In a previous blog, we addressed accounting for leases when a lessee is granted access to a part of a building at first and then granted access to the rest of the building at a later date. In this post, we’ll address something similar: the accounting straight-line rent calculation for leases when a tenant signs a contract that legally requires the tenant to expand the leased premises by a predetermined amount at a later date. This scenario is called a “Phase In” or “Must Take” in real estate circles.
For instance, a tenant could sign a lease for a building where the tenant occupies the first floor in year one, but must also lease the second floor in the second year.
As we stated in our previous blog, under current GAAP rules, the FASB states that if rents increase because the tenant gets access to additional property, then rent expense should be allocated proportionally to the fair value of the additional property.
Straight-line rent calculation example
Consider the following scenario:
A retailer signs a 10-year lease with a landlord to lease a warehouse with a total area of 100,000SF. In the first 2 years (Jan 1, 2016 – Dec 31, 2017) the tenant will occupy 50,000SF. Beginning in year 3 (Jan 1, 2018), the tenant must occupy an additional 25,000 SF. Finally, in years 5-10, the tenant must occupy the entire 100,000 SF. Rent payments start at $24/SF and increase annually by $0.50/SF, so for Jan 2016 to Dec 2016, rent is $24/SF; for Jan 2017 to Dec 2017, rent is $24.50/SF, etc. Finally, rent is fully abated (free rent) for the first 6 months. Let’s assume this is an operating lease.
How do you straight-line the lease above? In order to answer this correctly under GAAP, we need to ask one simple question: Does the tenant have access to the entire 100,000SF at the beginning of the lease? It does not matter if the tenant is actually using the entire space. What matters is if the tenant has access to it. This simple question could cause significant differences in the accounting treatment. (To understand when to start amortizing a lease, see our blog here). Let us now perform our analysis.
Scenario 1: Tenant has access to the entire warehouse, even though it is only utilizing 50,000SF as stated in the lease agreement.
Under this scenario, the entire lease payments would be straight-lined as if the entire warehouse were being leased in the beginning. The steps are as follows:
Step 1) Calculate the total payments
The total payments required under the lease is 21,962,500. See Schedule 1 below:
Step 2) Calculate rent expense by dividing total payments by the lease term, and prepare the amortization schedule
Monthly rent expense is 183,020.83 (21,962,500 divided by lease term of 120 months), and annual rent expense is 2,196,250. See Schedule 2 below:
Important notes: Note that under this scenario, expense is the same every year at 183,020.83 per month.
Scenario 2: Tenant does not have access to entire warehouse; tenant gets access as stipulated in the lease contract.
In this scenario, rent expense will be allocated proportionally to the fair value of the additional property as access is granted. The steps are as follows:
Step 1) Calculate the total payments
The total payments required under the lease is 21,962,500. This total is the same as Schedule 1 in the first scenario above.
Step 2) Allocate the expense to each additional property per the square footage in that period
We allocate expense each year as a percentage of the square footage occupied in that year to the total percentage. So the expense for the first year is 50,000 divided by 850,000 multiplied by 21,962,500. See schedule 3 below.
Important notes: Note that under this scenario, rent expense is not constant each year, unlike scenario 1. It increases as access to the additional property is granted. See Schedule 4 below.
Thank you for reading. If you have any questions about these calculations or about any other problems in lease accounting, leave a comment below!