Lease Accounting Under ASC 842 (Lessee and Lessor)

Effective for public companies for fiscal years beginning after December 15, 2018, and for private companies for fiscal years beginning after December 15, 2021 (confirm the applicable effective date and any subsequent FASB amendments for the specific reporting entity and period in question), ASC 842, Leases, replaced the prior standard, ASC 840, and fundamentally changed how tenants account for their leases. Under ASC 840, most tenant (lessee) leases — the standard operating lease covering most office, retail, and industrial space — never appeared on the tenant's balance sheet at all; the rent obligation was disclosed only in footnotes. ASC 842 ended that: with narrow exceptions, a lessee must now record a right-of-use (ROU) asset and a corresponding lease liability on its own balance sheet for virtually every lease with a term over twelve months. The landlord side of the same lease — lessor accounting — changed comparatively little, but both sides still straight-line rent, and both sides intersect directly with how a CRE entity's balance sheet and income statement are built.

At lease commencement, a lessee first classifies the lease as either an operating lease or a finance lease, using criteria that ask, in substance, whether the lease effectively transfers ownership of the underlying asset to the lessee: does the lease transfer ownership by the end of the term, does the lessee have a purchase option it is reasonably certain to exercise, does the lease term cover the major part of the asset's remaining economic life, does the present value of the lease payments amount to substantially all of the asset's fair value, or is the asset so specialized it has no alternative use to the lessor at lease-end? Most CRE tenant leases — office, retail, or industrial space leased for a fraction of the building's economic life — fail all five tests and are classified as operating leases.

Regardless of classification, the lessee initially measures the lease liability at the present value of the remaining lease payments, discounted using the rate implicit in the lease if it is readily determinable, or, far more commonly for a tenant, its own incremental borrowing rate (IBR) — the rate it would pay to borrow a similar amount, on similar terms, secured by similar collateral. The ROU asset is initially recorded at that same amount, adjusted for prepaid rent, lease incentives received, and initial direct costs. For an operating lease, the lessee then recognizes a single, straight-line total lease cost each period (combining the effective interest on the liability and amortization of the ROU asset so the two components sum to a constant expense), rather than reporting interest and amortization separately as it would for a finance lease.

On the landlord's side, ASC 842 asks the same five classification questions, applied from the lessor's perspective, to sort a lease into operating, sales-type, or direct financing. Because a CRE landlord's tenant leases almost never transfer ownership of the building, are almost never for the major part of the property's remaining economic life, and almost never have a present value of payments approaching the property's fair value, the overwhelming majority of CRE landlord leases remain operating leases for the lessor — meaning the landlord keeps the property on its own balance sheet, continues depreciating it, and simply recognizes rental income.

That rental income, however, is recognized on a straight-line basis over the lease term whenever the lease includes fixed, scheduled rent that varies period to period — contractual rent steps or an initial free-rent period — rather than recognized as billed. This is functionally unchanged from prior GAAP and is the mechanic covered in detail below.

Straight-lining takes the total fixed cash rent contractually due over the entire lease term and spreads it evenly across every period of that term, regardless of how the actual cash payments are scheduled. The mechanics: sum all fixed, non-contingent cash rent payable over the lease term (including the effect of any free-rent or rent-abatement period, where cash due is zero), then divide by the number of periods in the term to produce a constant straight-line rent recognized in revenue (by the lessor) or expense (by the lessee, as part of its single lease cost) every single period.

Because actual cash rent is rarely constant — free rent at the start means cash collected is below the straight-line average early on, and contractual rent steps mean cash collected exceeds the average later — the difference between straight-line rent recognized and cash rent billed accumulates on the balance sheet. From the lessor's side, this typically appears as a straight-line (deferred) rent receivable: an asset that builds up during the free-rent and low-rent early years, as recognized revenue outpaces cash billed, and then runs down to zero over the balance of the term, as cash billed in the higher-rent later years outpaces the constant straight-line revenue.

A tenant signs a 5-year (60-month) lease. The first 3 months are free rent. Starting in month 4, base rent is $20,000 per month for the remainder of Lease Year 1, then steps up by $1,000 per month at the start of each subsequent lease year.

Cash rent by year: Year 1 — 9 months (months 4–12) at $20,000 = $180,000 (months 1–3 are free, contributing $0). Year 2 — 12 months at $21,000 = $252,000. Year 3 — 12 months at $22,000 = $264,000. Year 4 — 12 months at $23,000 = $276,000. Year 5 — 12 months at $24,000 = $288,000.

Total contractual cash rent over the 5-year term = $180,000 + $252,000 + $264,000 + $276,000 + $288,000 = $1,260,000.

Straight-line annual rent = $1,260,000 ÷ 5 years = $252,000 per year, recognized as revenue (lessor) or lease expense (lessee) in every single year of the term, regardless of how much cash actually changes hands that year.

Comparing straight-line revenue to cash billed each year produces the deferred rent receivable balance shown in the schedule below — building to $72,000 by the end of Year 1, holding flat through Year 2 (when cash and straight-line rent happen to match exactly), and then unwinding to precisely zero by the end of Year 5, since total cash and total straight-line revenue over the full term are, by construction, identical.

When a property is purchased subject to existing, in-place leases, GAAP purchase accounting requires the buyer to separately value the difference between each lease's contractual rent and current market rent for comparable space, and to record that difference as an intangible on the acquisition balance sheet, distinct from the value of the building itself. If contractual rent exceeds market rent, the buyer records an above-market lease intangible asset, representing the extra value the buyer paid for above-market cash flow it will collect from that tenant. If contractual rent is below market, the buyer instead records a below-market lease intangible liability, representing value the buyer effectively did not pay for, because that tenant is contractually underpaying relative to the market.

Both intangibles are measured at the present value of the rent differential over the lease's remaining term (in some cases including a reasonably assured renewal option, depending on the specific facts), discounted at a market rate appropriate to the credit risk of the tenant and lease. Both are then amortized over the remaining lease term as an adjustment to rental revenue: the above-market asset amortizes as a reduction to rental income, since the outsized contractual rent driving that asset will not persist once the lease rolls to market, while the below-market liability amortizes as an increase to rental income, since the tenant's rent will eventually reset upward to market. Getting the direction backward is a common error — the intangible amortization always pulls reported rental income *toward* market, not away from it.

A buyer acquires a property with 10,000 square feet leased to a single tenant with 5 years remaining on its term. Contractual rent is $25/SF/year; current market rent for comparable space is $22/SF/year. The rent differential is $25 − $22 = $3/SF/year × 10,000 SF = $30,000 of above-market cash flow per year for the remaining 5 years.

Discounting a 5-year, $30,000 annual annuity at an assumed 7% market discount rate: the present value annuity factor is [1 − (1.07)⁻⁵] ÷ 0.07 ≈ 4.1002, so the above-market lease intangible asset recorded at acquisition is approximately $30,000 × 4.1002 ≈ $123,000.

That $123,000 asset amortizes over the 5-year remaining term — roughly $123,000 ÷ 5 ≈ $24,600 per year — as a reduction to rental revenue, so the buyer's GAAP income statement reports rental income below the actual contractual cash rent it is collecting from that tenant, reflecting the fact that a portion of the cash rent collected each year is really a return *of* the premium the buyer paid at acquisition, not a return *on* the property's ongoing market rental rate.