Leases and Their Role in Valuation

A lease is a contractual agreement in which one party (the lessor) agrees to allow another party (the lessee) use an asset for a stated period of time. In return, the lessee agrees to make fixed cash payments to the lessor. Since the title does not transfer to the lessee, this is not considered a sale and thus the asset is not recorded on the books of the lessee, rather it stays on the books of the lessor. While this makes sense, there is a problem. Leases are allowing a firm to obtain an asset in return for a future commitment of payments, this is essentially adding an asset to the firm and a corresponding liability. When a firm accounts for this transaction as a lease rather than a sale, it is essentially able to avoid putting the liability on their balance sheet; this is often referred to as “off-balance sheet financing”. This can lead to investors underestimating the liabilities a firm has and therefore poses a risk to the investing community.

Enter capital leases. Under U.S. GAAP, two forms of leasing exist. The first is an operating lease and the second being a capital lease; with the former reflecting the above discussion. Capital leases on the other hand are required to be accounting for in a different manner in which the asset and corresponding liability are reflected on the lessee’s balance sheet. A lease will be classified as a capital lease if it satisfies any one of the following requirements.

1. The life of the lease exceeds 75% of the economic life of the asset.
   (Lease a truck for 9 years that has a useful life of 10 years)
     
2. The present value all future lease commitments is greater than 90% of the current fair market value of the asset.
   (The PV of lease payments is $1,000, when the FMV of the asset is $850)  
   
   
3. The title of the asset transfers from the lessor to the lessee at the conclusion of the lease.
   (After 10 years of leasing a computer, the title of ownership transfers to the lessee) 
         
4. There is bargain purchase price option included in the lease.
   (At the end of a machinery lease, the lessee can purchase the asset for $100, despite the FMV at that time being significantly higher)

In essence, a lease that meets any of the criteria above--while not meeting the legal requirements of a sale--is an economic sale. Since this is the case, the asset being leased is removed from the books of the lessor and placed on the books of the lessee. In addition, the present value of all lease payments are considered a liability on the lessee’s balance sheet and an asset on the lessor’s. This does have a valid reasoning since these type of leases are essentially a form of capital financing and thus should be included in the liabilities section of the balance sheet. Rather than the lessee considering the payment to the lessor an expense, it is now an amortization of the liability with the difference between the payment and the amortized amount classified as interest expense (another indication of debt financing). In addition, the lessee can now depreciate the asset over its useful life.

While much more could be said about capital lease (a possible future topic), I believe from a valuation stand point it is relatively clear as to the treatment. Since they are already classified as assets and a corresponding liability, not too much more needs deep consideration. However, I do not feel the same for operating leases.

If a lease agreement does not meet any of the four criteria outlined above, it will be considered an operating lease. Under this treatment, the lessee does not record the asset nor the corresponding liability. The payments are simply considered lease expense. This is a preference for many firms, as it will give the appearance of a stronger balance sheet (lower debt); thus, it is common for firms to attempt to structure leases in a manner that will allow operating lease treatment under U.S. GAAP. One of the most common assets to be classified as operating leases, while taking on more of an appearance as capital financing, is retail real estate. Since the economic life can be very long for a retail location and the lessor generally has no interest in transferring title at the end of the lease, it is relatively easy to structure a deal in such a way that it will be classified as an operating lease.

With the above said, think about industries such appear retailers and restaurants. In these industries, many operating leases are created for the real estate being used in the ordinary course of business. While these leases are structured in such a way that they are treated as operating leases, they do constitute a large portion of the operating expenses and, in my opinion, represent a form of debt financing. I say this due to the fact that they allow the firm the use of an asset in return for a requirement of a fixed payment; sounds a whole lot like debt financing to me.  

From my perspective, it would be necessary to take the expected future payments of these leases (in many cases this figure can be found on the firm’s 10-K) and discount them to their present value and capitalize them, adding both an asset and liability to the pro-forma statements. The discount factor should be the firm’s pre-tax cost of debt for the firm (pre-tax since the payment being discounted is a pre-tax item). In addition, these payments should no longer be treated as lease expense, but as interest expense. The net effect of this process would be an increase to EBIT, EBITDA, and the weight of debt in the WACC calculation.

Since the EBIT, EBITDA and WACC all play a very important role in a DCF valuation, this process can be key to an accurate calculation in some cases. Is this always right? As with most valuation topics, there can be a long debate about how valid this theory is. However, I do believe that in certain industries that rely heavily on operating leases, not creating pro-forma financials with these operating leases capitalized will create an error in your final valuation.

As a last note, while I believe this process to be an accurate treatment for many operating leases, in cases where the operating leases do not represent a major portion of the firm’s expenses, I do not believe this process will yield a material difference the final valuation.