Rent Guarantees – How to account for them

Rent Guarantees – How to account for them

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  • On March 5, 2018
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I recently asked an accountant how they intend to account for a rent guarantee on acquisition of a property.

In their mind, it’s rental income that we’ve been guaranteed and should therefore be accounted for as income over the period of the guarantee.

Now, something in my mind just likes the simplicity of their answer. We have acquired a property for £100 which is based off a fully let property and will recover the agreed rent for the vacant units (say 20% vacancy equating to £5) over the next 24 months. Unfortunately, IFRS has other views.

As such, I have written a summary below so that one can understand the core concepts and crucially, the correct accounting treatment required under IFRS.

 

What you need to do.

1 Agree that the terms of the agreement meet the definition of a rental guarantee.

This must be your first step. If it’s not clear, speak to the deal team to obtain further detail about the terms of the acquisition.

The basic definition includes:

  • The seller guarantees a minimum tenancy level of the building.

    This does not have to be 100%.

  • The buyer does not need to meet certain requirements to be eligible to receive it

     So there is no obligation on us, the acquirer. We can leave the property vacant for the term if we wish to do so.

  • The payments under the guarantee do not change based on external factors such as yields, but rather represent a percentage of the initial purchase price of the building. Essentially, the rent guarantee agreement does not stipulate that if market yields move, the guarantee value changes. This is important as it has an effect on the accounting.

 

2 Once we agree the contract is a rent guarantee, we then classify this as an available-for-sale financial asset (IAS 39). The accounting is as follows:

  • On acquisition, we need to separate out the fair value of the rental guarantee from the initial purchase price.So separate the transactions. Remember, we don’t double count assets on the balance sheet (think IAS 40.50)
  • We measure the rent guarantee at fair value and take any movement in the fair value to the profit and loss.
  • Where the movement in fair value is due to the discount rate used in the calculation of fair value, this movement under IAS 39 will be accounted for in other comprehensive income.Note that under IFRS 9: Financial instruments (effective 1 January 2018), the fair value movement will go through the P&L. (It’s very technical, so ask the audit manager to confirm your accounting approach).

Example (using a December year-end)

1 Jan 2016           Acquired a property for £100m with a rent guarantee of £3m p.a. for 3 years assuming the property is 100% vacant

31 Dec 2016        Fair value of property excluding the rent guarantee is £98m

The property is 100% vacant

1 Jan 2017           We let 50% of the property

31 Dec 2017        Fair value of property is £110m. Fair value of rent guarantee is £0.5m

(Excluding net present value calculations)

 

Journals (because I love journals)

1 Jan 2016           Dr Investment Property                £97m

Dr Rent guarantee                           £3m

Cr Cash                                                                 £100m

Property acquired and rent guarantee separated from the asset value, assuming all inclusive of costs.

31 Dec 2016        Dr Investment Property                £1m

Cr Fair value (P&L)                                           £1m

Fair value of investment property £98m.

31 Dec 2016        Dr Cash                                                 £1m

Cr Rent guarantee                                           £1m

Cash received by the seller, assuming fair value of rent guarantee is £2m.

31 Dec 2017        Dr Investment Property                £12m

Cr Fair value (P&L)                                           £12m

Fair value of investment property £110m.

31 Dec 2017        Dr Cash                                                 £0.5m

Cr Rent guarantee                                           £0.5m

Received 50% of agreed guarantee as the 50% of the property has been let.

31 Dec 2017        Dr Fair Value (P&L)                          £1m

Cr Rent guarantee                                           £1m

Reduction of fair value, based on the 50% change in vacancy, to represent the £0.5m (50% of annual rent of £1m) that will be received at 31 Dec 2018.

 

RESULT! GET IN THERE!

Hope this makes sense. The tricky bits for me are always the net present value calculation and the unwinding of interest. Perhaps in the next letter we will include an example of how to account for these.

Any questions, please give me a shout at outsource@selesgroup.com. If you need any training in property accounting, give us a shout.

 

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