February 23, 2019

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Build-To-Suit Lease Accounting – Part 3 – 90% Maximum Guarantee Test

Build To Suit – 90% Maximum Guarantee Test

We’ve already discussed the six automatic indicators of ownership in Part 2. I recommend reading this in case you haven’t yet.

The six automatic indicators of ownership are not the only way that you can be considered the “owner” of a construction project. The other main method is that you fail the 90% Maximum Guarantee Test. Per ASC 840-40-55-10:

Beginning with the earlier of the date of lease inception or the date that the terms of the construction arrangement are agreed to, if the documents governing the construction project could require, under any circumstance, that the lessee pay 90 percent or more of the total project costs (excluding land acquisition costs) as of any point in time during the construction period, then the lessee-agent should be deemed to have substantially all of the construction period risks and should be considered to be the owner of the real estate project during the construction period.

There are many intricacies when it comes to identifying the costs to include, which costs to exclude, how to accrete prior costs and discount future costs; however, I want to start with the most relevant information that will apply to most first. As the “under any circumstances” suggests in the codification above, this test is a “worst case scenario” type of test. Essentially, what this means is that if you have an unlimited exposure to cost overruns, then you will automatically fail this test.

Ernst & Young (EY) regularly publish their “Financial Reporting Developments – Lease Accounting” guide online for the public.  I pulled the following from this publication (revised August 2015), and you can find E&Y’s latest publications here:

Cost overruns
An obligation to fund construction cost overruns would be included in the maximum guarantee test. A lessee’s unlimited obligation to cover costs over a certain amount (for example, an obligation arising from the lessee-general contractor’s entering into a fixed-price contract) would result in the lessee’s maximum guarantee being in excess of 90% of the total project costs. Therefore, the lessee would be considered the owner of the project during the construction period. Any payments that the lessee could be required to make as a result of cost overruns or change orders should be considered carefully. Payments made by the lessee during the construction period for tenant improvements also should be carefully considered. Payments for normal tenant improvements would not impact either the maximum guarantee or the lease classification tests. Payments for any other tenant improvements (for example, those originally included in amounts to be paid by the lessor) should be treated the same as other cost overruns.

Note the sentence regarding “normal tenant improvements”.   Normal tenant improvements (see Part 2 for discussion) do NOT impact this test.  In other words, your “construction project” should exclude these types of costs.  This is important as you’ll see in later parts.

What to include in the maximum guarantee test

So this section, admittedly, will not help most people as most people never need to get as far as actually calculating out a % for this as they generally are 100% liable for overruns or their costs are limited to a number that does not require a mathematical computation as it is extremely low as compared to the total project.  Therefore, I am going to list the relevant codification guidance here, as well as some of the firm guidance.  As always, please feel free to submit a question if you have any questions at all.

Implementation Guidance and Illustrations

840-40-55-8

Except as indicated in the following paragraph and paragraph 840-40-55-15, the maximum guarantee should include, but not be limited to, the following:

  1. Lease payments that must be made regardless of when or whether the project is complete (a date-certain lease)
  2. Guarantees of the construction financing (however, such guarantees can only be made to the owner-lessor as specified in paragraph 840-40-55-15(d))
  3. Equity investments made (or an obligation to make equity investments) in the owner-lessor or any party related to the owner-lessor
  4. Loans or advances made (or an obligation to make loans or advances) to the owner-lessor or any party related to the owner-lessor
  5. Payments made by the lessee in the capacity of a developer, a general contractor, or a construction manager-agent that are reimbursed less frequently than is normal or customary for the real estate construction industry in transactions in which the developer, general contractor, or construction manager-agent are not involved in the project in any other capacity
  6. Primary or secondary obligations to pay project costs under construction contracts
  7. Obligations that could arise from being the developer or general contractor
  8. An obligation to purchase the real estate project under any circumstances
  9. An obligation to fund construction cost overruns
  10. Rent or fees of any kind, such as transaction costs, to be paid to or on behalf of the lessor by the lessee during the construction period
  11. Payments that might be made with respect to providing indemnities or guarantees to the owner-lessor.

840-40-55-9
The following guidance relates to the application of the maximum guarantee test:

  1. If, in connection with the project, the lessee or any party related to the lessee makes or is required to make an investment in the lessor, or any party related to the lessor, other than investments considered to be in substance real estate as discussed in paragraph 840-40-55-15, the cost of that investment is to be included in the maximum guarantee test. Likewise, if, in connection with the project, the lessee or any party related to the lessee makes or is required to make loans or advances (including making time deposits) to the lessor or any party related to the lessor, other than loans that in substance represent an investment in the real estate project, those loans or advances are to be included in the maximum guarantee test.
  2. If the lessee, in the capacity of a developer, a general contractor, or a construction manager-agent pays or can be required to pay costs relating to the project that are reimbursed less frequently than is normal or customary, those payments are to be included in the maximum guarantee test. Thus, if the lessee can be required to make payments at a time when the owner-lessor of the project does not have the funds or a committed line of credit available to make the required reimbursements, the maximum payment amount that the lessee could be required to make is included in the maximum guarantee test. For this purpose, a line of credit would not be considered committed if there is a possibility that the reimbursement would not occur because the lender, as a result of a provision in the loan agreement, agency agreement, or other documents pertaining to the transaction, can withhold funds for any reason other than misappropriation of funds or willful misconduct of the owner-lessor or its agent.
  3. Any guarantee or commitment made to the owner-lessor by a party related to the lessee should be included in the maximum guarantee test as if that guarantee were made by the lessee unless the owner-lessor, guarantor, and lessee all are under common control, in which circumstance the guarantee or commitment may be excluded from the maximum guarantee test. Thus, situations in which a private entity (lessee) is controlled by a shareholder that also controls the lessor are not required to consider such guarantees or commitments in performing the maximum guarantee test.
  4. Any indemnification or guarantee of the owner-lessor against third-party claims relating to construction completion must be included, at its maximum amount, in the maximum guarantee test without regard to the probability of its occurrence.
  5. Total project costs include the amount capitalized in the project by the owner-lessor in accordance with generally accepted accounting principles (GAAP) plus other costs related to the project paid to third parties other than lenders or owners. For example, cancellation fees that would be payable to subcontractors if the project were to be cancelled before completion would be included in total project costs. Transaction costs that would not be capitalized by the lessor as construction costs in accordance with GAAP, such as a facility fee (that is, a fee paid to establish a master lease facility), are specifically excluded from the definition of total project costs. Consequently, if the lessee were to pay any transaction costs to or on behalf of the lessor at the time the construction arrangement is entered into, the lessee would be considered the owner of the construction project because that payment by definition would exceed the total project costs incurred to date at that time. Likewise, imputed yield on equity in the project is specifically excluded from the definition of total project costs.
  6. Land acquisition costs should be excluded from project costs for purposes of applying the maximum guarantee test regardless of the land value relative to the overall project value. Land carrying costs, such as interest or ground rentals incurred during the construction period, are considered to be part of total project costs.
  7. A lessee’s unlimited obligation to cover costs over a certain amount (for example, an obligation arising from the lessee-general contractor’s entering into a fixed-price contract) would result in the lessee’s maximum guarantee being in excess of 90 percent of the total project costs. Therefore, the lessee would be considered the owner of the project during the construction period.
  8. Any payments that the lessee could be required to make as a result of cost overruns or change orders should be considered carefully. Payments by the lessee for project costs that are not reimbursed by the owner-lessor will cause the lessee to be considered the owner of the project during the construction period. However, lease payments made during the construction period do not automatically cause the lessee to be considered the owner of the project, although those payments would need to be considered in both the maximum guarantee test and the lease classification test. Payments made by the lessee during the construction period for tenant improvements should be carefully considered. Payments for normal tenant improvements, as described in paragraph 840-40-55-15(b), would not affect either the maximum guarantee or the lease classification tests. Payments for any other tenant improvements (for example, those originally included in amounts to be paid by the lessor) should be treated the same as other cost overruns.
  9. If the lessee is obligated to make payments in either of the following circumstances, those payments should be included in both the maximum guarantee test and the lease classification computation:
    1. The lessee is obligated to make a payment under the lease regardless of whether the construction project is completed (as would be the circumstance in a date-certain lease).
    2. The lessee is required to prepay rent, those payments should be included in both the maximum guarantee test and the lease classification computation.

    With respect to the lease classification computation, any lease payments made during the construction period should be accounted for in accordance with the guidance in paragraph 840-10-25-6(d).

  10. The following contingent obligations assumed by the lessee are the only contingent obligations that are to be excluded from the maximum guarantee test:
    1. Permitted environmental indemnities as discussed in paragraph 840-40-55-15(c)
    2. Indemnifying the owner-lessor for permitted third-party damage claims as discussed in paragraph 840-40-55-15(d), other than claims arising directly or indirectly out of the lessee’s failure to complete construction or to cause construction to be completed by a specified date (for example, claims brought by lenders to accelerate payment of construction financing)
    3. Claims brought by the owner-lessor relating to fraud, misapplication of funds, illegal acts, or willful misconduct on the part of the lessee
    4. A bankruptcy of the lessee.

    All other contingent obligations, including contingent obligations resulting directly or indirectly from the lessee’s failure to complete construction (for example, default obligations under the related lease agreement if failure to complete construction is an event of default under the lease), must be included in the maximum guarantee test at their maximum amount without regard to the probability of their occurrence. Lessee obligations that result from the lessee’s bankruptcy are to be excluded from the maximum guarantee test only if it is reasonable to assume, based on the facts and circumstances that exist on the date the construction agreements are entered into, that a bankruptcy will not occur during the expected period of construction.

  11. In performing the maximum guarantee test, the lessee must consider each alternative course of action available to the owner-lessor in the event of a lessee default under any applicable construction period agreement. For example, if the owner-lessor can cause the uncompleted project to be sold and trigger the lessee’s maximum guarantee payment, or alternatively, activate the lease and enforce its rights thereunder, the lessee must perform the maximum guarantee test assuming that the lessor will select the alternative with the highest cost (as a percentage of total project costs) to the lessee.

I’ll actually plug E&Y one more time here. Their leasing guide (link reposted here) has detailed information on the inclusions and exclusions in the maximum guarantee test.

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