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Position yourself for greater profits through Due Diligence
September 8, 2009
Ensure you build an accurate forecast of projected revenues
By Michael Stoyan
When purchasing a multi-residential property, a comprehensive look at a building’s profit and loss statement will help you better estimate the projected revenues and create a healthy cash flow model.
Real estate professionals know that before you sign a definitive agreement, you need to conduct due diligence. But what does due diligence entail? What are the best practices? Can you do it yourself or should you hire a firm that specializes in bringing forward business exposures or risks, enabling you to make an informed business decision?
When buying a multi-residential asset, many building owners make assumptions with regard to forecasting future revenues including vacancy rates, bad debts and common area maintenance costs. They often assume a vacancy rate and estimate expenses.
“On the surface, these numbers may seem to meet your projected financial model. However, closer inspection of the accounting records may present a different picture,” says Jonas Cohen, Vice-President of Fuller Landau Consulting Ltd., specializing in mergers and acquisitions, corporate finance and due diligence.
“Our clients appreciate the objective view and the peace of mind we provide via due diligence.”
Given today’s tighter lending environment, an accurate financial forecast is even more important than ever.
That’s where an exhaustive look at a building’s net operating income (NOI) will help you accurately value the targeted asset. Buyers know they need to verify a building’s cash flow, but they don’t always look hard enough at the numbers. They know what the variables are, but they may not have the internal resources to do a full financial forecast.
To put things into perspective, a $10,000 miscalculation of the NOI can have as much as a $200,000 difference on a proposed purchase price, based on a five pe rcent capitalization rate. That’s where a buyer can benefit from engaging an outside professional services firm with real estate experience.
Suppose you’ve assumed a five percent vacancy rate. Careful inspection of the building’s accounting records may show that the vacancy rate is closer to eight per cent. If that’s the case, your financial model is flawed.
A professional services firm that specializes in due diligence not only checks the vacancy rate in the building you are considering but they also check the vacancy rates in other comparable buildings. If the asset under consideration has higher vacancy rates than the benchmark, proper due diligence will uncover the underlying reasons such as demographics or, it could mean there’s an underlying issue the purchaser has to address.
Another area that needs to be vetted is cash flow and the timing of rent payments. You know the building has a certain cash flow, but do you know when the rent payments are made? Suppose you assume you are receiving rent revenues on the first day of the month. What if that is not the case?
An outsourced firm that specializes in due diligence can verify when rent payments are truly made and calculate the bad debts expense. If you’re collecting rent cheques that are three weeks overdue, or there are bad debts that have not been written off, then you’re financing your tenants’ cash flow at the expense of your own.
Capital expenditures, versus day-today operating expenses is another area of due diligence where an experienced due diligence firm can help you create an accurate financial forecast. As a buyer, you have to make certain that the seller hasn’t capitalized items that should have been treated as an operating expense. This would have the effect of overstating profit. If profit is overstated, you could be paying too much for the building.
In addition, the buyer needs to have an accurate forecast of future capital expenditures in order to develop an accurate cash flow model that will be acceptable to lenders.
Acquisition Structures and Tax Implications
How you structure your proposed acquisition from a tax standpoint has to be considered. You could structure your acquisition through a corporation or, as a partnership or, as an individual purchase or, as a trust.
Each of these structures has different rules on how and at what rate the income from the property will be taxed. For instance, will the income be taxed at personal or corporate tax rates. If there are start up losses, will those losses be trapped in a corporate structure or will they flow through a partnership.
“If you are financing the purchase, how the debt is structured will affect how the profits are taxed”, says Gordon Jessup, Tax Partner at Fuller Landau.
If, for instance, a partnership acquires the property and the partnership is the debtor, this impacts your ability to claim capital cost allowance.
You cannot claim capital cost allowance in order to create a loss, so in a structure where you have multiple people coming together to buy a property, it is generally better to have them borrow the money individually and have them contribute the proceeds into a partnership structure.
The partnership calculates the income at the partnership level, claims the capital cost allowance and allocates it out to the partners who can then claim the interest expense. This may create a better tax result than if the debt was held inside the partnership.
It’s all part of your overall tax planning. Depending on what your goals are, you may want to use another tax structure like a family trust as a way of income splitting. For example, the purchase could be structured in such a way that income from the property could accrue to children for their education.
Keep in mind that various tax strategies can be implemented regardless of an acquisition. All property owners should explore possible tax savings especially if they are considering a future sale, have long-term holdings, or have succession planning objectives.
Lastly, how a property is purchased will have tax implications when you sell. A professional services firm specializing in the structure of real estate will know how to structure the transaction to your specific benefit.
If you are buying multi-residential properties, it’s likely you already have your own in-house accounting department. You might ask: “Why do I need to hire an outside accountant?” There are a couple of reasons why an outside accounting firm specializing in real estate can compliment your existing accounting firm or department.
First, an outside accounting firm is not duplicating the work your in-house department is already doing. Their job is to identify the risks that you, as the buyer face and to examine tax structures that will work to your advantage.
Secondly, hiring an outside firm won’t disrupt your day-to-day operations. Your people are focused on their day-to-day responsibilities and they’re not forced into a situation where they have to produce reports or meet the deadlines of sellers or lenders. It also keeps financial information confidential so people inside your business do not have access to sensitive information.
As you can see from the few examples we have cited, due diligence and structuring a transaction is a complicated process. There is no cookie cutter approach or one-size- fits-all plan. In these cases, an external accountant should be seen as an extension to your in-house accounting department. A specialty firm can provide your internal CFO the information they need to close and structure a successful deal in today’s challenging real estate market.
This article appeared in the October 2008 issue of Canadian Apartment Magazine.
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