Embedded leases in commercial real estate: what counts and what doesn't

An embedded lease is a lease contained inside a contract that is not called a lease. Under ASC 842, a contract is or contains a lease if it "conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration" (FASB, Topic 842 paragraph 842-10-15-3). Nothing in that sentence requires the document to say lease anywhere.

The published guidance on this topic is extensive and almost entirely about equipment. Search the term and you will find the same four examples: IT hosting, managed services, logistics contracts, and power purchase agreements. Those are real. They are also not where a real estate team's exposure sits.

The two tests, and the one that usually decides it#

Identifying an embedded lease is a two-part question, and it is worth separating them because they fail in different ways.

The first is whether there is an identified asset. The asset can be specified explicitly, by naming a suite or a unit, or implicitly, by being the only asset that can perform the function. A supplier's right to swap the asset for another defeats this test, but only if that right is substantive. Both ASC 842 and IFRS 16 treat a substitution right as substantive only where the supplier has the practical ability to substitute alternative assets throughout the period of use and would benefit economically from doing so. A clause reserving the right to relocate you, which no provider would ever use because moving you costs them money, is not a substantive substitution right.

The second is whether the customer has the right to control the use of that asset, which FASB's review materials describe as having both the right to obtain substantially all of the economic benefits of the identified asset and the right to direct its use.

In practice, most space arrangements clear the control test easily. You occupy the cage, you decide what goes in it, you hold the access badge. The identified asset test, and specifically the substitution question, is where these analyses actually turn.

The embedded leases that are actually space#

Here is the set that real estate and lease accounting teams tend to find only when someone goes looking. The right-hand columns are where the analysis turns, not a conclusion. Every one of these is facts and circumstances, and the answer belongs to your accounting policy and your auditors rather than to a table.

The twelve month point is worth isolating. A short-term arrangement can be scoped out under the practical expedient, but the assessment runs on the term including reasonably certain renewals, not on the stated term. A rolling twelve month colocation agreement that both parties have renewed for six years is not obviously a short-term lease, and that is a conversation to have before the auditor has it with you.

Why these never reach the rent roll#

The reason embedded leases go unfound is not that the accounting is hard. It is that nobody sends the contract to the people who would do the accounting.

A lease database is, in practice, a list of documents that somebody filed under lease. The colocation agreement was signed by IT. The 3PL contract was signed by supply chain. The billboard licence came out of marketing. The concession agreement was negotiated by store operations, and the parking addendum was buried in an amenity schedule. Each of those functions has its own contract repository, its own renewal calendar and no reason to think real estate wants to see any of it.

So the failure is at intake. And it repeats every year, because the contracts that were missed at adoption are the same contracts nobody is routing now. This is the same structural problem that makes lease abstraction valuable in the first place, applied to a set of documents that were never treated as leases to begin with. Reading across every contract type a portfolio depends on, rather than only the ones filed under lease, is what contract analysis is for.

How to run an embedded lease review#

1. 01Start from spend, not from contracts. Pull the general ledger for the period and sort by vendor. Contracts hide; payments do not. Look at categories where space is plausibly involved: hosting and data center, warehousing and logistics, storage, parking, signage and advertising, facilities services, and anything paid monthly at a stable amount.
2. 02Set a materiality threshold and say so in writing. You are not reading every vendor agreement in the company. Document the threshold and the rationale, because the documented scope is what an auditor will ask about.
3. 03Ask each function for its repository. IT, supply chain, marketing, store operations, facilities. Ask specifically for agreements that give the company the use of physical space or equipment, in those words, rather than asking whether they have any leases. They will say no to the second question.
4. 04Screen on the identified asset first. Does the contract name a specific cage, bay, unit, structure, footprint or suite. If nothing is identified explicitly or implicitly, the analysis usually stops there.
5. 05Test the substitution right properly. A right to relocate in the contract is not enough. Ask whether the provider could practically exercise it throughout the term and whether it would gain economically by doing so. Most relocation clauses in space agreements fail both.
6. 06Then test control, meaning substantially all of the economic benefits and the right to direct the use.
7. 07Check the term including reasonably certain renewals before concluding anything is short-term.
8. 08Separate the lease and non-lease components, or apply the practical expedient to combine them, consistently with the policy election the company has already made. A colocation invoice bundles space, power, bandwidth and remote hands, and those are not all lease payments.
9. 09Document the conclusions, including the negative ones. The contracts you assessed and concluded were not leases are as much a part of the audit trail as the ones you booked. Whatever you find flows into the same close and remeasurement process as everything else: see closing ASC 842 without surprises and the lease remeasurement checklist.
10. 10Fix the intake. A review that does not end with a routing rule is a review you will run again in two years. The rule is simple to state: any agreement conveying the use of space or equipment goes to lease accounting before signature, regardless of what the document is called.

FASB has heard the same complaint#

This is not a case of practitioners finding something difficult that the standard-setter considers settled.

In the post-implementation review of Topic 842, FASB's public roundtable materials record that "greater emphasis has been placed on identifying embedded leases as a result of the Leases standard because operating lease liabilities and assets are required to be recognized on a lessee's balance sheet," and that "stakeholders noted significant costs and complexities associated with identifying embedded leases and questioned whether additional or amended guidance is needed to reduce the effort of identifying embedded leases." The same materials note that nonpublic entity stakeholders continue to raise embedded leases as an area the Board may consider simplifying, with some suggesting nonpublic entities be excluded from the requirement entirely (FASB, Post-Implementation Review of Topic 842, Leases, Public Roundtable discussion materials, September 12, 2025).

Two things follow from that. The requirement has not changed, so the work is still the work. And if the guidance is eventually amended, the companies that will adapt quickly are the ones that already know which of their contracts convey space, which is worth doing on its own terms regardless of what the Board decides.

Companies reporting under IFRS should note that IFRS 16 applies the same control model and replaced IFRIC 4, the interpretation that previously governed determining whether an arrangement contains a lease (IFRS Foundation). The classification consequences differ between the standards, which is the subject of finance lease vs operating lease and IFRS 16 software, but the identification question is the same one.

The unglamorous summary: embedded leases are found by asking every function in the company what space it is paying for, and then reading the contracts. The accounting is the easy half.