusion As the real estate market transitions into a new cycle in 2025, we remain cautiously optimistic for the future. With change comes opportunity, and we’re excited to see how the landscape evolves as we enter a phase of recovery and renewal. With more than 50 years of experience operating in all market cycles, we’re well positioned to continue helping companies unlock otherwise illiquid capital from their real estate assets. If you're interested in learning more, contact us today.
Corporate Capital Outlook - Q3 2024
Written by Colliers Corporate Capital Solutions, the report details the current state of the global economy and how that’s impacting the net lease sector. The report also features contributed content from Christopher Mertlitz, Head of European Investments at W. P. Carey, on what to expect as we enter a new real estate cycle and the outlook for sale-leasebacks.
A Resurgence of Investor Confidence
Earlier this week, real estate professionals from over 70 countries gathered in Munich for the annual EXPO Real trade fair. After a muted year of investment volume, participants were eager to meet with peers to discuss prospective deals and the outlook for the market. The mood can be best described in two words: cautiously optimistic. After rising interest rates caused months of uncertainty and volatility, attendees finally feel stability is on the horizon. Below are three key topics discussed as delegates look ahead to 2025. Interest rates on the decline Monetary policy decisions on both sides of the Atlantic were a major topic at this year’s EXPO. The European Central Bank began cutting rates this summer, followed by the Federal Reserve in September. These rate cuts are an indicator that inflation is on track to reach its target level for price stability. As a result, we’ve seen the bid-ask spread between buyers and sellers narrowing as real estate values adjust to more realistic levels. For investors waiting on the sidelines for economic clarity, this has also served as the impetus to start deploying capital into new and existing assets. At W. P. Carey, however, we would caution that investors should not focus too much on the next interest rate decision. Instead, they should consider the more important factor – long-term borrowing costs. Real estate investors typically borrow on a long-term basis given the length of their leases, so short-term rate cuts won’t have as much of an impact as some are anticipating. New sectors growing in popularity Post-pandemic challenges in sectors including office and some segments of retail have made investors far more selective in terms of capital allocation. Industrial remains among the most popular asset classes as it continues to benefit from strong market fundamentals. The e-commerce boom and logistics sector’s key role in European supply chains remain long-term growth drivers, while the emerging trend towards nearshoring will provide manufacturing and logistics with a further boost. We’re also starting to see some newer sectors growing in popularity. Self-storage, cold storage, senior living, hospitality and data centers have emerged as attractive investments, with strong operating fundamentals and positive long-term growth potential. As investors continue the flight to safety to protect returns, we expect to see a shift in the sectors – and geographic markets – receiving the most capital. An uptick in sale-leasebacks in 2025 Despite some volatility, the overall environment for sale-leasebacks remains favorable, with high-yield debt and leveraged loans continuing to be expensive. The influx of cash from a sale-leaseback remains incredibly valuable for companies, supporting debt restructuring, strengthening balance sheets and providing capital for operating expenses and growth investments. In addition, we continue to see interest from private equity firms in sale-leasebacks as a means of financing new acquisitions or bolstering the growth of portfolio companies. Last year alone, approximately 75% of W. P. Carey’s investment volume was attributable to transactions with PE-backed companies and we anticipate a significant portion of this year’s deal volume will be as well. While it will take some time for the sale-leaseback market to recalibrate and reach its new normal, we are starting to see the green shoots of a more stable industry as we gear up for a busy fourth quarter. We remain “cautiously optimistic” heading into 2025 and look forward to continuing to find opportunities to help companies unlock capital from their real estate assets.
Navigating Economic Tides: Interest Rates & Commercial Real Estate
Last month, the European Central Bank (ECB) announced it would cut interest rates for the first time since 2019, bringing the deposit rate down to 3.75%. This decision came following Eurozone inflation declining from its 10.6% peak in 2022 to 2.5% in June. But what does this mean for the European commercial real estate market? Inflation is cooling The rate cut is an indicator that inflation is on track to reach the ECB’s target of 2%, which is its desired level for price stability. Investors are hopeful that more stability in the market will further narrow the bid-ask spread between buyers and sellers, helping boost transaction volume. The rate cut will also lower borrowing costs for some investors and encourage more bank lending, increasing liquidity in the market and encouraging those on the sidelines to start deploying capital into new and existing assets. Still a muted impact Despite the positive implications, most real estate professionals expect the impact of the cut will be muted. While it’s a first step in reducing borrowing costs, there is not a universal consensus as to how the ECB will view future rate decisions. In its July meeting, the ECB decided to keep rates stable. A key issue remaining for the commercial real estate industry is the refinancing risk for maturing loans. While the cut will likely help some borrowers at the margin, it is not expected to have a significant impact on the pressures facing those needing to refinance. Additionally, cutting rates too quickly may not be ideal for some European economies. If inflation climbs back up, the ECB may have to reverse course and increase rates again, causing further volatility in the market. It is also important to consider the divergence between the ECB and the U.S. Federal Reserve’s own decision to hold rates steady for now. This could impact the Euro-U.S. Dollar exchange rate, which feeds into inflation via the prices for imported goods and services. Final thoughts While the ECB’s decision has garnered a lot of attention, we believe the more important factor is long-term borrowing costs. Real estate investors typically do not borrow on a short-term basis, but rather on a 5- or 7-year fixed rate basis. In this context, SWAP rates often matter more than the ECB’s (short term) deposit rate. As a result, we do not see this decision having a significant impact on the real estate investment market at this point in time. Investors should remain focused on their long-term strategy and direct their attention to factors within their control like quality underwriting, timely execution and capitalizing on opportunities when they arise.
The Power of REITs
Inflation, interest rate volatility and market dynamics have shaken the foundations of standard investment models. As a result, investors are looking for avenues that promise long-term growth and security. Investing in Real Estate Investment Trusts (REITs) has gained considerable attention, particularly because REITs have a unique blend of income generation, diversification and stability. So, what exactly are REITs, and why should investors consider them? What is a REIT? A REIT is a specialized company that owns, operates or finances income-producing real estate assets, including commercial and residential properties, hotels, healthcare facilities, industrial spaces and more. REITs were created by the U.S. Congress in 1960 to allow individual investors to access the benefits of real estate investment once reserved for institutions and wealthy individuals. One of the key distinguishing features of a REIT is its tax structure. A REIT must meet the following IRS requirements: Income Distribution: Distribute at least 90% of taxable income to shareholders as dividends. Asset Composition: At least 75% of assets must be invested in real estate, cash or U.S. Treasuries. Shareholder Requirements: Must have a minimum of 100 shareholders and no more than 50% of its shares can be held by five or fewer individuals during the last half of the taxable year. Types of REITs There are three main REIT types, each with different specializations: Equity REITs: Own, manage and develop income-generating properties (e.g., industrial, retail or warehouse facilities). Mortgage REITs: Invest in or originate mortgage loans and mortgage-backed securities, often borrowing money at lower short-term rates and investing in higher-yielding mortgage assets. Hybrid REITs: Combine features of both equity and mortgage REITs. Benefits of Investing in a REIT REITs have gained significant popularity among investors in recent years, and for good reason. They offer a range of potential advantages, including: Accessibility: Offer access to the real estate market with a lower initial investment. Diversification: Enable investors to diversify investments across different properties in various real estate sectors and geographic locations. Steady Income Stream: Can provide reliable income due to requirement to distribute 90% of their taxable income to shareholders as dividends. Liquidity: Publicly traded REITs offer more flexibility as investors can quickly buy or sell shares on the stock exchange. Professional Management: Typically have a management team of experienced real estate professionals who leverage their expertise in portfolio management to optimize property performance. Portfolio Growth Potential: Offer portfolio growth potential from property appreciation and higher rental income. Tax Advantages: Provide a tax-efficient investment option, with dividends often taxed at lower rates than ordinary income, allowing investors to grow their wealth more efficiently. Why Should Individuals Invest Now? REITs offer investors a unique opportunity to gain exposure to the real estate market without the burden of property ownership and can provide steady income streams and the potential for long-term capital appreciation. Their comparatively low correlation with other assets also makes them an excellent portfolio diversifier, which can help reduce overall portfolio risk. As a result, REITs may be a valuable addition to an investment portfolio for individuals seeking steady income, diversification or a combination of both.
Countdown to ICSC Las Vegas
ICSC Las Vegas, one of the largest tradeshows for the retail industry, is on the horizon with an expected 30,000 attendees eager to network and reconnect face-to-face with industry leaders and peers. After a somewhat sluggish 2023, attendees will be looking to the conference to shed some light on the retail landscape and offer insights on new trends and opportunities within the sector. Consumer spending, retail vacancies and sale-leaseback activity will be among the most pressing topics discussed at the show. Here's an overview of each: Consumer spending remains steady Despite inflationary concerns, consumer spending has remained steady over the past year, as core retail sales, excluding gasoline, food service and auto vehicle purchases, increased by 3.3% at the end of 2023. As a result, demand for retail space has remained strong and the market is starting to see in uptick in new developer-built retail locations coming online. W. P. Carey has completed several deals that align with this trend – for example, the acquisition of 22 recently built and to-be-completed car wash facilities across the U.S., leased to Tidal Wave Auto Spa, a prominent car wash operator. With interest rates projected to decrease in late 2024, the market will likely continue to see a ramp up in new development over the coming months. Retail vacancies at record lows Strong demand for retail space has resulted in record-low vacancy rates, with total retail vacancy reaching 4.2% at the end of 2023. Low vacancy rates are a positive sign for investors like W. P. Carey as it provides greater confidence in long-term leases and the ability to re-lease vacant buildings if the need arises. However, it also means more competition for less space which is pushing retail rents significantly higher. This makes it more expensive for retailers looking to expand and acquire new space, which in turn increases operational costs. Sale-leaseback activity picks up With rents rising significantly, retailers – particularly those looking to grow their real estate footprints – will be seeking new ways to access capital. This will likely contribute to greater demand for sale-leasebacks, where a retailer sells its real estate to an investor (like W. P. Carey) for cash and simultaneously enters into a long-term lease. This is a valuable business decision for most retail companies because owning real estate can serve as a drag on their balance sheet. By unlocking the value of their real estate through a sale-leaseback, retailers can reinvest proceeds into their core competencies, leading to better overall returns and long-term growth.
Charting a Path Forward
The CFO role has evolved over the years, expanding from its traditional financial focus to a broad range of strategic responsibilities. Today's CFOs wear many hats – from financial planning to compliance and risk management and strategic decision-making, among many others. In an environment marked by rapid technology advancements, market volatility and regulatory changes, CFOs play a crucial role in guiding organizations through challenges to build resilience and maintain profitability. In this blog, we delve into CFOs’ top priorities for 2024, drawing from a recent Gartner survey, and explore how leveraging sale-leasebacks can unlock capital to address these priorities. 1. Leading Transformation Efforts Embracing technology and automation remains a top challenge for organizations. Recognizing the crucial role of technology in enhancing business efficiency, compliance and competitiveness, CFOs will focus more on leading digital transformation efforts, both within their departments and across the entire organization. CFOs are integral to driving business transformation, especially in evaluating the best initiatives to adopt and their contribution to the bottom line. As companies scale, continuous implementation of emerging technologies becomes essential for efficient growth management. 2. Evaluating or Improving Financial Strategy Managing the finance function is a core responsibility for CFOs, and is vital for business growth and continuity. With the current economic and market volatility, CFOs will focus more on evaluating and improving the finance function's strategy. A robust financial strategy is essential to meet short and long-term financial goals and ensure positive business outcomes. It offers a better understanding of the company's present financial situation, assesses potential risks, outlines income goals, identifies competencies, investment strategies and funding options necessary to realize those goals. 3. Improving Finance Metrics, Insights and Storytelling Understanding financial metrics and insights is crucial not just for CFOs, but the whole organization. As such, leveraging data visualization can help simplify complex concepts, streamline reporting and foster collaboration across the organization. This can enable companies to tell stories and drive better understanding of their messaging among core audiences, including investors, which can potentially boost valuation. CFOs will prioritize improving finance metrics, insights and storytelling to achieve these and other benefits. 4. Leading Change Management Efforts CFOs will also prioritize leading change management in 2024. Resistance to change among employees is a common challenge often triggered by factors like fear of the unknown, lack of trust in leadership or loss of control. Effective change management is thus vital to organizational success. Strategic leadership promotes consistency, builds employee trust, enhances cost management and enables organizational agility, among other benefits. 5. Optimizing Costs Optimizing costs is yet another area of precedence for CFOs in 2024. Strategic cost management is essential for the realization of organizational goals, especially in volatile times. Possible initiatives include, promoting cost-consciousness across the organization to reduce operating costs, adopting new technology and automation to address inefficiencies, embracing data-driven decision-making and improving vendor management. The Key to Make it All Happen The success of an organization's financial initiatives hinge on the availability of capital. Particularly in an uncertain rate environment, access to liquidity is essential in providing companies with flexibility and growth capital. For companies that own their real estate, sale-leasebacks offer an alternative capital source to support CFOs’ 2024 priorities. These transactions enable companies to access immediate funds while maintaining operational control of their facilities. However, several considerations must be addressed to determine the suitability of a sale-leaseback for a business. First, sale-leasebacks only makes sense if the company owns its real estate. Additionally, a strong credit profile is necessary and a willingness to commit to a long-term lease is essential. The W. P. Carey Solution With all the conditions met, a sale-leaseback is a handy strategy that CFOs can explore to raise the much-needed capital to support the above priorities. At W. P. Carey, we have helped many companies in North America and Europe leverage this financing solution for over 50 years. If you're considering unlocking capital for your operations this year through a sale-leaseback, contact W. P. Carey today!
Expectations for MIPIM 2024
MIPIM, the world's largest real estate conference, will get underway in Cannes next month with over 20,000 delegates expected to attend. As in years past, many will be looking for the conference to bring some clarity on what the real estate industry should be looking out for in the year ahead. While the industry outlook remains murky, investors entered 2024 with a sense of optimism. Here are the biggest questions delegates will be looking to answer at MIPIM 2024. Have Eurozone interest rates reached their peak? The market consensus is generally that the European Central Bank (ECB) has completed or is nearing the end of its rate hiking cycle. However, much to the disappointment of the market, the ECB did not give an indication on when rates would be cut. As a result, a continued upward pressure on yields and downward pressure on real estate valuations is expected through 2024. On a positive note, interest rates reaching their plateau should help jump start the investment market. Greater predictability will contribute to value discovery, cap rate stabilization and tightening bid-ask spreads. This will result in greater transaction activity and hopefully many discussions around prospective deals at MIPIM! What's the outlook for the European sale-leaseback market? Given borrowing costs are expected to remain high in 2024, sale-leasebacks will continue to be an attractive solution for companies to unlock the value of otherwise illiquid real estate assets. Furthermore, with a large share of speculative-grade debt expected to mature in 2025 and 2026, more companies will likely leverage sale-leasebacks for additional proceeds to get refinancing done. Sale-leasebacks offer permanent, long-term capital with no refinancing risk or balloon payments, which remains a very attractive alternative for companies in need of extra cash. In addition, M&A activity is expected to increase in 2024, with private equity firms sitting on over $2.5 trillion in dry powder. Typically when M&A activity increases, there is an uptick in sale-leaseback opportunities, as private equity firms are increasingly leveraging sale-leaseback financing as part of the capital stack for new acquisitions. How can the real estate industry make ESG commitments a reality? The rollout of the EU’s Corporate Sustainability Reporting Directive (CSRD) has put increased pressure on real estate companies to both implement and report on their ESG initiatives. As a result, companies are developing strategic plans to create and maintain sustainable real estate portfolios while also preparing to meet upcoming compliance standards. The challenge the real estate industry faces today is turning commitments into reality. One of the most important steps companies can take is creating more efficient and automated processes for the procurement and management of ESG data. The use of business intelligence and building technology significantly enhances the data collection process, allowing companies to evaluate potential building improvements, review opportunities to reduce emissions and meet future reporting requirements. MIPIM offers a valuable platform for the industry to discuss new ideas and possible solutions related to ESG.