Since the COVID-19 outbreak, the health and economic upheavals in the U.S. have taken a toll on most businesses, with many financial reporting implications. The effects of the disruption on the real estate industry, including real estate investment trusts (REITs), have been widespread but not uniform, with the impact varying by sub-sector. Organizations urgently need to better understand the immediate and potential long-term accounting and disclosure implications of COVID-19 on the real estate market.

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COVID-19 and financial reporting challenges of the real estate industry

Stay-at-home orders, mandated closings of non-essential businesses, and a shift to a remote work model following the outbreak of COVID-19 had immediate effects on the real estate industry. With shops closed and discretionary spending moving online, the already beleaguered retail sector has suffered. Meanwhile, the halting of business and leisure travel has negatively affected hotels and others in the hospitality industry. As landlords face rent shortfalls and lease renegotiations because of the outbreak, lenders may be exposed to increased liquidity risk. In this paper KPMG reports on the key resulting accounting issues and provides thoughts on future implications.

Introduction

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Rent concessionsThe COVID-19 disruption has decreased rent collections significantly in certain property sectors. For example, for retail shopping centers, a recent NAREIT survey indicated that only 45.6 percent of May rent was received1. To help alleviate the economic pressures facing tenants, some landlords have offered concessions, including one-off rent reductions, rent waivers, and deferrals of lease payments. Lessees not receiving concessions have in some instances decided, or been forced by their liquidity circumstances, to make rent payments lower than the full amounts (i.e., short-pay).

While the lease modification guidance addresses routine changes to lease terms from negotiations, the Financial Accounting Standards Board (FASB) has acknowledged that the lease accounting guidance did not contemplate concessions being so rapidly made as a result of the COVID-19 outbreak. Therefore, the FASB offered relief

during the second quarter of 2020 by permitting entities to elect to apply or not apply the lease modification guidance for concessions related to the effects of the COVID-19 disruption that do not result in a substantial increase to the rights of the lessor or the obligations of the lessee. Concessions that only grant a rent reduction or waiver, or defer lease payments, would typically qualify, as would such concessions coupled with short-term lease extensions roughly equivalent to a free-rent or deferral period. In contrast, concessions that are made with longer-term lease extensions or added rights to use additional underlying assets would typically not qualify.

For qualifying concessions, instead of performing an evaluation of the rights and obligations under the original lease, companies may elect to account for the concessions in either of the following ways:

Early trends indicate that lessors are opting to account for concessions as if they are part of the existing rights and obligations of the parties. The accounting that follows will

depend on the nature of the concession. For example, free rent or rent forgiveness will typically be accounted for as negative variable rent.

1 Source: REIT Industry May 202 Collections, NAREIT, May 18, 2020

As if they are part of the enforceable rights and obligations of the parties under the existing lease contract.

As a lease modification in accordance with the full lease modification requirements.

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Meanwhile, in a pure rent-deferral scenario for an operating lease, many lessors will continue to recognize the unchanged total operating lease payments as income on a straight-line basis over the lease term. While profit and loss would be unaffected for operating-lease lessors continuing straight-line recognition of rent deferrals, these lessors would see an increase in operating lease receivables for the deferred rent payments and reduced cash flow. Lessors accounting for rent deferrals in sales-type or direct financing leases may or may not continue to recognize interest income during the deferral period. Some lessors continuing to recognize interest income that have not increased rent payments in later periods to compensate for lost interest are taking the difference between (1) the interest income that would have been recognized had

payments been increased and (2) the interest income that would be earned based on the deferred payment schedule and a revised implicit rate (calculated based on the deferred payment schedule), as negative variable lease income.

When considering eligibility for the practical expedient, lessors should be aware of the consequences of granting multiple concessions within a short time frame. They should also evaluate the ASC 842 contract combination guidance when determining whether to evaluate multiple concessions collectively or individually. Moreover, we think it is important for lessors to think beyond the accounting implications when considering potential concessions to grant. The concessions should be factored in other evaluations, such as (not exhaustive):

For real estate organizations that report under the fair value method, the FASB staff guidance on rent concessions provides lessors options on recognizing the impact of those concessions on revenue. Depending on the option selected, a fair value reporting company will need to be mindful about the impact on fair value determinations. For example, if the lessor continues to recognize revenue based on when it has a valid receivable for payment, it should exclude any deferral of those payments from the future cash flows used to estimate fair value in order to avoid double counting those future cash flows on the balance sheet.2

Regardless of whether an entity reports under the fair value method, we expect the majority of the stakeholders in real estate investments will request robust and detailed disclosures from funds/operators on what rent concessions have been given, the anticipated timing and method for recovering these concessions, the accounting of these concessions, and the effects on income, distributions, and overall return on the investment.

2 For more discussion of fair value and the COVID-19 outbreak, refer to “COVID-19 and its impact on fair value reporting for real estate,” KPMG, April 14, 2020.

Cash flows for impairment

testing

Cash flows for distributions

Creation of receivable balances with collectibility

concerns

Fair value reporting issues

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CollectibilityAll lessors must monitor changes in collectibility of unpaid lease payments individually for each lease. Economic effects of the COVID-19 outbreak may change the assessment of collectibility for some leases. Significant rent deferrals and short-payments may call into question whether the lessee will be able to repay. For example, those with a retail-industry tenant may, either as a result of the economic circumstances or because of deferred or short-paid rent, determine that it has become less than probable that the lessee will pay substantially all of the lease payments due. In such instances, a lessor must adjust the accounting for the affected lease, even if no formal modification has been discussed or approved.

For operating leases, collectibility is an ongoing assessment that can change based on facts and circumstances after the commencement date. When collectibility is less than probable, the lessor's income recognition is constrained to cash received, and all lease receivables should be completely reserved for on the balance sheet. This could have a potentially material impact on long-term leases, if the tenant is in significant distress or in a bankruptcy process.

In contrast, sales-type or direct financing lessors do not reassess collectibility after the commencement date, even for significant events or changes in circumstances such as the COVID-19 disruption. Rather, starting from January 1, 2020, public entities that close at the end of the calendar year should account for net investments in leases under the new Current Expected Credit Losses (CECL) standard.

The CECL standard requires entities to estimate expected credit losses based on current economic conditions, as well as reasonable and supportable forecasts of future economic conditions. As of the transition date of January 1, 2020, for calendar year-end public entities, publicly available economic forecasts generally did not predict a recession in the near term and therefore, these forecasts did not reflect the current economic disruption and dimmed future outlook in estimated credit losses. Adjusting for current economic conditions and reasonable

and supportable forecasts of future economic conditions may result in estimated credit losses that are significantly different from the recent past.

Forecasting in light of considerable uncertainty may prove challenging for finance-lease lessors, especially given the recent disconnect between the stock markets and economic data, such as unemployment and economic output. Companies should carefully review modeling outcomes to ensure that estimated credit losses are reasonable and aligned with their economic forecasts and the tenants’ actual credit risk. As the impairment evaluation also looks at non-credit risk, lessors will need to consider the effect of decreases in fair value of real estate assets, such as potential declines in estimated residual values.

Additionally, lessors that have not elected the practical expedient to separate lease and non-lease components, such as common area maintenance, will also need to consider collectibility through the lens of the revenue guidance for the non-lease components. For contracts where the practical expedient was elected and the predominant element was determined to be the non-lease component, as could be the case with some specialty real estate scenarios such as certain sectors of senior housing, the entire collectibility assessment will be performed in the context of the revenue guidance because the entire combined component is accounted for as a revenue performance obligation. Ordinarily, an entity does not reassess the collectibility criterion under the revenue guidance, unless there is a significant deterioration in the customer’s creditworthiness—which could arise under current economic circumstances. Such significant changes could result in discontinuance of the general revenue model and revenue recognition based on receipt of nonrefundable consideration.

Financial statement users will seek expanded disclosures relating to collectibility assessments, and these considerations will likely relate to multiple disclosure areas, including risks, significant estimates, and leases.

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Impairment considerations for real estate assetsWe expect that changes in the business climate, market prices of real estate assets, and anticipated future cash flows may trigger impairment testing. In addition, lessors should consider whether balance sheet items, such as capitalized initial direct costs or tenant improvement incentives, are impaired. Although most entities have in place robust impairment testing processes, COVID-19 introduces an additional layer of complexity and underscores the need for carefully reasoned and documented judgments.

For calendar-year-end companies, as of end of Q1 there was still considerable uncertainty as to how COVID-19 would unfold. Our analysis of disclosures reveals that in addition to measures companies have taken in response to the outbreak, many contained discussions of impairment. The last 100 days have provided a clearer picture of changes in the market, and real estate lessors continue to evaluate their assets for potential impairment.

The effects of COVID-19 on the real estate market have not been uniform, and indeed vary considerably by sector (Exhibit 1).

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3 For discussion of valuation insights, see “Goodwill impairment valuation insights,” KPMG, April, 9, 2020.4 Source: “Permanent store closures could hit 25K in 2020, Coresight says,” Retail Dive, June 9, 2020

Within the retail and hospitality sectors, the prospects for returns to ‘normalcy’ are more promising for some than others. Retailers with a strong e-commerce presence will benefit as consumers continue to shop online. Those close to metropolitan areas are likely to see a relatively quicker rebound in in-store traffic but for many, physical store sales will remain depressed for the foreseeable future. This is likely to result in significantly more store closures in 2020 than previously estimated, with certain retailers not only forced to shut physical locations but also file for bankruptcy4.

As for the hospitality sector, after spending the last several months with little social interaction, many people

are looking forward to more recreational time and the opportunity for local travel. Lodging establishments near beaches may be primed for a strong summer season, while full-service, luxury resorts that have typically relied on customers flying in to visit will likely see extended stagnation. Venues for large gatherings, such as conference centers, may also continue to experience low utilization for months, or even years, to come as events are typically planned well in advance and take time to be rescheduled. Hotels could explore alternative ways to use this excess capacity, such as partnering with universities seeking additional student housing to facilitate social distancing when in-person classes resume for some this fall.

High impact (retail, hospitality)

While these visible market effects should be incorporated for impairment analyses, companies will also need to consider expectations for the future, including the prospects for recovery3.

Exhibit 1. Expected impairment impact by sector

Health care

Office

Medium impact

Hospitality

Retail

High impact

Industrial

Storage

Data centers

Low impact

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Many companies have shifted to a work-from-home model during the ongoing outbreak, and there is a prevailing view that a structural shift in the way people work has occurred. Employers that have long struggled to attract high-caliber local talent may benefit from this shift and use it as an opportunity to expand the available talent pool. However, we think that lessors should not take these anticipated structural changes as a foregone conclusion in considering their assumptions for vacancy and replacement rates, etc. Few companies have the ability to immediately transition to a permanent work-from-home model given the long-term nature of existing lease arrangements. It takes time to develop plans, including what mentorship and team development look like in a virtual world. As leases mature, companies may consider more flexible working arrangements by relocating from commercial business districts (CBDs) to more suburban areas.

Nonetheless, history has shown time and again that humans are social creatures, leading to the enduring appeal of cities with vibrant CBDs. Even if the number of people working from home does increase and offices move to suburban locations, individuals may long to live in CBDs for social interaction during non-working hours.

On the healthcare front, many health systems are looking to consolidate from large locations in favor of other office strategies. Although senior housing facilities are likely to experience a short-term negative effect from COVID-19, this could translate into a long-term growth opportunity if operators develop ways to proactively deal with future outbreaks. Specifically, facilities with comprehensive plans, skilled nurses, and on-site medical personnel may benefit as safe havens.

We anticipate that the industrial, storage and data center sectors will continue to perform strongly as compared to others in the industry. These properties have experienced

few effects of social distancing measures and are likely to benefit from shifting preferences in commercial real estate assets.

Medium impact (office, health care)

Low impact (industrial, storage, data centers)

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For certain companies, developments such as granting of concessions and short-payments have given rise to considerable liquidity concerns.

In addition to the short-term concessions sought by lessees, COVID-19 will likely have long-term effects on the types of contractual terms lessees will negotiate.

Looking forwardDespite the continued uncertainty in how the industry will look following the COVID-19 outbreak, there has been a shift to long-term planning. Commercial real estate executives may consider the following in preparation for the new reality:

Lease structuring

Liquidity management

In particular, those in the retail and hospitality sectors may negotiate for a higher proportion of variable rent to shift some of the risk of store closures to the lessor and mitigate the potential effects of a second wave of infection or other unforeseen closures. This will likely introduce volatility in the financial statements and may make revenue predictions difficult.

These liquidity constraints could raise concerns about the ability to meet certain contractual debt covenants, which companies may want to proactively renegotiate when possible.

Lessees may also seek to enter into contracts with shorter initial terms and multiple renewal options given the uncertainty in consumer preferences. For example, retailers may be hesitant to sign long-term leases as consumers are likely to continue shopping online even as stores reopen. Lessors will have to exercise judgment when determining the accounting lease term, and prepare expanded disclosures of such judgments.

In addition to negotiating short-term relief from certain covenants, companies may also consider modifications to current financing to avoid tense negotiations with lenders in the future. Accounting for loan modifications is complex and may impact the income statement.

Tenants may negotiate additional improvement allowances for reconfigurations of space. For example, office tenants may wish to make changes to accommodate social distancing. While these allowances are likely to be non-recurring, tenants may also request concessions given increased operating expenses, such as antibody testing required before moving back into leased areas.

Lessors should also consider the potential domino effect of tenants’ liquidity positions in assessing the ability to meet their own debt-servicing requirements.

Contractual language surrounding force majeure clauses may be amended at lessees’ request for specific concessions in the event of future outbreaks.

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While many in the industry will undoubtedly face hardship as a result of the COVID-19 disruption, REITs with flexibility to diversify and availability of resources may benefit from attractive opportunities to acquire assets.

In a period of uncertainty, internal controls remain critical for maintaining discipline and continuing to provide reliable reporting and disclosures.

Purchases of real estate and leases

Internal controls considerations

The availability of distressed assets, either in below-market leases or ownership, provides the potential for conversion of spaces into more attractive uses (for example, converting suburban retail spaces into warehousing areas that enable same-day delivery). Buyers should consider the impact of favorable lease contracts while performing accounting for asset acquisitions.

The requirements, timelines and rigor surrounding Sarbanes–Oxley Act (‘SOX’) compliance have not been alleviated. REITs should consider the impact of remote working arrangements and operational changes on their internal controls over financial reporting. The accurate assessment and documentation of impacts to people, processes, and use of new tools and technologies on their SOX control environment are key to ensuring continued compliance.

Those considering acquiring sales-type or direct financing leases through an asset purchase will need to evaluate whether the leases are considered purchased credit deteriorated (PCD) under the new CECL standard. As there are both financial and non-financial components to the net investment in a finance lease, the determination as to whether the receivable is PCD is based on assessment of both tenant-specific credit risk and real estate valuation. PCD receivables may be more common following the outbreak. This would result in the initial measurement of the allowance for credit losses being reflected as a basis adjustment to the net investment in the lease rather than reported in current earnings.

Internal controls need to be appropriately identified and documented in the face of evolving processes and substantial volumes of information surrounding leasing and tenant monitoring, including tracking collections, and review and authorization of deferral and abatement requests. Assessing the relevant impacts to reporting and disclosures in the face of evolving regulatory pronouncements is key.

While we do not think that a fully remote working environment is imminent, certain geographical markets that have been historically underpriced may become more appealing. Mid-sized cities with a vibrant and diverse community, access to national hub airport, and a relatively lower cost of living may see an influx of newly remote-working employees.

Given the continued uncertainty surrounding COVID-19’s economic impacts, REITs will likely be required to employ additional judgment and analysis when assessing impairment and related disclosures. Key inputs into valuation models, such as cash flow forecasts, are likely to fluctuate, resulting in impairment assessments. REIT management should ensure that key controls over valuation and impairment keep pace with these changes and sufficiently support the assessments management is performing.

Companies facing liquidity problems may sell or spin-off assets, resulting in favorable terms for potential buyers.

Cyber security risks are rising with employees being encouraged to work from home. REIT management must ensure proactive measures, including data protection and information security controls. They should also promote awareness and education to thwart cyber attacks.

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ConclusionAll companies should consider whether the economic effects of the COVID-19-induced uncertainties will affect accounting outcomes. Though standard-setters and governmental agencies have provided some relief, the need to revise accounting policies comes at a time when finance and accounting departments are also facing operational challenges from virtual closes and remote working. Companies have no time to waste.

Our U.S. GAAP and IFRS Standards resources will help you to better understand the potential accounting and disclosure implications of COVID-19 for your company and the actions management can take now.

For a more in-depth discussion of the financial reporting topics discussed in this article, please refer to the following:

— Defining Issues: FASB discusses and responds to COVID-19

— Hot Topic: Coronavirus – FASB staff guidance on accounting for COVID-19 rent concessions

— Hot Topic: Coronavirus – Potential impacts on the accounting for financial instruments

— Hot Topic: Coronavirus – COVID-19 increases risk of impairment of goodwill and long-lived assets

— Hot Topic: Coronavirus – Potential impacts on the accounting for financial instruments

— Leases: Real estate lessors

Additional resources

In times of economic turbulence and an uncertain future, transparency of financial information is of paramount importance. Financial statement preparers and auditors have an important role to play to ensure that financial reporting is transparent and unbiased, which allows investors to make informed decisions. A clear, concise, and balanced approach is fundamental in maintaining stakeholder trust.

The financial reporting impacts of COVID-19 are numerous and complex. KPMG professionals have a detailed understanding of how real estate companies are likely to be affected and the steps that they can take now to meet their financial reporting, operational, strategic and control objectives.

How KPMG can help

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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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Reza van Roosmalen Principal, Accounting Advisory Services 212-954-6996 rezavanroosmalen@kpmg.com

Amit Singh Director, Accounting Advisory Services 212-954-6019 Amitsingh5@kpmg.com

Dritan Muneka Director, Accounting Advisory Services 212-954-1413 dmuneka@kpmg.com

Shirley Choy Managing Director, Audit 646-321-6237 schoy@kpmg.com

Ronan Curran Director, Financial Due Diligence 917-603-8913 ronancurran@kpmg.com

Eric Carlsson Director, Internal Audit 973-214-6769 ecarlsson@kpmg.com

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