Capitalizing Leases

[Guest MikeTheCannon]

So I'm taking a value investing course being offered through Stanford (so far I'm really enjoying it) and capitalizing leases came up in this weeks topic. I posed a version of this question today to the professor:

 

Do you treat capitalized leases with the same level of seriousness as a standard financial liability? For example, if a company has signed a 20 year lease, do you treat the PV of entire 20 years as a liability?

 

The professor suggested that I treat the lease obligation as I would any other normal liability... however I can't help but think that leases are different than standard liabilities. For example, if the company broke their lease tomorrow surely they wouldn't be on the hook for the entire 20 years. The landlord would find another tenant eventually allowing them to recuperate some of their money. The landlord wouldn't be allowed to sue/claim for lost income while also renting out the same location to another tenant (I don't think). If that's the case, use the present value of the entire lease seems to be overstating the obligation.

 

I would love to hear other peoples thoughts on this.

 

- Mike

[KJP]

For what purpose are you capitalizing leases?  To determine some kind of enterprise value?  To calculate ROIC?  To assess the likely of bankruptcy or the likely outcome of a liquidation?

 

Why you're doing the capitalization is relevant to how you do it.  For example, the fact that the company may not owe the full lease amounts if it breaks the lease is very relevant to some of analyses mentioned above but not others. 

[Guest MikeTheCannon]

For what purpose are you capitalizing leases?  To determine some kind of enterprise value?  To calculate ROIC?  To assess the likely of bankruptcy or the likely outcome of a liquidation?

 

Why you're doing the capitalization is relevant to how you do it.  For example, the fact that the company may not owe the full lease amounts if it breaks the lease is very relevant to some of analyses mentioned above but not others. 

 

Thanks for the response!

 

The goal this week was to calculate a variety of performance metrics: ROIC, FCFROIC, Growth in book value, etc. We also included Liabilities-to-Equity as a proxy for risk. It was the liability-to-equity ratio that really got me thinking about whether or not capitalized leases would be overstating the company's obligations. In the example we were working on, the capitalization of leases double the ratio from 1.5 to 3.0. I figured that if the leases weren't in the same league as other liabilities than perhaps the 3.0 was overstating the risk.

 

The idea that my purpose should dictate my assumptions seems like a good one to keep in mind. Thanks!

[ScottHall]

IMO more brain matter has been wasted on this topic already in the broader value investing community than it will ever be worth.

 

The broader point is a modeling circle jerk that doesn't really matter. It's just a question of framing. People who obsess over this stuff, to me, show that they are not capable of honing in on things that will really matter to their investment results.

 

But if we are being holistic, from a creditor's perspective, it does not make sense to capitalize operating leases. The claims are capped in bankruptcy as described at the link below; as you can see, the idea of deducting the whole "NPV" of operating lease liabilities can be totally absurd and will tend to underestimate any recoveries to creditors.

 

Furthermore, upon bankruptcy, preferential leases can be "assumed and assigned," basically meaning that they can be sold off for cash. How much of a fixed liability is this, then, if these leases actually can contribute meaningful value to the bankruptcy estate?

 

That said, for most people this is not an issue to dwell on from the creditor's perspective as most will not be in a position where it will matter to them.

 

I think many in the value investing community just want to be smarty pants about esoteric stuff for street cred purposes. I learned about this when I was 18 and have NEVER found practical use for it.

 

YMMV, I guess.

 

https://www.law.cornell.edu/uscode/text/11/502

[alwaysinvert]

I broadly agree with Scott, but it may of course matter greatly to a business if they have lots of long lease contracts and suddenly their revenue starts falling... What to do with it specifically in a model is Excel circlejerk kind of stuff in my view too. You should have a feeling for what kind of business effects leasing has under different scenarios and not knowing if these are material or not merely because they happen to be off-balance sheet, well, that could be a fatal mistake.

 

If you are using real estate operationally with a 20 year lease at market rates, you better make sure that lease could be used for multiple purposes with the same or better value-add. If not, you're in for a real shitstorm if business turns sour and you need to get out of the contract (depending on the exact terms, obviously).  The not so helpful answer is that valuing leases often is very hard to separate from an evaluation of the business prospects generally.

 

[Guest MikeTheCannon]

Thanks for all the responses!

 

I'll try to focus on a more holistic view of the business rather than just an excel view.

 

- Mike

[DooDiligence]

IMO more brain matter has been wasted on this topic already in the broader value investing community than it will ever be worth.

 

The broader point is a modeling circle jerk that doesn't really matter. It's just a question of framing. People who obsess over this stuff, to me, show that they are not capable of honing in on things that will really matter to their investment results.

 

But if we are being holistic, from a creditor's perspective, it does not make sense to capitalize operating leases. The claims are capped in bankruptcy as described at the link below; as you can see, the idea of deducting the whole "NPV" of operating lease liabilities can be totally absurd and will tend to underestimate any recoveries to creditors.

 

Furthermore, upon bankruptcy, preferential leases can be "assumed and assigned," basically meaning that they can be sold off for cash. How much of a fixed liability is this, then, if these leases actually can contribute meaningful value to the bankruptcy estate?

 

That said, for most people this is not an issue to dwell on from the creditor's perspective as most will not be in a position where it will matter to them.

 

I think many in the value investing community just want to be smarty pants about esoteric stuff for street cred purposes. I learned about this when I was 18 and have NEVER found practical use for it.

 

YMMV, I guess.

 

https://www.law.cornell.edu/uscode/text/11/502

 

Modeling circle jerk or Occam's razor?