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Building Success: An EisnerAmper Real Estate Blog

New Accounting Standards Allow Sellers or Lessees in Sale-Leaseback Transactions to Recognize Gain in Certain Circumstances

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August 4, 2016

By Ed Opall, CPA

A very interesting by-product of the new revenue recognition standard (ASU 2014-09, Revenue from Contracts with Customers – Topic 606) issued on May 28, 2014 and the new lease standard (ASU 2016-02, Leases – Topic 842) issued on February 25, 2016 will be a change in accounting for sale-leaseback transactions, which is a popular tool for financing real estate and equipment. The primary reason for sale/leaseback transactions is to generate cash flow from appreciated long-term assets and still retain the right of use. If the transaction is structured properly in accordance with the new standards, seller/lessees will be allowed to recognize the sale immediately rather than defer recognition of gain over the life of the lease. Accordingly, it is likely that we will be seeing more of these transactions once the standards are adopted. Companies with significant real estate holdings who would employ sales and leasebacks as a financing vehicle would be able to strengthen their balance sheets as a result of this new guidance.

The effective date for revenue recognition (for calendar year reporters) is 2018 for public companies and 2019 for private companies. The effective date for the leasing standard (for calendar year reporters) is 2019 for public companies and 2020 for private companies with early adoption permitted in 2017. The revenue recognition standard allows for early adoption in calendar year 2017 for public companies and 2018 for private companies. Both the revenue recognition standards and the leasing standards need to be adopted in order to recognize the gains from sale-leaseback transactions.  

In order to recognize the sale transaction, the transaction must qualify as a sale under the revenue recognition standards. Under the new revenue standards, the 5 core principles are as follows: 

  • Identify the contract with the customer.
  • Identify the separate performance obligations in the contract.
  • Determine the transaction price.
  • Allocate the transaction price to separate performance obligations.
  • Recognize revenue when performance obligations are satisfied.   

A bona-fide contract would possess all of the following criteria: 

  • The parties to the contract have approved and are committed to perform their respective obligations.
  • The entity can identify each party’s rights regarding the goods or services to be transferred.
  • The entity can identify the payment terms for the goods or services to be transferred.
  • The contract has commercial substance (risk, timing, or amount of future cash flows are expected to change as a result).
  • It is probable that the entity will collect the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer.  An entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. 

The key provision of the revenue recognition standard for sales treatment is that there must be commercial substance. The sale must result in a complete change of control from the seller to the buyer and there must not be substantive repurchase options tied to the agreement. The buyer must have paid the transaction price or have the ability and intention of paying the transaction price.

The transfer of control to the buyer/lessor must also be clear in the lease agreement to not include provisions that revert control back to the seller/lessee. Under the new leasing standards for lessees, leases are classified as either financing or operating. Only an operating leaseback would qualify the sale for immediate profit recognition in a sale/leaseback transaction. Below are the criteria for determining if a lease is a financing lease. If the lease does not have any of the stated criteria, it is considered an operating lease. 

  • The lease transfers ownership of the underlying asset to the lessee by the end of the lease.
  • The lease grants the lessee an option to purchase the underlying asset and the lessee is reasonably certain to exercise.
  • The lease term is for the major part of the remaining economic life of the underlying asset. 
  • The present value of the sum of the lease payments and residual value guaranteed by the lessee equals or exceeds the fair value of the underlying asset.
  • The underlying asset is of such a specialized nature that it is expected to have no alternative use at the end of the lease term without significant modifications. 

In essence, the lease must not be for such a long length of time and of such significant payment terms that it is in substance a sale of the property back to the lessee. The first 4 criteria are similar to the current standards, albeit without the bright-line objective tests. A new criterion has been added in the new standards where the underlying asset must have alternative uses with only reasonable alterations required to release to another lessee. That would preclude certain industrial equipment or certain improved real estate from sale recognition.

The standard also states that the buyer/lessor would need to classify the lease as an operating lease for their purposes as well for the sale/leaseback to be recognized. A lessor treats the lease as an operating lease unless both of the following criteria are met: 

  • The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments and any third-party guarantees by third parties equals or exceeds the fair value of the underlying asset.
  • It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy the residual value guarantee. 

Under the new standards, both the sale transaction and the lease transaction will need to be recorded at fair value.  Since both transactions are typically consummated as a package, the parties could (at least in theory) negotiate off-market terms on the sale and make up for it with off-market terms on the lease.  The guidance requires adjustment of these terms to fair value so that the accounting reflects the commercial substance of the transaction; otherwise the seller/lessee ends up with deferred income or prepaid rent and not the intended result.

Once fully adopted, the new revenue and leasing standards could, if structured correctly, provide opportunistic seller/lessees to “more or less” have their cake and eat it too.  Care needs to be taken to ensure that the “more or less” part of the strategy works.  Consult your friendly accounting firm for guidance.

A sale-leaseback transaction that does not qualify for sales recognition would be considered a financing arrangement. The seller would retain the asset on its books, even though it no longer legally owns the asset.  The cash proceeds would be considered a financing obligation.

The Evolution of a Business Plan: Investors Share Value-Add Success Stories

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A version of this article was first published by Real Estate Weekly Online on June 28. 

When The RADCO Companies CEO Norman Radow was in the workout business, his company foreclosed on $8 billion worth of real estate over 2 years. The owners varied: some were undercapitalized developers, while others couldn’t handle their projects. Today, some of them are even spending time in Club Fed. But they all had a common denominator, Radow pointed out: They would not change their business plan when the market told them to.

EisnerAmper tax partner Lisa Knee, who moderated the “Economics of Real Deals” panel during IMN’s 17th Annual U.S. Real Estate Opportunity and Private Funds Investing Forum, encouraged the speakers—which included Radow—to share how their business plans evolved in wake of changing market trends and their resulting successes.

After the workout business, Radow transitioned into buying multifamily, “because Fannie Mae and Freddie Mac were there, and it had liquidity.” But he quickly learned he couldn’t compete for shiny new apartments against the Behringer Harvards of the world, which could close in 30 days. That’s when he discovered the Class-B value-add space.

“Eighteen months later, something profound was going on,” he recalled of the year 2013. “There was the most dramatic demographic change since the end of World War II … and we were seeing it in reverse. The market was moving faster than we could catch it.”

Since then, rents have grown each year—in Atlanta, as much as 10% or more. “This isn’t an inning,” he said of the market. “This is a whole new season.” His firm just closed on a multifamily deal in which tax credits are expiring, and with them, subsidized rents. RADCO is paying under-market rents, and he expects to be able to mark-to-market “and leave the cap rate in the dust.”

RADCO also had a project in Colorado “that was a manager’s special with all of my favorite flavors: lead paint, asbestos, aluminum wiring, and single-pane windows,” Radow said. After rectifying the problems, recladding the building, and taking down the mansards, RADCO made the building look brand new and hip for Millennials. “We’re 25% net growth in year one, and will refi in July with 120% repayment in equity,” he noted.

“Since we’re talking about multifamily opportunity, everyone talks about repositioning for Millennials,” Knee pointed out. “But what about the empty nesters?”

Post Brothers president Matt Pestronk noted that Millennials are all about immediate gratification—they want to walk to, not drive, and get what they need in 5 minutes. And for the most part, Baby Boomers are looking for the same thing—but living in 4 times the size of the units of Millennials.

Post Brothers has responded by building multi-generational properties, like the large-scale gut renovation of an iconic Philadelphia apartment complex that was originally built for World War II servicemen in the ‘40s. The developer purchased the property for $84 million, and the project, called Presidential City, will cost over $240 million, he said. Each tower will have its own identity; large units as per the Boomers and smaller units as per the Millennials, with shared amenities. Another project—“an interesting sociological experiment,” he said—will have 38 condos on the top half of the building, with units 4 times the size of the 151 rental apartments in the lower half of the building.

“Larger urban spaces for people selling houses is a totally underserved niche in the Northeast,” Pestronk continued. But with construction prices extremely high, most of Post Brothers’ projects are rehabilitations, which means it’s hard to prove out the projects’ values during the capital-raising phase. “But when you achieve your projections everyone says, ‘I should have thought of that,’” he said.

“And what about Gen Z?” Knee asked, quickly noting that the alphabet is running out of letters.

That’s where Vie Management CEO Ari Rosenblum is playing in the student housing space. Five years ago, he said, his firm noticed a large number of buildings getting stranded, primarily those far away from campus. Years ago, a lot of capital had come into the space and the sector got frothy, and investors who were non-student housing operators were buying.

“But over time, if the buildings were not properly capitalized or not owned by a dedicated student housing owner and operator, they got stranded,” he noted. “There was no clear path for the owner to get them to profitability.”

Vie Management stepped in with a physical and management revitalization plan for the properties, and discovered that even if a property were 2.5 miles away from campus, you can attract some of the better students through creating a destination project that felt like a “spa hotel experience.” That meant property management treating students as guests and not acting like a warden; as well as conducting physical upgrades like ripping out carpet, putting in stainless steel appliances, upgrading fitness centers, and repainting and re-landscaping. You can’t forget technology: Many of its buildings have Wi-Fi boosters, Nest thermostats, and door locks students can open with a smartphone.

“Our management has seen dramatic rent increases by looking at peers of the same vintage but just running tighter,” he said, pointing to projects like East Carolina University’s The Landing, where Vie invested 5% to 10% of its purchase price, raised rents 11%, and then left 18 months later with a big IRR.

On the office side, CenterSquare Investment Management senior vice president Chad Burkhardt spoke about Fossil’s previous corporate headquarters in North Dallas, a 200,000-square-foot building connected to a manufacturing building, both which sat vacant for 3 years. The company that had developed Fossil’s new build-to-suit held on to the old property and was trying to find a “unicorn,” a tenant that wanted 200,000 square feet of office.

“We all know that’s not a real thing,” Burkhardt laughed. “They hung out there for a really long time, and the pricing went down. We thought we could buy the office for $100 per square foot vacant and the manufacturing building for free.”

Its strategy after purchasing the property with a creative partner was converting the manufacturing building to covered parking, therefore increasing the parking ratio, an important amenity for Dallas. “If you don’t have an edge on parking, we won’t even touch it,” he said. Within 6 months, the building had a lease with a Fortune 50 company for 12 years

Argosy Real Estate Partners managing partner David Butler also found an off-market deal in Dallas’ West End district that was owned by an orphan fund.  It had a 10-year CMBS loan maturity this October, and the firm bought it for the long term. Argosy replenished the reserves, put a small amount of money in it, and re-tenanted it. In a little under a year, Uber signed on to be a ground-floor tenant, turning it into a creative tech building.

 “When we underwrote the building, we planned on waiting for loan maturity, rebalancing the loan, and putting new equity in it,” he said. “When we finished the business plan, we asked, ‘Why don’t we test the market?’ It was purchased by a big technology real estate farm, and we made 6 times our money in a little over a year and a half. It wasn’t planned or underwritten that way—we had planned to hold it for at least 5 years.”

Knee then asked about failures investors experienced that turned into a success, because they were able to rethink their plans.

Rosenblum recalled a project in which Vie was halfway through in Texas. It then discovered, from a capital perspective, it wouldn’t have the draw it thought it would. “Capex was cut 40% from where we budgeted, so we had to pare back and figure out what our best ROI items were in units,” he said. “We had to think on our feet. We didn’t do our flooring program throughout the units; pared back on the pool redo, and revised the fitness center. We got the rents we pro formaed anyway—it showed we actually had been overspending, and it was a good lesson.”

Lisa Knee July Panel

MetaProp NYC Creates the Global Real Estate Tech Confidence Index

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July 7, 2016

By Morgan Piscitelli

MetaProp NYC, the first real estate tech accelerator, recently released their findings from an index they created called the Global Real Estate Tech Confidence Index. The initial results of the index, designed together with the Real Estate Board of New York, were positive. MetaProp NYC’s Global Real Estate Tech Confidence Index measures the health of the real estate technology market, according to the views of investors and startup founders worldwide. The index is based on responses to 4 questions, with a response range from 0 to 10. 

To create this new index, MetaProp NYC polled real estate tech investors and founders, asking about company growth and their thoughts on the future conditions of the market. The results showed that the investors were more confident about the real estate tech market than entrepreneurs. MetaProp NYC found that “90% of investors intend to make either the same amount of investments as last year or more,” according to co-founder and managing director Aaron Block. The index also reported that many expect the real estate tech market will grow more competitive during this year.

Another expectation of the 2016 real estate tech market reported by the Index was that customer growth would be moderate. Although most startups are expecting to double 2015 revenue, some are not expecting to bring in any revenue at all. However, despite this expectation, many startups reported having aggressive hiring plans for 2016.

“As opposed to other industries such as advertising or finance, the real estate industry is just beginning to embrace innovation and technology,” said EisnerAmper LLP Partner Steven Kreit. “This index is a great tool to see how investors and entrepreneurs see the short term and long term prospects for the industry.”

The data collected from MetaProp NYC’s Global Real Estate Tech Confidence Index shows that in 2016, many real estate investors seem more inclined to lean into real estate tech trends, while entrepreneurs remain more skeptical.

EisnerAmper is an independent member of Allinial Global.
EisnerAmper is an independent member of EisnerAmper Global.