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- 10/2023
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October 2023 Comments
In this issue:
Role of UCA Cash Flow in Commercial Real Estate Underwriting
The UCA cash flow statement in one form or another plays two critical roles in assessing an income producing property.
With minor adjustments, the property's Net Operating Income (NOI) closely approximates a UCA cash flow statement. For example, reported rental income on the property's operating statement needs to be adjusted for any changes in the rent receivable balance on the property's balance sheet. If rent receivables increase from period to period, the actual cash inflow from rental income is less than the accrual rental income and NOI reported on the operating statement. And vice versa. In addition, a similar adjustment must be made for rental deposits since an increase or decrease in this balance will increase or decrease cash inflow from rental activity.
Further, the expense structure in NOI must be adjusted for increases or decreases in accrued operating expenses along with a further adjustment if the balance sheet reports any new leasing costs that are amortized over more than one year.
In general, the net impact of such balance sheet adjustments is minor such that a property's NOI approximates cash available for debt service on a UCA cash flow statement.
The second critical role played by the UCA cash flow statement is identification of the cash source or sources available to pay the debt service on the income producing property. On the surface, this appears to be the objective of the first role noted above. After all, if adjusted NOI is sufficient to meet debt service on the income producing property, what further assessment is necessary?
A further assessment is necessary for a very basic reason. It is the obligor, not the income producing property, which pays the property's debt service. The obligor may be a sole proprietorship, a partnership, a limited liability company, a Subchapter S corporation, or a Subchapter C corporation. The obligor may engage in numerous business activities or own numerous income producing properties. In addition, the obligor likely reports operating expenses for all its business activities on its income statement. The credit assessment issue is whether the obligor will generate sufficient operating cash flow to pay all business operating expenses as well as meet debt service on all its borrowed funds - a far more comprehensive assessment.
Only a true cash flow statement - not a cash flow proxy such as traditional "cash flow" - is designed to address this issue. Among the true cash flow statements, the UCA is the most practical and useful for this purpose.
There is the theoretical possibility that a single asset entity, regardless of how it is organized as a business operation, will bypass the need for a full analysis of the obligor. But that possibility can be confirmed only by applying UCA cash flow analysis to the single asset entity. The single asset entity may possess only one income producing property, but it may well be involved in a range of other business activities which drain its cash resources and impede its ability to properly pay debt service on its single income producing property.
Back to the beginning. The UCA cash flow statement plays two critical roles in assessing an income producing property.
In the final analysis, it all comes down to the Role Two results and a clear identification of the likely source of cash available to service all the obligor's interest-bearing debt. This point is strongly emphasized in the Financial Regulators' Policy Statement issued in October 2009 - and basically unchanged since then - that the analytical process begins with a full assessment of the obligor and not with an assessment of the income producing property.
Good advice in today's highly uncertain commercial real estate environment.
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Issues for Pass-Through Business Operations
For a Subchapter C corporation, the owner payout rate is customarily defined as dividends issued to owners by the corporation divided by profit after tax. It represents one element in computing the return on investment for an owner of a Subchapter C corporation.
There is a counterpart owner payout rate for the pass-through business operations - Subchapter S corporations, partnerships, limited liability companies (LLCs), and even sole proprietorships - which may be defined as distributions or withdrawals divided by profit before tax. However, the pass-through owner payout rate is not strictly comparable to the Subchapter C corporation owner payout rate since pass-throughs do not pay or report federal income tax on company profits. Recall that the obligation to pay federal income tax on the taxable income of a pass-through rests with the owners, partners, or members.
Consequently, the owner payout rate for pass-throughs performs a very different role than it does for Subchapter C corporations. At a minimum, distributions and withdrawals - one and the same in practice - provide owners, partners, or members with the cash necessary to pay federal income tax on taxable income.
At this point, two analytical issues emerge. The first is to clearly identify an operating profit or loss based on business income tax return information. The second is to estimate the minimum distribution or withdrawal that would meet the federal income tax on taxable income.
With respect to the first issue, the accrual income statements are of little, if any, help since taxable income may differ significantly from accrual profit before tax. Yet the business income tax returns, with the exception of Schedule C for a sole proprietorship, do not identify taxable income in a single location. The lender is required to sum the taxable income amounts and offsets reported at various lines on a) Schedule K (Form 1065) for a partnership and LLC or b) Schedule K (Form 1120S) for a Subchapter S corporation.
The second issue emerges once the first issue is resolved since the relevant amount of distributions or withdrawals issued by the pass-throughs to satisfy the federal income tax obligation depends on the effective income tax rate for the owners, partners, or members. This rate can vary significantly within the ownership structure of a pass-through. The exception is a sole proprietorship which, by definition, has a single owner and, therefore, a single effective income tax rate.
Even if the taxable income issues are resolved to the lender's satisfaction, the assessment difficulties continue. Withdrawals are the sole source of compensation for a sole proprietor since salaries for a sole proprietor are not tax deductible according to IRS regulations. Therefore, a sole proprietorship may report sufficient withdrawals - a difficult number to identify since it is not reported on Schedule C - to satisfy its income tax obligation but not sufficient to provide decent compensation to its sole owner. If so, it would certainly appear to be a highly marginal and high risky business operation.
A similar issue applies to partnerships and LLCs. Neither may claim a tax deduction for salaries to partners or members. Therefore, partners or members look to either guaranteed payments or to distributions - or to some combination of the two - for their sources of compensation.
The assessment difficulties ease a bit with the Subchapter S corporation since salaries to owners are tax-deductible. Therefore, the primary issue is the adequacy of distributions to meet owners' income tax obligation on taxable business income.
At the end of the day, there are only a few conclusions we can reach with any degree of certainty.
And keep in mind a final point. There is a practical tendency for favoring distributions as a source of owner, partner, or member compensation since distributions are tax-free income to the recipient. Only if they exceed "basis", or owner's equity, in a business operation are distributions subject to income tax at the long-term personal income tax rate.
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Operating Events vs. Financing Events
The personal cash flow statement is fraught with problems. The data for constructing the statement is pulled from numerous sources such as personal income tax returns, Schedules K-1, accrual financial statements, and personal financial statements. Some of the data may be readily verified, but some may be no more than rough estimates by a guarantor.
There are other problems apart from the more obvious data problems. One is a classification issue that focuses on the similarities and differences of distributions and capital contributions. Distributions add to a guarantor's cash resources. Capital contributions have the opposite impact. They diminish a guarantor's cash resources. The issue is whether either should be included in the array of cash revenue and cash expenses that sum to a guarantor's personal cash flow available to support the debt service for his or her company.
The issue can be resolved by reference to the purpose of both cash flows. Distributions provide the guarantor with cash revenue that he or she uses to offset personal living expenses, personal income tax payments, and personal debt service. Capital contributions, on the other hand, provide the guarantor's company with additional cash that it may use to meet a cash flow shortfall.
In effect, cash distributions are an operating event and should be included in the array of cash revenue and cash expenses that sum to an estimate of a guarantor's personal cash flow. Cash contributions, however, are a financing event. As such they are excluded from this array of cash revenue and cash expenses. They play no role in the estimate of a guarantor's personal cash flow support for company debt service.
Keep in mind that the best indicator of a guarantor's cash support for his or her company's debt service is not a highly suspicious estimate of a personal cash flow surplus or deficit. Rather, the best indicator is the cash amount readily available from a guarantor's highly liquid personal assets.
Fortunately, this information is available in monthly bank, broker, or financial management statements.
Unfortunately, it is uncommon in the industry to require such statements on a periodic basis. Yet they can save the lender considerable frustration in attempting to assess the likely value of a personal guarantee.
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Shoring Up Access to Cash Repayment Sources
On Wednesday, November 15th and on Wednesday, November 22nd, Shockproof! Training conducts live webinars on Commercial Loan Documentation and on Commercial Real Estate Loan Documentation, respectively.
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Please note that all single topic Webinars and each session in the Credit College Courses are recorded and available for use and review, should participants prefer the flexibility of on-demand sessions and webinars.
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To access a 12 minute company overview, please click here.
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Please note, too, that Shockproof! Training recently incorporated a learning path function into its website that suggests single topic webinars and Credit College Courses that might be applicable for selected positions within financial institutions. The positions in question range from newly appointed credit analysts in commercial business and commercial real estate lending to experienced loan review officers, specialty lenders, and board members.