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Gain a Better Understanding of Your Affordable Housing Financial Statements – The Basics

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

Learning Objectives

General overview of how to read and interpret affordable housing financial statements Background information as 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 – 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)

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

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

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

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

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

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

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 – 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 – Nonfinancial Information

Understand where the project is located Understand the age of the project – often included in

footnote 1 about the Organization 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

Background – Nonfinancial Information (cont.)

Same balance sheet, which project would you want to own? This one….

Background – Nonfinancial Information (cont.)

Or this one?

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

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 – 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

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

Balance Sheet

Financial picture of the project as of a particular date – a snapshot in time

Two main sections Assets Liabilities and Equity

Two main types – classified and non-classified Non-classified most commonly used for real estate

industry

Balance Sheet

Balance Sheet (continued)

Not necessarily a representation of the underlying value of the property It will not show you the quality of the assets or the

market value in most cases Balance sheet will not reflect appreciation in the fair

value of the property however will recognize permanent impairment of the property

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

Income Statement

Statement of Changes in Equity

Highlights the activity with owners Represents cumulative earnings from the project

+/- current year net income (loss) plus contributions from owners less distributions to owners

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

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 (if any) Subsequent events

Time consuming to read – often overlooked but very informative

Real estate footnotes often disclose non required information at the request of the owners

Footnotes

Some footnotes are required by accounting standards, for example:

Footnotes

Some footnotes are requested by other interested parties (syndicators, lenders, management):

Footnotes – Additional Examples

Additional footnotes to discuss Please refer to handout with sample footnotes

Monthly Financial Statements

Allows for timely financial results of the project Usually compares budget to actual Emphasis on monitoring operations Variance analysis

May not include all year-end accrual adjustments Amortization of deferred charges Accrual of interest on soft debt Accrual of related party fees


Other performance indicators to consider: Ratio analysis Accounts receivable balance Occupancy

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 Assets or Fixed Assets – real property (real estate, equipment, furniture and fixtures)

Term – a loan’s maturity Term Loan – a 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

Definitions (continued)

Cash-Out Refinance – refinance at a higher loan balance for personal use

Effective Age – an appraisal’s 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 – Internal Rate of Return - 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

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


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


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


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


Does the current year income statement contain one time items that should be adjusted for when annualizing the results of the project Real estate tax refund 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

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

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

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

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

Break Even Ratio

(Debt Service + Operating Expenses) / Gross Operating Income

Gross Operating Income includes vacancy and other tenant charges

Most lenders prefer a ratio of 85% or less Rents can decrease 15% before the property breaks

even and cannot service the debt from operations

Signs of a Nonperforming Property

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

Questions? Thank you!

Chris Bailey, CPA Robert Kitchen, CPA [email protected] [email protected] 937-390-7366 937-390-7323

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