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4/29/2016
1
Gain a Better Understanding of Your Financial Statements
Presented by: Chris Bailey, CPA
Robert Kitchen, CPA
About Clark Schaefer Hackett
Top 60 CPA firm with more than 75 years of history
More than 400 employees in 7 locations 75 professionals focusing solely on
Affordable Housing 30 years of firm experience in Affordable
Housing Serving more than 1,300 clients across the
industry
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Learning Objectives
General overview of how to read affordable housing financial statements Background information to why this information is
needed Overview of the components of the financial
statements Ways to analyze and extract information from the
financial statements
Background
How is a real estate project different than other businesses? It is often highly leveraged and generates losses
due to depreciation, interest and other operating expenses
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Background – Leveraging Your Investment
A very modest investment permits an owner to control a valuable rental property – often a 20% down payment
As the property increases in value the owner’s return on the investment increases at a multiple of the increase in the value of the property
Background – Leveraging Your Investment
Example: Assume that an investor purchases a rental home for
$100,000 with a down payment of 20% or $20,000. Five years later the investor sells the property for $110,000, for a net increase of $10,000. Over the five‐year period the value of the property has increased a modest 10%. However the investor’s return on his initial investment of $20,000 is 50%: all because the investor was able to leverage the initial investment.
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Background – Leveraging Your Investment
However; cash flow from a rental property is maximized when the property is not leveraged and minimized when the property is highly leveraged
Therefore, cash flow from operations is needed to service the debt on the project
Background – Unique Real Estate Accounting
Net Income is not the overriding benchmark Net Operating Income and Cash Flow are the main
benchmarks Focus on asset appreciation Tax minimization (pass through entities)
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Background – Unique Real Estate Accounting
Unclassified balance sheet presentation Assets and liabilities on the balance sheet are not
broken down b/w current (less than one year) and long‐term
Some internal statements will disclose the expected fair value of the rental property.
Cost segregation studies completed for tax purposes can accelerate depreciation out of 27.5 years for tax
Background – The Legal Entity
Most real estate financial statements represents the activity of a single project Real estate projects often have different ownership
structures within a controlled group Helps limit legal issues from affecting an entire real
estate portfolio Most real estate projects are set up as pass through
legal entities – (limited liability companies or limited partnerships)
The legal entity will impact how the financial statements are prepared and presented C‐corporations (except for nonprofits) are not
preferred due to the additional layer of tax
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Background – The Legal Entity – 1031 Exchange
Some real estate properties are owned in tenant in common – often to facilitate a 1031 exchange
Selling a relinquished property and acquiring a replacement property in a tax –deferred exchange under IRC Section 1031
Typically any income producing real estate asset will qualify as a like‐kind exchange
Defers gain on the appreciation of real estate Allows for wealth amplification Reinvest the avoided tax bill to produce additional
income and equity growth Cons ‐ Complex and expensive
Background – Trusting the Numbers
The financial statements will often be accompanied by a report from an outside auditor
An audit is the process of verification that the financial statements can be relied upon as having been fairly presented
Be aware of qualifications in the report “except for” “subject to” that may indicate issues that the auditor found during the audit that was not corrected by management
Review (less assurance than an audit) Compilation (no assurance provided) Monthly statements are often prepared internally by
management and may not include all accruals which are often done at year‐end
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Background – Audit Opinions
Unmodified or clean opinion
Qualified opinion
Background – Basis of Accounting
Most financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP)
or Income tax basis of accounting
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Background – Basis of Accounting ‐ GAAP
Required by most lenders Promotes comparability among financial statements Most third party users are knowledgeable and
understand GAAP Limits of income tax basis of accounting income tax basis of accounting does not record
unfunded obligations or commitments until paid and interest due to a related party cannot be accrued and deducted
1031 exchange as we discussed previously The recognition of casualty gains and losses could
be in different periods
Background – Basis of Accounting – Income Tax Basis of Accounting
No third party users of the financial statements No third party debt The cost of complying with GAAP would exceed the
benefit Owners are involved in day to day operations Owners interested in the tax implications of
transactions Avoids duplication of accounting records for book and
tax (one depreciation schedule) Footnotes are often omitted saving time
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Background ‐ Accounting 101
Interest, real estate taxes and other project costs clearly associated with the acquisition, development and construction of a real estate project will be capitalized – usually the time before certificate of occupancy
Permanent loan costs are capitalized and amortized (expensed) over the life of the loan
Organizational / Start up costs are written off as incurred for GAAP but capitalized for tax
Interest rate swaps – the fair value of the swap is recorded for GAAP but only the effective portion realized during the year is recognized for tax
Background ‐ Accounting 101
Nonprofit organizations may receive conditional notes payable
If repayment is deemed remote then the funding is recorded as income and temporarily restricted net assets
Otherwise its recorded as a liability – interest may be accrued if applicable
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Background ‐ Accounting 101 ‐ continued
Understand the accounting of the key transactions of a real estate entity Purchase of the property Refinance / loan modification Sale of the property Casualty gains / losses Real estate impairment
Background ‐ Accounting 101 ‐ continued
Purchase of the property If the sale occurs between entities under
common control (related parties) then the carrying value of the property by the seller could transfer to the new owner ‐ OR ‐
If a business combination occurred then acquisition related costs (settlement costs) are expensed and the building is recorded at fair value if vacant ‐ OR ‐
Recorded at selling price with settlement costs capitalized (same for income tax basis)
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Background – Nonfinancial Information
In order to understand a project’s financial health a user of the financial statements must understand and analyze the entire financial statements while using nonfinancial information
Examples of nonfinancial information……
Background – Project Type
HUD (often twice as many pages) RD Tax credit only HUD and Tax credit (or other combinations) Investment property Nonprofit – for profit
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Background – Project Type
Understand the tenancy type (Family, Senior, Special Needs) Senior properties traditionally report lower
turnover ratios and operating costs Sometime special needs projects are underwritten
conservatively which allows for stronger performance
Background – Nonfinancial Information
Understand where the project is located Understand the age of the project – often included in
footnote 1 about the Organization As a general rule older properties are expected to generate
higher levels of cash flow compared to new properties b/c rental income tends to grow higher than operating expenses and debt service is often fixed – the largest expense of the project
The management agent may include descriptions of the property and pictures for potential tenants on the internet
Google street view may present an unaltered view of the project and surrounding area
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Background – Nonfinancial Information (cont.)
Same balance sheet, which project would you want to own? This one….
Background – Nonfinancial Information (cont.)
Or this one?
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Background – Other Information
Understand that some larger projects are split into multiple legal entities therefore be aware that the financial statements may not include the activity of the entire project just the legal entity
The footnotes may indicate if the project is third party managed and sometimes the management company is listed. If your familiar with the management company or their reputation in the industry could provide some inside information
Has the project met stabilized operations – projects still in the lease up phase will be expected to incur operating losses
Components of the Financial Statements
Balance Sheet Income Statement Statement of Changes in Equity Statement of Cash Flows Footnotes
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Balance Sheet
Financial picture of the project as of the balance sheet date – a snapshot in time
Two main sections Assets Liabilities and Equity
Non‐classified balance sheet most commonly used for real estate industry
List of all items owned by/owed to the property List of all debt and other items owed by the property Equity is the difference between the two
Balance Sheet
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Balance Sheet (continued)
Not necessarily a representation of the underlying value of the property
Balance sheet will not reflect appreciation in the fair value of the property however will recognize permanent impairment of the property
It will not show you the quality of the assets or the market value in most cases
Deferred maintenance obligations is often the missing element not included
Income Statement
Represents the earnings of the project for the period represented – usually one year
Often more important to investors than the balance sheet
Valuable guide in anticipating how the property will do in the future
Historical record for a series of years is more important
An income statement that presents operating results will clearly show the net income directly related to the project versus costs of financing, depreciation and related party or entity fees
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Income Statement
Statement of Changes in Equity
Highlights the activity with owners Represents cumulative earnings from the project +/‐ current year net income (loss) Contributions from owners Distributions to owners Real estate companies often distribute excess cash
rather than investing the proceeds back into operations
Owners will purchase new properties in a separate legal entity in part from the distributions earned from multiple properties
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Statement of Changes in Equity
Statement of Cash Flows
Reflects the change in cash of the property for the period presented
Separated into three main sections: Operating Investing (capital expenditures) Financing (lending and activity with owners)
Two types of cash flow statements (direct or indirect)
Cash flow generated from operating activities is a very important reporting measure for real estate entities
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Statement of Cash Flows
Footnotes
Help the reader of the financial statements understand matters in more detail from the previous four statements
Will include : Accounting policies ‐ depreciation method Nonrecurring items Related party transactions Details of debt financing Contingent liabilities – lawsuits pending Time consuming to read – often overlooked but
very informative Real estate footnotes often disclose non required
information at the request of the owners
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Footnotes
Some footnotes are required by accounting standards, for example:
Footnotes
Some footnotes are requested by other interested parties (syndicators, lenders, management):
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Monthly Financial Statements
Allows for timely financial results of the project Usually compare budget to actual Emphasis on monitoring operations May not include all year‐end accrual adjustments Amortization of deferred charges Accrual of interest on soft debt Accrual of related party fees
Monthly Financial Statements
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Definitions
Depreciation – except for land assets wear out so they are devalued or depreciated every year
Fair Market Value – the price of an asset product or service in a current competitive market
Net worth – Assets less liabilities Owner’s investment – the money owners have
invested in a project Pro Forma – Projecting or forecasting future
income, expenses and cash flows Secured loan – Loan secured by collateral (which
will be liquidated if the borrower defaults on the loan)
Definitions (continued)
Tangible Asset or Fixed Assets – real property (real estate, equipment, furniture and fixtures)
Term – a loan’s maturity Term loan – Loan, usually given in one lump sum
at the closing, repayment is monthly over a stated term.
Working capital – difference between current assets and current liabilities
Draw down – taking an advance on a line of credit Capacity – borrowers’ ability to handle a certain
level of debt Retained earnings – net profits accumulated
through the project’s life – can be negative
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Definitions (continued)
Cash Out Refinance – refinance at a higher loan balance for personal use
Effective age – an appraisals estimate of the physical condition of a building
Loan to value – the outstanding loan balance versus the market value of the property
Tenant in common – shared ownership of a property – each owner has the right to occupy and use all of the property
IRR – used to measure the profitability of investments. A higher IRR makes the investment more desirable
Opportunities
Rising real estate taxes but financial results of the project continue to decline and local housing economy has not rebounded– possible appeal of the valuation for real estate taxes
Mortgage footnote discloses an interest rate that is considerably higher than today’s rates ‐ refinance
Significant utility costs compared to industry – sub meter the project – push utility costs to the tenants –review project grounds for water leaks / unauthorized car washes If tenants are not required to stay current on utility
bills the project is stuck with the cost when the tenant moves out – review leasing policies and procedures
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Opportunities (continued)
High vacancy costs even though the project has a waiting list – the project is not timely preparing the unit for the next tenant
High or low benefit costs compared to salary costs in relation to industry standard Lower benefit costs may indicate that benefits are
not comparable to the competition which could indicate potential staff turnover higher than the industry norm
Higher benefit costs are an opportunity to review health initiatives or find a cheaper provider
Opportunities (continued)
Excess cash on the balance sheet / Cash in excess of FDIC limits – opportunity to invest cash that will not be needed in operations and receive a higher rate of return
High accounts payable trade – may not be taking advantage of discounts for early payments from vendors
Significant bad debt expense – project is not timely evicting tenants
Review maturity dates of mortgage debt for refinancing
Review legal fees for tenant eviction to industry
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Opportunities (continued)
Understand the largest expenditures on the income statement – If a project has high salary costs then future labor
costs will be of note for budgeting High utility costs will dependent on future energy
costs Other costs will be dependent in part on
inflationary changes Focus on the largest costs in order to maximize
potential savings
Opportunities (continued)
Review the footnote for rent restrictions that the project has committed to
If the project is showing cash flow issues limited operating cash High trade payables Depleted replacement reserve and /or operating
reserve Owner operating deficit guarantees that have been
fully funded Impairment of the housing complex
If yes you may consider if deferred maintenance may be an issue. Often deferred maintenance is the “plug” in any project’s budget
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Opportunities (continued)
Does the current year income statement contain one item items that should be adjusted for when annualizing the results of the project Real estate tax refund Excess water bills Casualty gain / loss Contingency loss – lawsuit Repairs not capitalized
Consider reviewing current year against multiple years to determine trends and better indicate the results of the current year
Is the project‐ cross collateralized? Related party fees above market rates?
Other Tools
Use Excel, graphs and software to quickly analyze financial results
Financial statements often contain the raw data but to effectively and efficiently review the information it must be broken down even further
There is much more than just the total assets and net income
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Ratios
Ratios help analyze a company’s financial condition while comparing to others in the same industry
Lenders look very carefully at ratios Liquidity ratios show if the project is cash rich Ratios come from all four statements and the
footnotes Helps analyze how operating decisions impact the
financial results
Common Real Estate Ratios
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Common Real Estate Ratios
Common Real Estate Ratios
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Debt Service Coverage Ratio
Covenant on many mortgage loans Be careful – the DSCR is not always calculated at the entities year‐
end – review the loan documents Debt service = monthly mortgage payment (principal and interest) Net operating income (see next slide) A DSCR of 1.0 is called a break even cash flow b/c the net
operating income (NOI) is just enough to cover the mortgage payments
The lender likes a higher DSCR which allows more net operating income available to service the debt
Helps determine how much debt the project can handle A DSCR of .95 indicates negative cash flow and reserve
withdrawals, owner advances would be needed to keep the project afloat
Covenants can range from 1.10 to 1.35 (LIHTC 1.15)
Debt Service Coverage Ratio – NOI
Net operating income – calculated differently by each lender –ASK
Standard calculation
Some lenders insist on a vacancy % regardless of the actual collection loss
Lenders may also require a management factor of 3‐6% even if owner managed – They would incur these costs if they took back the property
Loan payments (interest) are not included as an operating expenses
Remove corporate expenses not related to the project
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Debt Service Coverage Ratio – continued
Lenders really care about cash flow – that’s how they will be repaid
I talked with a lender recently and they are looking for debt service of 1.25X or greater.
They take into account dividends to owners and capital expenditures at $100/bed or $200/unit
If the entity is a C‐corp they will factor in income tax Statement of Cash Flows when prepared is very valuable to their
analysis
Signs of a Nonperforming Property
Physical Occupancy levels below 90% ‐ Net rental income / Gross potential loss Soft market conditions Competitive properties in close proximity Ineffective tenant screening / high eviction rates Poor property condition that limits curb appeal
Negative cash flow – Statement of Cash Flows – cash provided by
operating activities less debt service in the financing section or
A negative DSCR– 3 straight years High administrative costs related to oversight and
compliance requirements by IRS and state housing agencies
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Signs of a Nonperforming Property ‐ continued
Occupancy – most syndicators underwrite tax credit properties based on the assumption that “effective” or “economic” occupancy of 93% The 7% loss is turnover of units, discounts, and collection loss Occupancy below these levels could impact cash available for
debt service and owner distributions
Signs of a Nonperforming Property ‐ continued
Smaller properties in unit size often have more operating challenges Less likely to withstand operating issues Capital and overhead costs can be easily spread
over a larger number of units Equity investors tend to pay a premium to
invest in larger projects allowing for lower levels of debt
Construction costs in excess of budget – some project’s never recover without some sort of cash infusion / restructuring of debt
Real estate taxes higher than budget
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Real Estate Valuation Concepts
How do I determine what my property is worth? Divide the annualized NOI or cash flow by the
capitalization rate Capitalization rate – the rate of expected return on
the investment property A ratio of income to value
Questions?Thank you!
Chris Bailey, CPA Robert Kitchen, [email protected] [email protected]‐390‐7366 937‐390‐7323