Capitalising rent with a multiple or with the IFRS 16 lease liability, why the two differ by the remaining lease term, and the double count that mixes them.
Lease-adjusted leverage adds a debt-like amount for leases to financial debt and divides by EBITDAR, earnings before rent. The amount can be rent times a fixed multiple, traditionally 8, or the IFRS 16 lease liability, the present value of the remaining rents. For an illustrative retailer with $400 million of debt and $60 million of rent, the 8x convention gives 4.19x and the IFRS 16 liability gives 3.31x, against 2.67x on debt alone. The 0.88 turn gap between the two adjusted figures is the remaining lease term, not the credit.
Worked in full in Credit Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A retailer, an airline or a restaurant chain that rents its estate carries a fixed obligation that ranks, in practice, alongside its debt: miss the rent and the business loses the sites it trades from. Two companies with the same EBITDA, one owning its stores with a mortgage and one renting them, look very different on net debt to EBITDA unless the rent is capitalised. Lease adjustment puts them on the same footing. The question is how to measure the debt-like amount, and the two methods in use answer it very differently.
| Input | Value |
|---|---|
| Financial debt | 400 |
| Cash | 50 |
| EBITDA after rent | 150 |
| Annual rent on property leases | 60 |
| EBITDAR (EBITDA + rent) | 210 |
| Rent multiple, traditional convention | 8.0x |
| Incremental borrowing rate | 6% |
| Average remaining lease term | 6 years |
Under IFRS 16 the rent leaves operating expenses and is replaced by depreciation of the right-of-use asset and interest on the lease liability, so reported EBITDA rises to roughly EBITDAR, here $210 million. It is only roughly: short-term leases, low-value leases and variable rents stay in operating costs.
Rent multiple method: lease debt = $60m × 8.0 = $480m
Adjusted leverage = ($400m + $480m) / $210m = 4.19x gross; ($880m − $50m) / $210m = 3.95x net
IFRS 16 method: lease liability = rent × annuity factor = $60m × (1 − 1.06−6) / 0.06 = $60m × 4.92 = $295m
Adjusted leverage = ($400m + $295m) / $210m = 3.31x gross; 3.07x net
Excel for the liability, rent in arrears: =PV(6%,6,-60); the leverage: =(Debt+Lease)/EBITDAR
| Method | Debt | Denominator | Gross | Net |
|---|---|---|---|---|
| Debt only, EBITDA after rent | 400 | 150 | 2.67x | 2.33x |
| IFRS 16 lease liability, EBITDAR | 695 | 210 | 3.31x | 3.07x |
| 8x rent, EBITDAR | 880 | 210 | 4.19x | 3.95x |
The two adjusted figures differ by $185 million of lease debt, 0.88 turns of EBITDAR. Neither is wrong; they answer different questions. The IFRS 16 liability measures what the company has contractually committed to pay, discounted: 4.9 years of rent. The 8x multiple measures what it costs to stay in business in those sites, on the assumption that the sites are needed for the long term and the leases will keep being renewed. At a 6 per cent rate, 8 times rent is the present value of 11.2 years of payments, so the multiple implicitly assumes a much longer commitment than this tenant has signed.
| Remaining term, years | Lease liability, $m | Rent multiple | IFRS 16 leverage | 8x leverage |
|---|---|---|---|---|
| 2 | 110 | 1.8x | 2.43x | 4.19x |
| 4 | 208 | 3.5x | 2.89x | 4.19x |
| 6 | 295 | 4.9x | 3.31x | 4.19x |
| 8 | 373 | 6.2x | 3.68x | 4.19x |
| 10 | 442 | 7.4x | 4.01x | 4.19x |
| 15 | 583 | 9.7x | 4.68x | 4.19x |
The IFRS 16 figure moves with the lease book, not with the business. A retailer whose leases run down towards expiry appears to deleverage every year with no change in its rent or its earnings; one that renews its estate for ten years adds $147 million of debt overnight and goes from 3.31x to 4.01x. A lender who reads that as a deterioration in the business misreads it: the renewal secured the sites, even though it lengthened the committed obligation. For credit work across companies with different lease profiles, a constant rent multiple is more comparable; for a single company's committed obligations, the IFRS 16 liability is the better measure.
Loan agreements often settle the question in the definitions. Many define leverage on a frozen-GAAP basis or exclude lease liabilities from debt. Read the definition before comparing a covenant ratio with an analyst's adjusted figure, as in how to calculate covenant headroom.
Take EBITDAR down 20 per cent to $168 million with rent unchanged, so EBITDA after rent falls to $108 million. Debt to EBITDA after rent jumps from 2.67x to 3.70x, a 38.9 per cent rise, because the fixed rent sits between EBITDAR and EBITDA and magnifies the fall. Both adjusted measures rise by 25.0 per cent, in line with earnings: 5.24x on 8 times rent and 4.14x on the IFRS 16 liability. The unadjusted ratio understates leverage in good years and overreacts in bad ones; the adjusted ratios carry the rent burden in the numerator all the time, which is why lenders to rent-heavy borrowers prefer them for downside cases.
Lease-adjusted leverage is (debt plus lease debt) over EBITDAR: 4.19x with 8 times rent, 3.31x with the IFRS 16 liability, for the same retailer. Match numerator and denominator, and remember that the IFRS 16 number is a measure of lease term as much as of leverage. The book's four EBITDAs and the covenant test are worked in the free workbooks for this case.
Eight times rent is a long-standing convention for the debt equivalent of an operating lease, treating the leased estate as permanently needed. At a 6 per cent discount rate it equals the present value of 11.2 years of rent. On an illustrative $60 million of rent it gives $480 million of lease debt, against an IFRS 16 liability of $295 million for six remaining years.
Close, but not identical. IFRS 16 removes rent on capitalised leases from operating costs, so EBITDA rises towards EBITDAR, but short-term leases, low-value leases and variable rents stay in operating costs. Using reported EBITDA with the lease liability is consistent; using it without the liability is not, and on the illustrative retailer understates leverage at 1.90x.
Under IFRS 16 a renewal adds the new committed rents to the lease liability. Extending the illustrative retailer's average term from six to ten years adds $147 million of lease debt and moves leverage from 3.31x to 4.01x with no change in rent or earnings. A constant rent multiple does not move at all.
This article is one calculation from Credit Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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