Real estate workouts - problems and opportunities for the CPA. (certified public accountant)by Mildner, Mark E.
Real estate markets in the U.S. are now confronted with great uncertainty and an abundance of workout situations. The current soft real estate market is the result of many factors, including: the Resolution Trust Corporation's (RTC) method of disposing of the various parcels of real estate entrusted to it, the current crisis in the insurance industry, a weak economy in many geographic areas, a decline in tax incentives for real estate owners, and lower expectations for future real estate values. These factors have been exacerbated by the intricate financial transactions used and heavy debts incurred (leverage) by syndicators and others to purchase real estate.
Many people are learning that leverage is a two-way street increasing the return on investments when times are good and creating disaster when times are bad. In the 1980s, real estate prices were bid up to unrealistic heights using substantial leverage. The result is that debt service requirements coupled with decreased cash flows from poor operations are forcing holders to sell real estate in order to survive.
Most people in the U.S. have some stake in the real estate market - whether it is because of their own home, other direct investments in real estate, investment through their retirement plans, or, indirectly, through an employer's ownership of or obligation related to real estate. The increase in real estae values in the 1980s helped fuel substantial new development and rehabilitation activities in many geographic regions.
Many people began to view real estate as a liquid asset, readily marketable, easily transferred, and offering substantial returns for short periods of ownership. What investors and asset managers have discovered in the early 1990s is that these assets, whether held directly or indirectly, are not as liquid or as marketable as previously believed. Consequently, many real estate investments have boomeranged. No matter how much the owner wants to sell; he or she may be forced to continue to fund operating and financing deficits if for no other reason than to delay negative tax consequences. The forgiveness of a debt will result in taxable income for an owner who may not have sufficient cash flow to pay taxes. Also, current federal tax laws and regulations that impose limitations on deductibility of passive activity losses have not improved the real estate market; in fact, they are probably contributing negatively.
Former owners who financed a portion of the sales price may find themselves owners again, by default. The greater the leverage the more severe the problem. It should be remembered that any transfer of real estate, even at a loss, may be subject to state and local real estate transfer taxes.
Given the difficult times and daily news of many well known developers in financial difficulty, an investment in real estate requires careful attention and good advice. This is especially true for properties where current cash flow from operations cannot cover the operating expenses and debt-service payments. Even if the owner is able to fund these deficits, few would be willing to do so for an unlimited time. The resulting workout situations can yield CPAs significant opportunities for demonstrating business acumen and providing value added services to clients.
IS THE CLIENT IN TROUBLE?
How can the CPA for a real estate venture identify potential problems at any stage in its life cycle? The accountant may wish to do this as an advisory service to the client. On the other hand, if the CPA is serving as auditor, he or she may want to do this as part of going concern considerations.
First, the CPA should review the original economics of the project. As a general rule, developers and lenders require detailed cash flows projections with several variations for changes in interest rates, occupancy rates, rental rates, and operating expenses. By doing an historical review, i.e., analyzing the present economics of a project versus the assumptions used prior to development, the CPA can gain insight into where the venture is headed.
Second, national and regional economic conditions should be reviewed, including occupancy rates, rental rates, financing rates, and especially the valuations of properties recently sold in the same geographic region. While individual real estate investments are unique, their value and operation are affected by local economics. CPAs must be aware of current events affecting national as well as local economics and analyze how those events affect their clients. For example, an auditor of a cooperative might inquire of the management whether it will raise the maintenance charge because of higher oil prices or increased real estate taxes.
Third, the accountant should consider conducting an operational and investment review, i.e., evaluate the cash flows of the operations with particular emphasis on comparing it to the prior year and the expected future cash flows. Care must be taken to review all assumptions that are incorporated into the model to ensure that the forecast will be as realistic as possible. This type of review will assist in understanding current and future trends, such as vacancy rates going up or down or whether a decline in operating revenue is being camouflaged by a decline in tenant improvements or a change to capitalizing items previously expensed. A careful analysis of current and future cash flow trends can never be overly stressed.
Last, a physical and third-party review of the property in question should be conducted. This first part of the process involves a physical inspection; the second involves inquiry of third parties involved in the property such as the client's bankers. A physical inspection is important to highlight deferred maintenance and whether substantial improvements are required to keep the building functioning. For new construction or even existing structures, it may be advisable to have an engineer identify problems that otherwise might go unnoticed. Undetected problems could result in future liabilities, e.g., costs of repairing structural damage. Direct contact with a client's bankers may yield information regarding the client's liquidity and financial health.
To summarize, examples of warning signs can be:
1. Decreasing, disappearing, or negative cash flows;
2. Unrealistic expectations of future events, including the economics of the project;
3. Declining vacancy, rental rates, and valuations;
4. Deterioration of the property or use of substandard materials; and
5. Poor or no financing payments.
The CPA can perform an evaluation and develop projected cash flows as outlined in Figure 1.
HOW TO EVALUATE CONDITION
The auditor should perform an evaluation of all conditions develop a projected cash flow as outlined below:
East End Project
Pro Forma Statements of Pretax Cash Flow
Gross rental income
Auxiliary income - electric
Real estate taxes
Salaries and fringes
Water and sewer
Maintenance & repairs
Management fee and expenses
Net of revenue over disbursements - free and clear
Net of revenue over disbursements before financing
Financing charges - interest and principal payments
Net cash flow
Note: The above format can be used in multi-column format to forecast for additional periods or used to forecast for different levels of occupancy (i.e., 50% to 100%) and/or rental rates.
THE IMPORTANCE OF CASH
While in most business situations return on investment is computed on net income, the real estate business operates on cash flows. Generally, a good developer is also a risk-taker and knows that the real estate business can be highly cyclical. His success, measured in terms of good cash flows, depends on the proper use of land, the density allowed, the design of the property, standards of construction, a production cycle as short as possible, approval from the proper agencies, use of new energy saving systems, continual control of costs, creative low cost financing, and the proper marketing of the finished product. Location can of course increase or decrease the total risk and can actually make or break the project. Strategically located properties of superior design and quality can be secure investments in any economic environment if purchased on a sound valuation.
An owner of real estate reacts like any other businessperson when he or she senses trouble. The owner tries to increase income and reduce expenses. The following steps are usually taken to achieve higher income and lower expenses: To reduce vacancies, concessions are offered; to attract tenants, leasehold improvements are made; to improve cash flows, maintenance is deferred; to reduce monthly expenses, utility usage is reduced. In general, the owner does everything possible to reduce costs. He or she starts thinking of applying for real estate tax certiorari and any other method to reduce taxes. The owner considers rearranging any existing financing. Percentage of occupancy, the income necessary to break-even, and the cash flows required for operations and debt service begin to dominate every decision.
THE CPA AS THE BRIDGE
OVER TROUBLED WATER
The CPA can play a significant role by becoming an important business advisor. The CPA is uniquely qualified to help his or her client in troubled situations. What are the true break-even points, both for cash flows and net income? Are there revenue items that can be increased, or have any been overlooked? Are there arrearages that can be collected? Can payments be delayed? Are all possible revenues being collected and all expenses being reported and recognized on a timely basis?
Expenditures the CPA can help identify include cost-cutting possibilities, expense deferrals, cost-saving features, as well as possible new markets and marketing improvements.
The CPA also can help the client in the use of tenant concessions. The widespread use of concessions does not guarantee a good tenant. When vacancies are high, some tenants will move in only after securing a six- or-nine-month free rent concession. Just prior to commencement of rent payments the tenant disappears and moves on to the next landlord who will also give a free rent concession. The lease agreement should spread concessions over as much of the term of the lease as possible, so that cash payments begin immediately. While the longer time spread for the rent concession may appear to reduce the gross rent roll, which landlords do not like because it may result in lower property values, it will obviously result in greater cash flows early on.
When advising a client regarding rent concessions, the CPA should be aware that sometimes the client is in a rush to reach a certain occupancy in order to obtain or increase financing based on occupancy covenants in a lending agreement. The possible results of this headlong rush should be measured carefully.
If the client is an active builder, developer, operator or investor, it may be difficult for him or her to recognize the problems of continuing as a going concern. Contrary to the good advice of a CPA, the client may not be receiving monthly statements of cash flows or the internal control system may be lax in that there is commingling of expenses among properties, or the pickup of accruals is not accomplished in a timely manner.
HOPE ALWAYS SPRINGS
Traditionally, all lenders are slow to repossess real estate, especially if the customer has had good relations with the bank and the properties have proven profitable in the past. Initially, lenders will try to help, usually with short-term loans, so that they will not have to classify the loan as non-performing. Lenders may also agree to a moratorium on principal payments and or reduce the interest rate, while agreeing to add the delinquent payments to the back end. In some cases, they may even agree to accept the cash flows from the property as partial debt service payments. While lenders may appear to be playing hardball, they will usually agree to a reasonable plan. Lenders will not agree, however, to take haircuts while allowing the borrower to reap the benefits of a turnaround. They will insist on being dealt in if values go up.
Naturally, if the borrower has signed a personal guarantee, the negotiations will become more one-sided favoring the lender's position. If the debt has been unsecured, the lender will probably insist on personal guarantees and pledging additional assets as collateral before assisting in a restructuring.
It is important to keep track of the players. Some properties are carved up and the CPA may end up dealing with the builder, developer, owners (general and limited partners), management, lenders, and possibly government officials, each with their own agenda. While all of them cannot be completely satisfied, it should be realized that the lender is generally not anxious to take back the property. Business economics and reasonableness may sway the lender toward some accommodation. Some borrowers have even put the banks on the defensive by invoking the legal argument that the lender misled the borrower. Lenders are generally loath to become involved in lawsuits involving lenders' liability.
Sometimes, lenders will even try to act as a middleman to work out a joint venture with another investor. They will try to squeeze more equity out of the client by taking other assets as additional collateral. The lender will especially want assets which are highly liquid to be used as collateral. The last thing the lender wants to do is to wind up owning the property and having to support the cash flow deficit. Lenders are also reluctant to foreclose if the property has an asbestos or other environmental problem. Where there are environmental concerns, foreclosure may expose them to liabilities far worse than default by the mortgagor. The federal, state and local environmental protection agencies can be a significant influence on future profitability and cash flows by ordering clean-up and imposing fines regardless of the financial ability of the polluter and current owner.
Reconstitute the Team
When a client finds itself in serious financial trouble, a team should be formed consisting of the client, the CPA and the client's attorney. This is probably the same team that was used to begin the venture (see "Buying' and Selling Real Estate: Advising Clients," by Philip Wolitzer and Mark Mildner, The CPA Journal, August 1990). Depending on whether the amounts involved are substantial, an investment banker and a real estate broker or appraiser should also be included. The team should concentrate on the following questions: * Can the client take on more debt? * Would refinancing with an equity participation for the lender be an improvement? * Are there any government programs that can be utilized? * Should we bring in additional or new limited partners and amend the partnership agreement?
All these issues can be part of a special report in which the CPA can deal with the various options.
Bank Regulators: New Force to be Considered
Unfortunately, bank regulators are not very sympathetic to difficulties in the real estate market. They insist upon prompt reclassification of loans, additions to loan loss reserves, strict maintenance of capital adequacy ratios, and, in general, force a very strict retreat from the easy money of the 1980s and friendly regulatory oversight. Regulators are discouraging banks from making additional real estate loans or accommodating clients whose projects face cost overruns. This may force clients to find additional investors or restructure deals to provide for more equity. Negotiations with banks are expected to get even tougher in the 1990s.
Appraisals are becoming more pessimistic in their valuations. On top of this, regulators are not applying rules in a gradual or orderly way but, so drastically, that the avalanche of declining values is progressing in geometric proportion. The very survival of banks is at stake. Bank examiners are taking a mark to market approach to real estate loans and investments forcing loan loss reserves to skyrocket. This is true even for borrowers currently servicing debt payments where the asset has lost value.
Today, lenders think nothing of asking for a 25% equity participation from the borrower after taking a very hard look at the feasibility of the project. Even then, decisions are made simply on the basis of not wanting to butt heads with regulators. Lenders have finally realized that their loans are really quasi-equity and they want more upside potential than a financing rate of return with a high downside risk.
The savings and loan fiasco has not helped the situation. The RTC now has thousands of properties for sale. This market overhang depresses prices even more than usual, affecting collateral and forcing the loan loss reserves of the banks to balloon. It is frightening to look at many financial institutions' exposure as reflected in their real estate portfolios. One thing to remember, however, is that the real estate industry is cyclical and refinancing will sometimes accomplish much more for the lenders than having to support cash flow deficits and managing properties, that is not their business.
CONSIDERING CHAPTER 11
Real estate builders, operators, and significant investors in default or heavily in debt and near bankruptcy continue to be reported almost every day. More and more financial restructurings are appearing in the media. Excessive risk taking is being curtailed because banks now insist upon more equity from borrowers. There is no question that economic activity has been curtailed. It seems to be prevalent throughout the 50 states and includes well-known and respected individuals and organizations. Cooperative conversions are practically at a standstill. Developers and builders cannot live without deals in the pipeline.
Builders are not anxious to cooperate with lenders in friendly foreclosures or bankruptcies, especially after learning that there may be taxable gains on the lost properties. Filing Chapter 11, however, gives the borrower breathing room, prevents foreclosure, holds up action on personal guarantees and, in general, gives the borrower some leverage for a workout.
WORKING THROUGH THE
CPAs face numerous problems in a workout environment. They not only include all the usual risks inherent in auditing real estate but also a review of the financial condition of the enterprise as a going concern. It is necessary to determine that if additional disclosures or an amendment the standard audit report for these conditions, e.g., an explanatory paragraph, are required, it could have a negative impact on clients' financial viability. While some parties want the audit completed quickly, others will be pressuring to complete future cash flow forecasts. The CPA will generally either review the underlying assumptions and calculations without rendering a formal report or he or she may opine on these forecasts. CPAs may want to limit their association with these forecasts because of the risks normally associated with them.
The CPA's opportunities include demonstrating business knowledge and expertise to an audience who may provide opportunities for additional assignments for assisting others through some rough times. While standard audit work has become very price competitive, workout situations are generally not under such severe competitive pressures. As a result of the higher level of effort generally required, assisting clients and attending workout sessions can result in substantial billings. The downside is that some of these billings can be slow at the collection end, and there may be a requirement for more time than is available, without hurting current client base.
CPAs are excellent business advisors. Analyzing the problems related to delinquent real estate loans, over-built capacity, shifts in demographics, and an economic recession cannot be solved simply by waving a magic wand. Computers can be a big help. The use of spreadsheets and answering the "what if' questions allows a CPA to forecast cash flows, income and expenses, and prepare the right kind of package that a client can present to a lender. Financial restructurings are the order of the day and a CPA's report can play a big part.
NO ONE SAID IT WOULD BE
The problems your client may face are numerous - negative cash flows, cash squeeze from lenders, disgruntled investors, staff turnover and tenant revolts. These situations require skills and fortitude that a client may not possess. While remaining independent, CPAs can provide significant input into a tense and turbulent environment. This type of assistance is significantly different than normal auditing. It puts the CPA in the role of a trusted business advisor who can voice an objective view without any vested interest, all this while providing a value added service. The rewards from this experience can be a forever grateful client and significant exposure to an array of lenders and investors.
These are difficult times for all parties with real estate interests. Advising clients to take a proactive, futuristic view may help them to avoid being put into a workout situation. While these situations test your skills and require substantial amounts of time, there is no greater accomplishment for a CPA than assisting a client back to financial health.
It is interesting to note that "vulture" funds purchasing real estate at distressed prices have already been formed, with their managers pouring through reams of information and statistics, ready to pounce on any perceived bargains. Many investors think that now is the time to buy, and have begun to search for real estate deals at bargain basement prices. Fortunately for real estate organizations, banks and other lenders have been reluctant to foreclose, preferring instead to restructure with the owner and allowing him or her to retain some, if not all, equity participation. The effect of this has been to decrease the supply of available real estate for "vulture funds." Also, financial institutions are not rushing to supply vulture funds, due to capital and lending constraints.
The lending practices of the past, which resulted in easy money, bidding up property values, and providing high returns to real estate investors are probably gone forever. This environment of tight credit and valuation uncertainty can provide unique opportunities for CPAs to provide qualified and experienced business assistance.
Philip Wolitzer, MBA, CPA, is Professor Emeritus at Long Island University and a Visiting Professor at Marymount Manhattan College. Mr. Wolitzer has a consulting practice in Litigation Support and Quality Control and he is a member of the AICPA, NYSSCPA, AAA, and American Arbitration Association. He has served on many NYSSCPA committees and is a past vice president and secretary. He has written many articles published in professional journals including the CPA Journal.
Mark E. Mildner, MBA, CPA, is an accounting manager at a major securities firm in New York City, monitoring and evaluating real estate investments. Mr. Mildner is a member of the AICPA and NYSSCPA, contributing author to the latest edition of Montgomery's Auditing and he has published in The CPA Journal.
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