Jump to content

Capitalising leases


petec
 Share

Recommended Posts

What do people think about the capitalisation of leases?

 

On the one hand, leases represent a commitment to pay, and so can be looked at as debt and capital employed.

 

On the other,

a) leases don't represent a capital outlay, so they're not capital employed, and if you include them for ROIC you'll underestimate potential cash flows.

b) there are plenty of commitments to pay that don't get capitalised as debt. For example, a company has to pay its employees (contractually for their notice period, and logically for the life of the company) but these costs aren't capitalised.

 

Do you include lease liabilities in EV when valuing companies or in invested capital when calculating ROIC?

 

I tend to think they should not be capitalised, but instead thought of as increasing operating leverage.

Link to comment
Share on other sites

You capitalize them. They represent assets that are used in order to conduct business. Changing some wording in the contract does not change the economic nature of the transaction.

Link to comment
Share on other sites

 

for me,it s more complicated to read the accounts

the rent don t go anymore in the ebiitda....it s interest and diminishing debt

and with a new contract,it does not go via capex

 

a lot of business doesnt account it in net debt

 

cash flow reading more difficult

and ebitda go up!!

Link to comment
Share on other sites

You capitalize them. They represent assets that are used in order to conduct business. Changing some wording in the contract does not change the economic nature of the transaction.

 

Doesn't it? If I lease a space for a restaurant, my economics are very different than if I borrow money to buy the plot.

Link to comment
Share on other sites

OK.

 

First, I should have clarified that I am thinking about operating leases here - in other words, leases where you don't own the property at the end of the lease.

 

On the asset side it should be blindingly obvious that the economics of owning a property are different to the economics of owning the right to use a property for a defined period.

 

On the liability side there are two key economic differences: I don't have to put up equity for a lease, and I don't own the property at the end (as I would with an amortising mortgage). In other words, I do not have to employ any of my capital. There is also a practical difference: some lenders look at LTV across the whole portfolio when assessing a mortgage on a single property. I don't think most property owners do this when considering a lease but I may be wrong.

 

The combined effect of these factors could have a significant effect on (for example) a retailer's ability to grow. One of the key uses of ROIC is to assess the rate at which a business can grow without needing financing, so capitalising leases for ROIC might give a false output here.

 

It may be that the answer is to capitalise operating leases for some purposes but not others. But overall I think they are more economically equivalent to a fixed operating cost than a debt obligation.

Link to comment
Share on other sites

 

If you want to do something different, you argue against this.

 

 

Well that's kinda the point ;)

 

Nobody thinks accounting is perfect. We all adjust accounting to get at what we judge to be the underlying economics of the business. IFRS recently changed its treatment of operating leases. It seems fair to ask whether the change was right.

Link to comment
Share on other sites

 

It may be that the answer is to capitalise operating leases for some purposes but not others.

 

I believe this is correct.  You'd have the same answer to the question of whether to include purchase accounting intangibles in the denominator of your ROIC calculation.

 

Taking your operating lease question, if you wanted to know who is the best at actually operating an airline (as opposed to how that operation is financed), you'd likely want to capitalize all leases so you're looking at an apples-to-apples comparison.  On the other hand, if you're trying to figure out how fast a company can grow without issuing additional debt/equity, then you need to take into account how they finance their growth.

Link to comment
Share on other sites

On the liability side your argument doesn't make sense at all. First off leases come in all shapes and colours. For some you do need a capital outlay, for some you don't. If you have a contractual obligation to pay something over a period of time, what is that if not a liability? Even in the cases where you say that you don't have an initial capital outlay. That's like 0% down financing. If you do 0% down financing isn't the money you borrowed a liability? Of course it is.

 

On the asset side are you not employing the asset in the use of your business? Does that asset not work to produce income? Think of it from the perspective of two airlines which are otherwise identical but one bought its whole fleet and one leased its whole fleet. Is the latter more asset light than the former? Of course not.

 

The idea that owning an asset outright or leasing it are vastly different from an economic perspective is also flawed. If that were true then one party is taking a massive bath on the deal. So then what you should see is that leasing companies are either duds or fantastically good businesses. Therefore lessors should trade at massive discounts or massive premiums. Alas that's not true either.

Link to comment
Share on other sites

Starbucks was in ~350 Teavana leases and got out at a cost of $30M. That was a fraction of the total leases. You can't get out of $200M of mortgage debt by passing the lender $30M. Seems like a big difference but I am an accounting noob.

Link to comment
Share on other sites

Starbucks was in ~350 Teavana leases and got out at a cost of $30M. That was a fraction of the total leases. You can't get out of $200M of mortgage debt by passing the lender $30M. Seems like a big difference but I am an accounting noob.

Well they also gave back the asset. I'm not familiar with the transaction. But to use your numbers and your example, if you're willing to pay a 15% breakup fee most banks will let you out of your mortgage contract.

Link to comment
Share on other sites

Starbucks was in ~350 Teavana leases and got out at a cost of $30M. That was a fraction of the total leases. You can't get out of $200M of mortgage debt by passing the lender $30M. Seems like a big difference but I am an accounting noob.

 

You can get out of the mortgage debt on those terms if you can sell the encumbered property for $170 million.  That is why Starbucks was able to get out of the leases on the terms you mention -- the landlord could release the assets.  In other words, the asset embodied in the lease -- the right to use the real property for a certain period of time -- was not worthless.  Indeed, some leases are worth more than the book value of the liability, because they are below market and can be sold for gains.  For example, Sears has been selling certain leases for a profit.

Link to comment
Share on other sites

You'd have the same answer to the question of whether to include purchase accounting intangibles in the denominator of your ROIC calculation.

 

 

Yes. I tend not to for one-off deals that were used to create a company some time ago, but I do for ongoing rollups.

Link to comment
Share on other sites

On the liability side your argument doesn't make sense at all. First off leases come in all shapes and colours. For some you do need a capital outlay, for some you don't. If you have a contractual obligation to pay something over a period of time, what is that if not a liability? Even in the cases where you say that you don't have an initial capital outlay. That's like 0% down financing. If you do 0% down financing isn't the money you borrowed a liability? Of course it is.

 

On the asset side are you not employing the asset in the use of your business? Does that asset not work to produce income? Think of it from the perspective of two airlines which are otherwise identical but one bought its whole fleet and one leased its whole fleet. Is the latter more asset light than the former? Of course not.

 

The idea that owning an asset outright or leasing it are vastly different from an economic perspective is also flawed. If that were true then one party is taking a massive bath on the deal. So then what you should see is that leasing companies are either duds or fantastically good businesses. Therefore lessors should trade at massive discounts or massive premiums. Alas that's not true either.

 

I am not arguing it is not a liability. But there are liabilities we don't capitalise. I am on a 3 month notice period. Does my company capitalise that liability? No.

 

The fact that the economics are different does not mean one side is taking a massive bath on the deal - it just means they're sharing the risks and rewards in a different way. If the price of planes doubles in your example, the beneficiary is the airline in one case and the lessor in the other. Surely that's a different economic outcome?

Link to comment
Share on other sites

Yea I'm starting to think that you're really trying to pull this one by the hairs.

 

Sure there are commitments that we do not capitalize because some are clearly operating expenses.

 

Your example of planes doubling is also pretty out there. Sure some freak even may happen and risks may be distribuited in freaky ways. But generally it doesn't happen. It's no secret that equipment will generally be worth less over time. It's also no secret the land will generally be worth more over time. These things make their way into the leasing rates. That's why you can rent a place in SF at a 3% cap rate when the mortgage is at 4% or whatever. You don't really loose out on the appreciation of the land, you still get the benefit through the lease rate.

 

I don't really have a dog in this fight though. You don't want to capitalize leases, then don't.

Link to comment
Share on other sites

We might not agree with IFRS, but it's the nearest thing to standardization that we have, and practically - what your 'approach' will be measured against. If you want to do something different, you have to argue that your 'approach' materially better reflects the economic substance of the transaction. A merely marginal improvement will not be good enough - to warrant a move away from 'standard'.

 

Ultimately, the substance of the lease is either financing or prepaid rent (ie: 30yr property lease). You choose.

The finance is either debt on your books, or debt on someone else's books (ie: lessor, or securitizer/factorer). The operational levers are changes in the future residual value (higher future cash flows, higher terminal value), and changes in the future interest rate (bond math). Many, many, ways to play.

 

Used to design these things in a previous life.

 

SD

 

 

 

 

 

 

 

 

 

Link to comment
Share on other sites

I think it's like anything else - mostly you should follow the accounting standards. But if you can find a place where you have a variant perception on lease accounting that makes a big difference to the value, that might be a source of under or over valuation.

 

 

Link to comment
Share on other sites

Ahhh Leases.  This was a major hidden risk that is no longer off balance sheet and still not fully understood (even by me!)

 

 

If you are in business you can generally either own or lease.

Owning you have to put up capital and pay the expenses. 

Leasing you don't have to put up the ownership capital but are now obligated to pay the lease.

 

Essentially it is a financing transaction where the business, if leasing, has decided to pay monthly for capital over time - essentially with an interest rate included - to someone else who lays out the capital. 

 

There is no questions that all else equal the business that owns the real estate is safer than the one that leases it.

 

And lease defaulting/liability is correlated with economic downturns. 

A business is contractually obligated to pay the remaining lease payments.

 

I think there are really 2 aspects to the lease liability.

 

1.  The remaining payments that a business is liable for.  For worse case liability purposes.

2.  The amount of capital that the business would require if the owned all the real estate (for ROIC purposes)

 

I have made a few mistakes with leases and try to avoid them and try to consider them very carefully when investing. 

If the future lease payments are big in relation to the equity value I generally just pass.  It is really just extra leverage that gets many businesses in trouble.

But they can always declare bankruptcy and reject them ....

Link to comment
Share on other sites

There is no questions that all else equal the business that owns the real estate is safer than the one that leases it.

 

Maybe this is what you meant, but I think your statement is only accurate when you NEED the specific real estate for the business. A coffee shop which owns the building is more stable. A software firm that owns an office building is less safe.

 

For lease accounting I generally think, is this necessary for the business? If this lease is cancelled, does it cause serious impairment?

 

I mean, if a retailer gets kicked out of all its leases, that is a huge deal. Revenue is going to zero.

But look at the tech companies - they've been functioning without office space for over a month now.

 

But 99% of the time I capitalize leases regardless, essentially when you do any capitalization of earnings you are implicitly capitalizing all the associated expenses.

Link to comment
Share on other sites

Starbucks was in ~350 Teavana leases and got out at a cost of $30M. That was a fraction of the total leases. You can't get out of $200M of mortgage debt by passing the lender $30M. Seems like a big difference but I am an accounting noob.

 

FWIW I looked into this and the cost of getting out of a lease is generally much higher than this. Getting out of leases is really expensive.

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...