Is My Building Really Worth Less Than my Apartment?
Building financial statements have taken on a new found prominence in the age of tough bank underwriting, as institutional lenders are now scrutinizing these reports to determine whether the collateral – the apartment being financed – as opposed to the borrower, are worthy of extending a loan. But to the non-CPAs in the crowd, these financial statements can be confusing, and without a basic understanding of certain fundamentals, the review can lead to misinterpretation and faulty conclusions. I’m not a CPA or a financial adviser, but I’ve reviewed many hundreds of building financial statements and provide some guidance here on how to get the most from your review.
The first thing to review is the balance sheet, or statement of assets and liabilities. This is a picture of the building’s financial position at some moment in time – usually year end – and sets forth the all-important cash position. Management discloses how much cash, or cash equivalent, it had on hand at end of year and is important in understanding whether the entity has the liquidity to pay ongoing expenses. A good rule of thumb is that a building should have about 1/3 of annual expenses in liquid cash at any time, in order to make current operational and non-recurring payments. The liabilities section of this statement will also show whether the building is on a land lease, or owns the underlying real estate, and also whether there is a mortgage or line of credit owing. A word of caution, however: assets are typically held at lesser of cost or market (“LOCOM”). This means that if the building was purchased 100 years ago by the coop, it would be held on the asset statement at historical cost. This can lead to much confusion when the apartment being purchased has a higher sale price than the building itself!! This is easily explained with the concept of LOCOM, but unfamiliarity with this concept can cause angst when a buyer notices this anomaly.
The income statement usually comes next in the statements, and is a reflection of income and expenses over time, and is not static as a balance sheet is. This schedule reflects income generated and expenses realized during the entity’s fiscal year, which is often the calendar year. This statement often compares latest year over the year prior, to establish trends. Take note of the following when looking at an income statement:
- Is income in line with expenses? Buildings are not supposed to be huge profit makers, but instead generally raise enough revenue (through common charges or maintenance fees) to pay the regular recurring expenses, and fund a building reserve. Be aware of buildings that year over year run in the red meaning that income before depreciation and amortization is a large negative number. That shortfall needs to come from somewhere, and is often a sign of a depleting building reserve.
- Is the building financing the reserve? Banks these days need to see 10% of annual expenses going into the building reserve, in order to fund future capital improvements. Failure to do so could mean that buyers won’t be able to get financing in the building, causing prices to go up as the pool of potential buyers gets smaller.
- Are expenses swinging wildly? Stability is the name of the game when analyzing a housing entity, and wild fluctuations in expenses means management does not have a firm grip on costs or is not planning well.
- Are large legal expenses explained? Be careful here, a large portion of the annual budget going toward legal fees means there is a dispute, or litigation, which can cripple a building financially. This is a red flag, and means that a buyer needs to get more information about the nature of the dispute, and whether it has been resolved.
- Depreciation and amortization? These are below the line non cash paper expenses that do not affect cash flow and should not raise concern. Most buildings show a net loss after depreciation and amortization, causing a large accumulated deficit over years. This is nothing to worry about. It’s a paper loss, allowing entities to structure against tax payments, and does not indicate fiscal distress.
Finally, when reviewing financial statements, don’t forget to read the auditor’s notes at the end. While not as interesting as a best-selling novel, these notes can shed much light on what is happening, and what is planned for a building. Pay careful attention to the note about the underlying mortgage in a coop, it will tell you when the current mortgage balloons (which is typical) and what the current rate and pre-payment penalty is. This information is valuable in understanding what might happen to future monthly carrying costs for the apartment.