The Credit Write-Up and the CRE Analytical Process (Session #1)
Q: If a real estate holding company or single purpose entity is 100% owned by a single investor, what goes into deciding whether or not to complete a separate return or include the taxable impact on the personal Form 1040 Schedule E?
A: The decision to prepare or not prepare an information-only tax return as a “pass-through” entity or file a business return and pay the taxes due in the entity’s name is determined by the legal structure of the business and the tax elections or implications associated with the choice of structure regardless of the number of owners.
If the business is a sole proprietorship, then the company's earnings would be captured on Schedule C and integrated with the other income the owner reports on his/her personal income tax return. Note that if the rental property itself is owned by a single individual directly, taxable earnings and expenses would be reported in Part I of the individual’s Schedule E in the owner's personal income tax return.
If the holding company or special purpose entity is organized as a Subchapter S Corporation, a partnership, or as an LLC, it must file the appropriate information-only business income tax return regardless of the number of owners. Each entity then reports taxable income to each owner (or the sole owner) based on percent ownership. Each owner (or the sole owner) then reports their share of business earnings on their personal tax return via Schedule E / Part II. Note that other business earnings are integrated into the personal income tax returns using the appropriate schedule or form. For example, an owner or partner reports “pass-through” business interest or dividend income on his or her Schedule B.
A Subchapter C Corp reports all taxable earnings and deductions in its own name and pays the corresponding income tax regardless of the number of owners.
Q: Please review how to identify distributions by reconciling the partners’ capital account or by reconciling retained earnings.
A: The process for identifying distributions by reconciling either the partners’ capital account or retained earnings account is the same.
Add current year net profit to beginning capital or retained earnings to define expected ending capital or retained earnings. If expected ending capital or retained earnings equals actual capital or retained earnings at year-end, no distributions were paid. If actual is less than expected capital or retained earnings at year end, the difference between the two amounts is the amount of distributions paid during the year.
Q: Can you use accelerated depreciation with real estate?
A: No. According to IRS guidelines, rental real estate must be depreciated on a straight-line basis over 27.5 years per the following quote on the topic:
"Any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads costs (and depreciation deductions) over 27.5 years, the amount of time the IRS considers to be the “useful life” of a rental property."
Note that this provision applies to depreciation expenses reported on business income tax returns. In preparing accrual financial statements, a company may choose a different depreciation schedule. For example, Sequoia Properties noted that it depreciates its improvements over 30 years and not over 27.5 years.
Q: Please discuss depreciation.
A: Depreciation is a process whereby the cost of fixed assets is recognized over the useful life of those assets. Straight-line depreciation is the most easily calculated method of rationally allocating the cost of fixed assets over its IRS or GAAP defined useful life. One simply divides the cost of the asset by the number of years of useful life. For example, a $100,000 asset would be depreciated at a rate of $20,000 per year over a five-year useful life using straight-line depreciation.
We saw in today’s CRE Underwriting kickoff webinar an example of how understating depreciation expense (or any other expense) distorts reported earnings. Sequoia Properties declared that buildings with a historic cost of $8.990,241 are depreciated over a thirty-year useful life. Dividing the historic cost by the thirty-year useful life suggests that depreciation expense in 2014 would be at least $299,675. We instead discovered, in reviewing the income statement, that total depreciation expense was only $16,258, meaning that depreciation expense and, in turn, total expenses were understated by $283,417. As a result net income for 2014 reported as $166,505 was overstated by $283,417. Actual net income was a loss of $116,912.
This distortion originated with Sequoia Properties presentation of financial information to their CPA. The accountant did not correct the under-reported depreciation expense because compiled statements are “limited to presenting, in the form of financial statements, information that is the representation of management”.
Q: Going back to the distribution, where did the rounded $300,000 figure you referenced in the webinar come from?
A: Please review the previous comments regarding Sequoia Properties’ understated depreciation expense in 2014. The company’s depreciation expense should have been stated as $299,675 (rounds to $300,000). Our comments referencing the $300,000 figure refer to depreciation rather than distributions.
Q: What is the effect on credit risk given that Net Operating Income (NOI) is unaffected by the understated depreciation?
A: Note, first, that NOI generated by an income-producing property is unaffected by depreciation expense because as a non-cash expense, it’s not included in the calculation of NOI. NOI is a measure of the property’s ability to generate cash flow adequate to service debt, rather than as a measure of the owning entity’s ability to generate adequate cash flow as a borrower. If the analysts limit their analysis to the narrow context of NOI, they could come away with an incorrect determination that credit risk is not affected by Sequoia Properties’ severely understated depreciation expense.
Therefore we have two issues to consider in this set of circumstances. One is to assess the borrowing company's overall credit risk position, rather than that of the property itself. The other is to assess the NOI of the subject property and its ability to cover interest-bearing debt on the property.
With respect to the first issue, we will explore credit risk in the broader context of analyzing the borrowing entity’s ability to generate adequate cash flow in the next webinar. We’ll analyze the more comprehensive accrual net income of Sequoia Properties as the borrower and Sequoia Properties’ “true and comprehensive” cash flow by employing the Uniform Credit Analysis (UCA) cash flow methodology. It comes down to assessing a company's credit risk position by thoroughly analyzing the borrowing entity, rather than limiting ourselves to analyzing the capacity of the property itself. We’ll also get beyond using cash flow proxies such as traditional cash flow or EBITDA.
In addition, we will analyze NOI in great detail in subsequent webinars.
Q: Why do we typically not see distributions accounted for in the debt service coverage ratio (DSCR) for CRE deals?
A: In general, the DSCR formula is defined by the institution considering the loan and may vary considerably from lender to lender.
If a CRE deal assesses the borrowing business entity rather than just the property’s performance, the DSCR should include distributions as a cash expense that reduces cash available to service debt. If a CRE deal focuses only on property cash flow, i.e., on NOI, then distributions play no role. Every CRD deal should assess both the borrower and the property as the Regulators" guidelines state. The real issue is whether the borrower can service the debt on the underlying income producing property or properties. It’s entirely possible that expenses and other cash outflows incurred by the entity can completely offset positive NOI generated by the property itself.