How Accounting Methods Impact Multifamily Acquisitions

In my previous article, I discussed Why Operating Cash Flow is more important than Net Operating Income. I alluded to the fact that various accounting treatments can have a huge impact on the P&L. Building on that discussion, it’s important to recognize that accounting methods impact multifamily acquisitions in significant ways. Because most private real estate companies have flexibility in choosing accounting treatments and typically don’t face the scrutiny of public audits, they can make accounting decisions that boost NOI, particularly when preparing an asset for sale.

For investors and sponsor real estate professionals alike, understanding these accounting nuances is critical. In multifamily transactions, buyers are often provided only a Trailing 12 (T12) P&L and a Rent Roll to inform investment decisions. Without deeper insight, it’s easy to overlook risks that can directly affect cash flow and valuation.

Cash vs. Accrual Accounting

One of the most fundamental ways accounting methods impact multifamily acquisitions is through the choice of cash-basis versus accrual-basis accounting. Cash-basis accounting reflects revenue and expenses on P&L when cash is exchanged versus accrual-basis accounting that reflects the revenue or expense when earned or incurred. Smaller companies tend to use cash-basis as it’s simpler whereas larger companies typically use accrual (public co.s are required to use accrual).

For multifamily properties, there are 2 major areas that the accounting basis can impact the P&L:

Bad Debt / Delinquency:

• Cash-Basis: Total Revenue represents what was “collected” in cash in the period and the P&L generally has separate line items showing the amount of bad-debt and delinquency. The bad-debt indicates what was written off in the period (i.e. evictions, skips, etc.) and the delinquency shows how much will be carried forward to the next period to potentially collect. For older class C/B assets, there is typically 2-3% delinquency and seeing this information is important to understand the existing tenant base.
• Accrual-Basis:  Total Revenue is presented as what was “earned” in the period and the P&L generally only has a line item for bad debt (what was written off). There is no line item for delinquency as it is treated as “accounts receivable”, which is reported on the Balance Sheet, which isn’t provided to buyers. Further, if a property is up for sale, companies can decide not to heavily enforce evictions by allowing residents to stay and carry a balance. This increases physical occupancy, which is important as some lenders require minimum occupancy and also inflates income as the cash collected is lower than what is accrued. The increased delinquency is not on the P&L and the bad-debt is only recognized when the tenant is evicted.

This is one of the reasons why some deals have a lot of delinquencies upon acquisition that some owners are not prepared for. Further, given the climate we are in today with covid-19 and the inability to evict, the delinquencies are increasing and if P&Ls are presented on an accrual basis, buyers will not have insight to the magnitude of it.

Normalized Expenses: 

• Cash-Basis: Expenses are booked when paid, which can result in line items that are ‘lumpy’ as invoices are not always received on a regular basis. For example, we have vendors, like landscapers, that provide invoices every 3-4 months, which on cash-basis, would be all booked in the month paid.
• Accrual-Basis: Expenses are booked when incurred, which should result in more smooth and predictable monthly expenses. To do this successfully, the accounting team needs to be skilled and have good processes for booking accruals. If done correctly, accrual basis on the expenses helps to assess the P&L on a normalized basis.

Treatment of Capital Expenditures

CapEx treatment is another area where accounting methods impact multifamily acquisitions. CapEx can be loosely defined as the money needed to cure major deferred maintenance, make property improvements, etc. If Capex is properly allocated, then it should improve the NOI via higher revenues or lower expenses and increase the property’s value. The key item to recognize is that generally Capex improves the property and is shown below the NOI line or on the Balance Sheet (treated as Capital) and is different from regular operating expenses such as routine repairs and maintenance (treated as Expense on the P&L).

It should be obvious that in order to boost the NOI, it would be best to treat as many items as “Capital” so that it’s booked below the line. As private entities, companies that own real estate can determine their expense vs. capital classification criteria as they deem fit. For example, there are many components to upgrading an interior unit such as new flooring, appliances, fixtures, etc. But there are also regular make-ready items such as painting, resurfacing, sheetrock repairs, etc. Some companies may choose to capitalize everything related to an “upgrade” unit and others may choose to expense the normal/routine expenses and capitalize only the upgrade features. Hence, the importance of understanding these treatment possibilities when reviewing R&M and turnover expenses on a P&L.

Summary:

The aforementioned examples are just some of the ways that accounting treatments can impact the assessment of the P&L. A poor understanding of these nuances can significantly increase the risk of a deal. The following are some ways in which these risks can be potentially mitigated:

• Request T12 Cash Flow Statement to see below the line items
• Request Delinquency Reports
• Request Historical Capex Schedules
• Work with reputable brokers, sellers, and management companies
• As a passive investor, partner with experienced sponsor real estate operators who understand these nuances

For sponsors, recognizing how accounting methods impact multifamily acquisitions allows you to adjust your underwriting and operations plan more effectively. Once understood and assessed, sponsors can effectively adjust their proforma’s and make appropriate decisions on their operations and capex plans upon acquisition.