Landlord Lease payments

Landlord Lease payments

Distinguishing between fixed and variable lease payments will impact the profile of a landlord’s earnings.

1. Overview

At commencement, a lessor identifies the lease payments, which include: (IFRS 16.70)

  • fixed payments, including in-substance fixed payments, less any lease incentives;Landlord Lease payments
  • variable lease payments that depend on an index or a rate;
  • the exercise price of a purchase option if the lessee is reasonably certain to exercise that option;
  • payments of penalties for terminating the lease, if the lease term reflects the assessment that the lessee will exercise an option to terminate the lease; and
  • the full amount (regardless of the likelihood that payment will be due) of any residual value guarantees provided to the lessor by the lessee, by a party related to the lessee or by a third party unrelated to the lessor that is financially capable of discharging the obligations under the guarantee.

Real estate leases will often include some or all of the following:

  • fixed payments (including in-substance fixed payments) (see Fixed and in-substance fixed payments), less any lease incentives (see Lease incentives);
  • variable lease payments (see Variable lease payments);
  • payments for terminating the lease early; and
  • payments for non-lease components: e.g. maintenance or utilities (see Common area maintenance and other non-lease components).

2 Fixed and in-substance fixed payments

Fixed and in-substance fixed payments are always included in a lessor’s lease payments. ‘In-substance fixed payments’ are payments that are structured as variable lease payments but that – in substance – are unavoidable. Sometimes, payments that at first glance seem to be variable are actually fixed. (IFRS 16.70)

A lease payment may initially be variable, but subsequently become in-substance fixed when the underlying variability is resolved. (IFRS 16.B42(a)(ii))

Food for thought – How should a landlord recognise lease income if uneven payments are intended to reflect expected changes to CPI or market rent?

Landlords may enter into a lease of real estate with scheduled rent increases. (IFRS 16.75–76 , IFRS 16.81)

For example, the lease agreement may include a fixed increase of two percent per year over the five-year term of the lease. The fixed yearly increase may be intended to reflect the parties’ expectations of the increase in the consumer price index (CPI) or in market rental rates over the five-year period. The question is how a landlord should recognise lease income each year.

Operating lease

Generally, lease income from operating leases is recognised by the landlord in income on a straight-line basis from the commencement date over the lease term.

Fixed increases (or decreases) in rental payments over a period of time, other than variable lease payments, are Landlord Lease paymentsreflected in the determination of lease income, which is recognised on a straight-line basis. For example, a contractual two percent per annum escalation of rents over the lease term is anticipated from commencement of the lease. Consequently, the landlord recognises lease income in excess of cash lease payments received in early periods. In later years, lease income will be lower than lease cash payments received.

In the example above, the fixed increase is not a variable payment that depends on an index or rate, but rather an unavoidable fixed payment. In addition, the straight-line basis appears to be the more representative pattern in which the landlord expects the tenant to derive the benefit from use of the asset.

Finance lease

In a finance lease, a landlord recognises a finance lease receivable at an amount equal to its net investment in the lease, which comprises the present value of the lease payments and any unguaranteed residual value accruing to the landlord. The lease payments include fixed and in-substance fixed payments.

Therefore, fixed increases in rental payments over the lease term are included in the initial measurement of the net investment in the lease.

3 Variable lease payments

3.1 Payments that depend on an index or rate

Variable lease payments that depend on an index or rate are included in the initial measurement of the lessor’s net investment in the lease, initially measured using the index or rate as at the commencement date. (IFRS 16.70(b))

This approach applies to, for example, payments linked to a CPI, payments linked to a benchmark interest rate (e.g. IBOR) or payments that are adjusted to reflect changes in market rental rates. (IFRS 16.28 )

After the commencement date, unlike for a lessee, IFRS 16 is silent on how a lessor should account for any subsequent change in the index or rate.

Food for thought – What if lease payments depend on property valuations ‘based on a market’ – are these payments that depend on an index or rate?

In some jurisdictions, lease payments are calculated as a percentage of an ‘assessed value’ of the property, which is updated on a regular basis. (IFRS 16.28, IFRS 16.70(b))

Determination of this value is regulated by the tax authority or government, and it may include market rents or values for similar properties in the area as the key input, adjusted for specific features of the property such as:

  • size;
  • facilities;
  • furniture and furnishings; and
  • maintenance or other services.

When the assessed values are closely related to market rents or property values, as described above, they may represent market rental rates (except when they are used to determine property taxes – see below). Accordingly, it appears that lease payments that are adjusted for changes in the assessed values of lease properties may be considered ‘variable lease payments that depend on an index or rate’ in those cases.

For example, we believe that if the assessed value is determined by the authorities, is updated on a regular basis and Landlord Lease paymentsincludes sufficient inputs that mean it represents a ‘market’ rent/value of the property, then lease payments that are calculated as a percentage of the assessed value are variable lease payments that depend on an index or rate.

The precise determination of the assessed values will vary – between jurisdictions and depending on further adjustments that may be included in the lease agreement – so companies will need to exercise judgement when evaluating whether the lease payments do in fact depend on ‘an index or rate’.

The percentage that is applied to the assessed value is not in itself a ‘rate’.

3.2 Variable payments other than those that depend on an index or rate

Variable lease payments other than those that depend on an index or rate – e.g. payments that depend on sales or usage of the underlying asset – are excluded from the lease payments and therefore from the initial measurement of the net investment in the lease or calculation of the total payments to be recognised on a straight-line basis. (IFRS 16.70)

IFRS 16 is silent on the lessor’s accounting for those variable lease payments. Considering that the Board has decided to carry forward substantially all of the guidance from IAS 17 on lessor accounting, the same treatment would apply. Therefore, these payments are recognised as income in the period in which the event or condition that triggers those payments occurs. (IFRS 16.BC231)

One key consideration for a lessor is that the presence of variable lease payments may affect lease classification. (IFRS 16.65)

Case – Landlord accounting: Percentage rent in a real estate

Landlord D enters into a five-year lease with Tenant T to be an anchor tenant at a regional mall.

Under the contract, T will:

  • pay a percentage rent to D equal to 5% of the first 2,000,000 in gross annual sales and 3% on any sales in excess of 2,000,000 during the period;
  • reimburse D for its portion of D’s actual property tax assessments and building insurance costs; and
  • reimburse D for its share of CAM costs.

D estimates T’s portion of property and insurance costs to be approximately 20,000 per year. D also estimates T’s portion of CAM costs to be 10,000 per year.

Landlord accounting

D needs to identify the lease and non-lease components and allocate the consideration to account for the transaction. D determines the following:

  • there is one lease component: the retail space;
  • property tax and insurance are not separate components: they do not transfer a good or service to the tenant;
  • D has the statutory obligation to pay the property tax; therefore, the reimbursement by the tenant is part of the total consideration (variable payments that do not depend on an index or rate); and
  • there is one non-lease component, CAM, which transfers a service to the tenant, separate from the right to use the retail space.

The percentage rent payments are genuinely variable, even if D and T can reliably forecast the annual sales.

In this scenario, the nature of the variable payments and their materiality in the context of the lease as a whole provide evidence that the landlord has not transferred substantially all of the risks and rewards of ownership of the property to the tenant. There are no other indicators that the lease is a finance lease. Therefore, D classifies the lease as an operating lease.

D estimates the stand-alone selling prices as follows:

  • the stand-alone selling price for the lease component includes property tax and insurance cost; and
  • the price charged for CAM represents the stand-alone selling price.

D allocates the variable consideration between the lease and non-lease (CAM) components. The portion allocated to the lease is variable and is recognised as income in the period in which the event or condition that triggers those payments occurs.

Revenue arising from CAM will be recorded in accordance with IFRS 15.

Food for thought – What is the impact of variable payments on lease classification for a lessor?

Under IFRS 16, lessors retain the IAS 17 dual accounting model and continue to classify leases as either an operating or a finance lease. (IFRS 16.63)

Like IAS 17, IFRS 16 includes indicators that individually or in combination would normally result in a lease being classified as a finance lease – e.g. if the lease term represents a major part of the economic life of the underlying asset.

However, if a lease includes a high proportion of lease payments based on sales or usage (as illustrated in Example 17 above), then this could indicate that the lease should be classified as an operating lease. This is because the lessor does not transfer substantially all of the risks and rewards incidental to ownership of the underlying asset due to the variability in the lease payments. (IFRS 16.65)

Food for thought – How should a landlord account for a co-tenancy clause that reduces the tenant’s rent when it is triggered?

Many retail leases include co-tenancy clauses that change the tenant’s contractual rent if, for example, a key (or anchor) tenant or a certain number of tenants vacate the property. In some cases, a tenant’s rent is reduced when the clause is triggered; in other cases, fixed rent becomes variable based on the tenant’s sales. Typically, these clauses stipulate that the tenant must resume paying the contractual rent either after a specified period of time or when the co-tenancy event is cured – e.g. a new anchor tenant occupies the vacant space.

It appears that the landlord should assess the substance of a co-tenancy clause on lease inception, or at the date of a lease modification if such a clause is added to a lease via a modification. In particular, the landlord should assess whether the co-tenancy clause is protective in nature – i.e. it serves to protect tenants from a potential drop in sales when a key tenant vacates its space or overall occupancy of the retail space declines. When this is the case, we believe that the landlord’s accounting for the lease should not consider the co-tenancy clause being triggered.

Indicators that the co-tenancy clause is protective in nature include the presence of one or more high-quality key tenants, a high level of occupancy and the property having a track record of retaining tenants.

For example, assume that a landlord signs an operating lease with a tenant in a shopping mall. The base rent is 100 per month and is payable in each period in which there is an anchor tenant in the mall. However, if the anchor tenant leaves, the rent is reduced to 80 per month. The rent reverts to the base level of 100 per month on the earlier of commencement of a lease with a new anchor tenant or expiration of six months.Landlord Lease payments

On lease commencement, the landlord assesses the substance of the co-tenancy clause. The landlord notes that the shopping mall is well established, with a history of high occupancy. There is a high-quality anchor tenant in place. The landlord therefore concludes that the co-tenancy clause is protective in nature.

On lease commencement, the landlord assumes that the co-tenancy clause will not be triggered and measures its lease income based on fixed lease payments of 100 per month. Subsequently, if the anchor tenant leaves, then in the months in which the co-tenancy clause is operative the landlord recognises rental income of 80 per month and discloses operating lease income of 100 and negative variable lease income of 20.

4 Lease incentives

Lease incentives are payments made by a lessor to a lessee associated with a lease, or the reimbursement or assumption by a lessor of the costs of a lessee. Payments made by the lessor to the lessee are not lease incentives when they are associated with other obligations of the lessee to transfer distinct goods or services to the lessor.

Examples of lease incentives provided by landlords include up-front cash payments to the tenant or assumption of costs of the tenant such as leasehold improvements, relocation costs and costs associated with a pre-existing lease commitment. Alternatively, initial periods of the lease term may be agreed to be rent-free or at a reduced rent.

Irrespective of its form, a lease incentive is part of the lease payments – i.e. the net consideration for the lease.

For an operating lease, this means that any lease incentive is recognised by the landlord as a reduction in income over the lease term.

For a finance lease, at commencement the landlord deducts any lease incentive payable from the lease payments included in the measurement of the net investment in the lease. (IFRS 16.70(a))

Food for thought – Does the determination of the ‘accounting owner’ of leasehold improvements affect the accounting for payments made by a landlord to a tenant for the cost of leasehold improvements?

Yes. In some cases, a landlord may reimburse the tenant for the cost of leasehold improvements. The standard does not contain specific guidance on the accounting for such landlord reimbursements. In our view, the appropriate accounting depends on whether the tenant or the landlord is the ‘accounting owner’ of the leasehold improvements – i.e. whether the tenant or the landlord accounts for the leasehold improvements as its property, plant and equipment. The company that controls the asset is the accounting owner.

For example, a tenant may construct the leasehold improvements and the landlord may subsequently reimburse the tenant. If the tenant constructs leasehold improvements that are its own asset, then we believe that any reimbursement of the tenant’s costs by the landlord is a lease incentive that should reduce the lease payments. However, if the tenant constructs the leasehold improvements for the landlord – i.e. the leasehold improvements are an asset controlled by the landlord – then the landlord’s payment represents consideration for a distinct good or service provided by the tenant.

In our experience, indicators that the tenant is the accounting owner of the leasehold improvements may include the following:

  • the tenant is not contractually required to construct or install the leasehold improvements;
  • the tenant is permitted to alter or remove the leasehold improvements without the consent of the landlord or without adequately compensating the landlord;
  • the tenant is not required to provide evidence of costs incurred to receive reimbursement;
  • the tenant bears the risk of cost overruns;
  • the leasehold improvements are unique to the tenant’s intended use of the leased asset; and
  • the leasehold improvements are not available to the landlord in a lease to other parties.

This list of indicators is not exhaustive and judgement is required in determining the weighting of indicators based on the specific facts and circumstances.

Food for thought – Should lease incentives granted by a landlord in an operating lease be recognised over the full lease term if the lease includes market rent reviews or lease payments based on an index or rate?

Yes. Lease incentives granted to the tenant in negotiating a new or renewed operating lease are recognised as an integral part of the lease payments relating to the use of the underlying asset. They are recognised as a reduction of rental income over the lease term using the same recognition basis as for the lease income – i.e. on a straight-line basis unless another systematic basis is representative of the time pattern over which the benefit of the leased asset is diminished. (IFRS 16.81)

The fact that a lease agreement includes market rent reviews or lease payments based on an index or rate does not impact the accounting treatment of lease incentives.

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments

Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments Landlord Lease payments

Leave a comment