For the adoption of ASC 842, and when future leases are added or modified, your team will need to assess whether a renewal option is “reasonably certain” to be exercised. “Reasonably certain” is intended to be a high threshold and reflects the existence of a significant economic incentives to exercise the option. This threshold is a higher level than the “more-likely-than-not” threshold used in other areas of GAAP, which is generally regarded as being more than a 50 percent likelihood of an event occurring.
At National Lease Advisors, we encourage our clients to review all the factors when making this “reasonably certain” evaluation. The impact could be significant to the balance sheet since the decision to assume an option is going to be extended can increase the lease liability significantly.
Not included in the evaluation is how much the team “loves that space.” Instead, the evaluation should focus on economic factors not only provided in the lease, but as they relate to your business.
Economic factors relevant to that assessment should include, but are not limited to, any of the following:
- Terms of the Renewal Option in the Lease. This is where National Lease Advisors can help. Is the option at a rate that could be considered favorable to market? An example of this is an option at less than 100% of fair market rent. Are there other terms or concession in the option language that make it favorable?
- Will the improvements have significant economic value when the option to extend becomes exercisable? If the improvements were paid out of a tenant improvement allowance from the landlord, it is likely they can be duplicated with a new lease in another building. However, if the tenant invested in the improvements with the goal that they will last “x” years, this may impact the decision. It’s important that the tenant consider the long-term. Improvements might have a significant economic value today, but will they still be relevant in 10 years?
- Is the cost related to relocating, or cost of returning the old premises to a contractually specified condition going to impact your ability to relocate to a comparable or more favorable opportunity?
- The importance of that underlying asset to the lessee’s operations, considering, for example, whether the location will be difficult to replace.
The above is provided to guide you to making a sound decision. If you want to walk through the evaluation of a site, please reach out to us and we will be happy to share our thoughts.
National Lease Advisors has created a niche in the industry by focusing on lease administration, lease audit, and adoption services for ASC 842, the new lease accounting standard. In addition to working directly with U.S.-based companies, the firm has developed an alliance program to serve the clients of commercial real estate brokers that exclusively represent tenants.