One of the primary issues federal agencies must address when leasing space is budget scoring. “Scoring” (as the term is routinely used in federal leasing) is the process by which the government determines if it is entering into an operating lease or a capital lease. The implications of this scoring process are dramatic: Operating leases allow agencies to budget their rent outlays annually whereas capital leases require the agency to budget, upfront, the entire net present value of all rental obligations it will incur over the duration of the lease term, including any option terms. As you can imagine, this latter structure is strictly avoided.
To be fair, scoring isn’t entirely unique to the federal government. Though the Office of Management and Budget defines six criteria federal lease arrangements must meet in order to qualify as an operating lease, the first four of these mirror private sector criteria outlined in FASB Statement No. 13. The two additional operating lease criteria are unique to the government. In all cases, OMB’s overriding goal is to ensure that ownership risk stays with the lessor — and that the lease structure itself isn’t used as a vehicle for the government to finance its ownership of the property.
In order to be scored as an operating lease, all of the following six criteria must be met:
- Ownership of the asset remains with the lessor during the term of the lease and is not transferred to the Government at or shortly after the end of the lease term;
- The lease does not contain a bargain-price purchase option;
- The lease term does not exceed 75 percent of the estimated economic life of the asset;
- The present value of the minimum lease payments over the life of the lease does not exceed 90 percent of the fair market value of the asset at the beginning of the lease term;
- The asset is a general purpose asset rather than being for a special purpose of the Government and is not built to the unique specification of the Government as lessee; and
- There is a private sector market for the asset.
In the case of government leases, it is the 90 Percent Rule that most frequently causes capital lease scoring. This is amplified in capital markets cycles where interest rates and/or equity returns are high. When initial lease offers score as capital leases, it’s a near certainty that the government will seek to modify its procurement to achieve an operating lease structure.
That is done, typically, in one of two ways: First, if tenant improvement dollars are included in the rent offer, the government will request that those be stripped out and the rent reduced. Secondly, the government may elect to shorten the term of the lease to the point that the total of the net rent payments totals less than 90 percent of the building value. Both solutions create a lease structure that is often more expensive for the government and more difficult for the property owner to finance.
It is the government that determines if a lease scores, and GSA undertakes a scoring calculation for virtually every lease. However, landlords can — and should — analyze their offers as well to anticipate the structure required to execute a successful lease.
Kurt Stout is the national leader of Colliers International’s Government Solutions practice group, which provides government real estate services to private investors and federal agencies. He also writes about federal real estate on his Capitol Markets team blog. You can contact Kurt by email or on Twitter.