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Property Financials 102: Accrual vs. Cash Accounting (and Why it Matters)

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Property Financials 102: Accrual vs. Cash Accounting (and Why it Matters)
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DANIEL CUNNINGHAM

APARTMENT ACADEMY

Editor’s Note: This is Part 2 of our discussion surrounding property financials in the multifamily industry. For Part 1, click here.

Last time we covered the typical property financials that you expect to encounter when you are operating an apartment building, and some of the meanings behind some of the definitions and numbers that you see. That includes the income statement and all of the definitions on the income statement.

Now we’ll discuss a subject that affects how that income statement looks, which is whether or not your property financials follow accrual or cash accounting.

Now, I’m not an accountant. So I’m using layman’s terms to talk about these things. And the same is going to apply here to accrual versus cash accounting because that’s how I understand it.

First of all, your property owners will elect to follow either accrual or cash accounting. Let’s start with cash.

Cash Accounting

Cash accounting is very simple to create. It’s very simple to understand. If somebody pays you $5 in rent, you put that you’ve received $5 on your income statement. And let’s say you pay a $5 invoice — you’d put that on the expense side of your income statement.

If that’s all you get for the month — you earned $5 in rent, you paid $5 out in expenses — you have zero net cash flow for the month. That’s very easy to understand. But there are some downsides to that kind of accounting.

One downside is that expenses can vary wildly from month to month. And any given month may not represent what the average expense should be. And you might be understating or overstating your cash flow for that month.

That’s especially meaningful if you’re a lender, for example, who’s trying to understand what kind of cash flow this property should expect to receive over time. It’s also deceptive to investors who might think their property is throwing off more money than it should because you forgot to pay a utility bill, which will increase your cash flow for that month with cash accounting.

Accrual accounting, in contrast, accounts for that.

Accrual Accounting

One very common thing that gets fixed in accrual accounting is that there are utility invoices that sometimes only get paid every other month.

If you’re using cash accounting, your cash will go up and down from month to month just by paying utility bills. And you’ve got to figure out which of those months represents the actual projected cash month for the next month.

Accrual accounting takes that out of the equation. In cash accounting, you count money when it’s received and you count expenses when they’re paid. But in accrual accounting, you record income when it’s earned.

In other words, if somebody owes you $5 in rent, it gets booked on the income side of your income statement whether or not it’s been paid to you yet. And expenses are recorded when they are incurred, but not necessarily when you pay them.

So even though you didn’t receive a gas bill this month, because it’s only paid every other month, you incurred a gas expense. You may have to guess at what that is, but accrual accounting demands that you register your actual expenses incurred on any given month.

Let’s say you pay your insurance upfront for the entire year, One-twelfth of that expense actually belongs in the expense of every single month. You might have paid it in cash upfront, but you are actually only going to recognize one-twelfth of that expense every month over the coming year.

Normalizing Your Property Financials Outlook

This normalizes your financial outlook for that property. It is why investors, and specifically lenders, want to see accrual accounting. It’s more difficult, and it’s more timely.

If you didn’t get an invoice, you didn’t get a bill that you expect, you have to remember that. And you want to go ahead and book it as if you have received it anyway. So there’s a lot more management to it.

But what you end up with is an income statement that is more meaningful. And you’re going to need a cash flow statement to fully understand the actual cash that went into your pocket at the end of the day.

When you’re using cash accounting, the bottom line of your income statement is generally the cash that you were left with at the end of the day. And whatever the income statement for accrual property says is net cash flow or free cash flow might not be the actual cash that you put in your pocket.

Why You Need the Cash Flow Statement

You need the cash flow statement to understand what actually happened at the property on an accrual basis.

For example, if you know that you didn’t get your utility bill this month but it was about $15,000, that would reduce your revenue by $15,000 on the accrual side. It’ll count as an expense even though you didn’t pay that bill. You’re just accounting for it. You actually still have that $15,000 in your pocket. So your cash statement will reflect that.

There are other things that you can account for that didn’t actually use your cash. And the cash flow statement will also do the reverse. It will account for things that you billed for when you didn’t actually get that money.

For example, you might be owed rent from a unit. A tenant might owe you $5 in rent. And the income statement will reflect the amount of rent that was owed to you. But if they didn’t pay you that rent, you don’t have that cash in your pocket. And the cash flow statement will reflect that.

The cash flow will also adjust. It’ll say, for example, that you said you were owed $100,000 in rent. But $15,000 worth of rent was not actually collected. So it’s going to subtract that from your bottom line to adjust down to an actual cash number.

That’s the purpose of a cash flow statement. It takes your income statement and adjusts it to an actual cash number. A lot of times, that’s the same as a cash income statement if you’re doing cash accounting. But if you’re doing accrual accounting, you’re going to need the cash flow statement to adjust it down to a cash number.

The Expense of Debt Service

Another important factor in accrual accounting is that the principal of your debt service expense is not on your income statement. Only the interest is reflected as an expense of the property. The principal piece that you pay is a retirement of liability, and the liability is on your property financials balance sheet.

Let’s say you owe the bank $1 million, for example, and your monthly payment is $20,000. $19,000 of that pays interest, and $1,000 of that goes toward the principal. The $19,000 will show up on your income statement, and the $1,000 that you paid toward the principal will go onto the balance sheet. It will reduce your balance from $1 million to $999,000.

That principal reduction is reflected on the balance sheet, but the $1,000 that went into that is also a use of cash and shows up on the cash flow statement. (I hope that makes sense.)

This is one of the things that can trick people when they look at an accrual income statement. They think they made $3,000 this month, but they don’t realize that only part of the debt payment is missing from the income statement. Part of that debt payment is on the cash flow statement, the principal piece.

Actually, they lost $2,000 that month because they had to pay $5,000 to pay down the principal on the debt service.

Again, the benefits of accrual accounting usually outweigh the costs. You need accrual accounting to get properties refinanced and to give investors predictable income so they can predict cash flow shortages and distributions. And you can’t do that reliably on a cash income statement.

You need to use an accrual income statement. Cash is easier; it’s a lazy way to do it but it’s not as insightful.

Why Reviewing Your Statements Monthly is Important

Let’s talk a little bit about the three different statements that you need to look at on a monthly basis.

We’ve talked a lot about the income statement so far. When the financial statements are produced, you’re expected to review them. What you are looking for? What should you be looking for on a monthly basis?

First of all, you should use the trailing 12 income statements to review any given month’s income statement. The trailing 12 shows you every income and expense line item for the prior 11 months. This is the easy way to pick up the anomalies you’re looking for.

You want to look across the vacancy loss item. You want to see that the vacancy loss is more or less the same. If this month suddenly has a big vacancy loss number, that’s a red flag. You want to pick that up.

Side note: from here we’re going to talk mostly in terms of accrual accounting. If you’re a professional manager, you’re probably dealing with accrual accounting.

You also want to verify that the loss to lease is being reduced over time. That means that as units are rolling, you are achieving market rent for those units.

Also, you want the difference between your market rent and your in-place rents to narrow over time. You want to see that go up.

All of that is easier if you’re comparing a 12-month trailing statement than if you’re looking at an individual income statement on its own.

Expenses

The same goes for the expense side. You want to look at expenses and see, more or less, a steady state of expenses in things like utilities in your property financials.

You’ll see seasonal changes, but you don’t want to see big spikes. For example, you don’t want to see big spikes in the water bill. If you see a big spike in the water bill, it means you probably have a water leak. And that’s the kind of thing you want to be scanning for.

In contrast, the expense for unit turns will vary wildly depending on how many units you have rolling in any given month. It’s common to see that vary. But you want to make sure you want to look at your line item where you’re showing resident charges.

When a resident moves out, you should be charging them for damages. If the line item for resident charges is zero in any given month, it could mean that somebody forgot to charge a resident who was moving out with damages.

There are always at least cleaning charges, and there are oftentimes damage charges. So that line item shouldn’t really be zero.

Debt Payments and Taxes

You also need to look at debt payments and taxes. These should be fairly steady.

If those amounts go up, or if your insurance rates go up at the end of the year, you want to make sure that you see that. You don’t want to carry the same accrual as before and forget that rates have gone up in a new insurance year.

Looking for Anomalies in Property Financials

Using that trailing 12 to look for anomalies in your property financials is really important.

On the cash flow statement, you’re going to look for odd uses of cash.

First of all, your capital expenditures will all be on the cash flow statement. You want to make sure what you’re seeing there represents what you believe to be an appropriate classification of those expenses.

You don’t want to generally see just regular maintenance items being capitalized. That’s usually not appropriate.

Again, you can have owners and investors who want you to capitalize as much as possible because they want to make the property look very profitable in any given month, which we talked about in part one. You can see them trying to hide things by capitalizing them.

What You Should See in the Cash Flow Statement

Also, if you’ve had any major expenses or replacements, like boilers or HVAC equipment, you want to make sure that that’s showing up there in the cash flow statement. Those shouldn’t be expensed on the expense side.

Again, unless you have an investor or an owner who is asking you to carry as much on the expense side as possible, you want to look at accrued trade payables. Those line items in accrued trade payables are an indication that bills aren’t getting paid.

If your accrued trade payables are going up, it means somebody is not paying bills. And you won’t see that on the income statement. It will look fine, but the cash flow statement will tell you that the property is not paying its bills.

You want to look for delinquent rent. If delinquent rent is going up, it means that somebody is not collecting rent.

The delinquent rent number on the cash flow statement is the net of uncollected rent from the prior month that was collected, versus rent that was due this month that was not collected. The difference you’re seeing on the cash flow statement is the net of those two numbers, so remember that.

If you have a loan, the last thing you want to look for on the cash flow statement is that the debt payment, the principal piece of the debt payment, is being accounted for on the cash flow statement as well.

The Property Financials Balance Sheet

The final component of the three financial statements is the balance sheet.

I haven’t met many property managers or even regional property managers who are looking at the balance sheet. But there are a few important things on that balance sheet that you need to be aware of.

Security Deposits

The first thing to look for on the balance sheet are your security deposits.

When you receive a security deposit, it is not income. It should not be reflected on your income statement. It is essentially a liability.

You have to give that money back to somebody at some point, less whatever damage charges you’re going to assess.

The security deposits that you have collected should appear on your balance sheet. The liability for security deposits that you owe should be there as well. And you want to make sure that you have enough security deposits to cover your security deposit liability.

A lot of properties get into financial difficulty and, rather than contributing capital to cover any operating deficits, the owner uses security deposits as operating capital. That’s a terrible idea, but it happens. And if it’s happening, you will see it on the balance sheet because you will not have the security deposits reflected there to cover the liability that should be there.

The security deposits you have on hand should be on the assets side. The liability of security deposits that you will, in theory, owe when people move out should be on the liability side. That’s the first thing to look for.

Unpaid Rent in Property Financials

You also want to look for unpaid rent.

Your unpaid rent represents an asset. It is money that you still expect to collect. But every month that somebody doesn’t pay you rent and you don’t collect it, that unpaid rent is going into this unpaid rent bucket. Because until you say differently the financials expect that you’re going to collect that rent at some point.

That number can grow substantially and represent an asset — in this case, money that you expect to collect at some point — that isn’t real. These people have moved out, they’re never going to pay the rent that they owe you for whatever reason.

At some point, you’ll need to write that off of your balance sheet. You should make that decision on a monthly basis. Determine how much of the rent reflected on the balance sheet is uncollectible and write it off so that that number doesn’t get too large.

That said, remember that that write-off becomes an expense. You have to reduce the income item that you said you were going to collect a month, six months, or a year ago. Now you’re going to write it off, so it will go onto your income statement. But you need to look for that.

You want to make sure that your security deposits and that your unpaid rent are in line with your expectations.

Other things that you want to look for, just to make sure that the principal balance of your loan is correct, including making sure that any capital contributions that your owners may have made are reflected properly.

Just a cursory review of the balance sheet on those items is probably enough. We could talk a lot about some of the other things that show up on the balance sheet, but that’s what I think you really need to be focused on when you’re on the operations side.

Other Metrics for Property Financials

We’ve already done a high-level walkthrough of the other financial statements. We’ll close with some other metrics that you want to be aware of as an operator. These are numbers that you should watch and track month over month.

Economic Occupancy & Leased Percentage

Occupancy is an obvious one. Economic occupancy is a very interesting and compelling number that you’re going to want to calculate every month.

To illustrate economic occupancy in an overly simplistic fashion, if you’re 100% occupied but 50% of those people received free rent that month, your economic occupancy is only 50%. You’re only receiving rent as if 50% of the people were paying or occupied because only 50% of them are paying. That’s economic occupancy. This can reflect the impact that concessions are having on your financials.

Leased percentage is not the same as percent occupied. Percent leased is a trend that looks at what your occupancy is today, how many notices you have coming up of people that intend to leave, and how many of those are pre-leased.

It’s looking 30 or 60 days down into the future to say what does my future occupancy looking like? What percent leased am I?

Effective Rent & Lease Renewal Percentage

Another great metric that everyone should be looking at is effective rent.

Effective rent is essentially the actual rent that you’re receiving when you take into account concessions.

Your monthly rent might be $1200, but if you’ve given them a one-month concession, you divide that over a year. So your effective rent is not $1200, it’s 1200 minus $100. So your effective rent is actually $1100 a month.

It’s important to track your effective concessions as well, and your lease renewal percentage.

When a unit comes up for renewal, what percent of those units are renewing and are staying with the property? Most owners want to see something very high. You want to see above 60%, but some owners want to see something very high.

Some owners will really be pushing rent. Some operators will want to really push rent because of a hot market, for example, and in that case, your lease renewal percentage may go down. That’s usually okay with everybody. But everyone should be on the same page with what your expectations are, and it should be tracked.

Debt Coverage & Delinquency

We talked about debt coverage in part one, but debt coverage ratio is the ratio of your NOI to your actual debt service. It should be greater than one. If it’s less than one, you’re trouble. If it’s less than 1.1, you’re probably in trouble, or you’re very close.

You might be in violation of the debt coverage covenant that the bank is looking for. And you’re at risk of the bank instituting protectionist measures. Those could include, for example, forcing you to deposit all of your rents into a lockbox so that they take the rent and pay themselves first and then give you the rest for expenses. So you want to watch your debt coverage ratio.

Delinquency percent is also important, but 3% to 5% delinquency is generally acceptable.

You want to track your lease expiration curve. Most properties do not want 100% of their tenants checking out in December. You may want more people checking out in the summer than you do in December.

Establish what your desired lease expiration curve is so that you can set your lease durations to fit that lease expiration curve.

There are also marketing analytics that you want to track. For each of your advertising sources, for example, how many leads are they throwing your way? What are you paying them for those leads? You want to track the cost of each lead.

How Resident Satisfaction Affects Property Financials

The last thing is resident satisfaction. You should be surveying your residents on a regular basis. You may even be surveying employees, and that’s becoming more and more important.

Resident satisfaction is a precursor to retention. So you want to make sure that residents are happy. And regularly performing a resident satisfaction survey allows you to get in front of any problems before the resident gives you notice.

Ideally, you’re producing all of those items every month. And if you do that, you will have a very good picture of the health of the property that goes beyond just the financials themselves.

We hope you took good notes! And fortunately, the only test you’ll have to take is waiting for you back on site in the leasing office.

Thanks for joining us for part two of our property financials discussion at the Apartment Academy.

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