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As businesses review their existing lease agreements, we have seen multiple instances where they’ve identified dilapidation clauses that haven't previously been reflected properly in financial statements. This is leading to revised accounting estimates, and in many cases prior year adjustments to previously reported results. As well as impacting financial reporting, there are also potential tax and cash flow consequences of additional dilapidations exposure that businesses need to consider. By nature, the calculation of dilapidations requires careful judgement, and often specialist involvement is needed to ensure that the provision can be explained and supported.
With the shifting demand for office space, lease terms are being negotiated differently, with more negotiating “power” residing with tenants as landlords seek to keep occupancy levels at a sustainable rate. This has given rise to a shortening in average lease terms, preferable rent levels for tenants, improved lease incentives, and changes to break clauses. There are some financial reporting concessions available where these renegotiations are directly attributable to COVID-19, but where they are not, they need to be considered under the existing accounting frameworks. The nature and terms of lease agreements can materially affect how these are accounted for, in terms of reported financial results, the ability of a company to meet investor expectations and compliance with existing lender covenants.
The decision taken by businesses to either rent or buy property is changing, due in part to the matters outlined above. This has tax, cash flow and gearing implications, for example stamp duty land tax and structuring considerations; and how the property purchase and any refurbishment costs will be funded, be that through existing reserves or new borrowings.
It is perhaps easy to forget the corresponding impact on landlords who have seen significant rent roll reductions, increased exposure to tenant default and voids, and a knock-on impact on property valuations. Certain sectors such as retail and hospitality have inevitably been hit harder than others. The combination of these factors have implications for future cash flows and the ability of landlords to comply with their own financial covenants, to meet their shareholder and investor expectations, and will also influence decision making over when to dispose of or acquire assets. How landlords address these challenges has inevitable consequences for tenants, particularly those looking to revise or exit their lease agreements as they reconsider their office space requirements.
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