FINANCIAL MANAGEMENT

National Apartment Association Education InstituteCertified Apartment Property Supervisor

HOUSEKEEPING

Restrooms Breaks Lunch Cellular Phones Smoking

2

LEARNING OUTCOMES: FINANCIAL MANAGEMENT

• Apartment Investment Basics

• Mortgages, Financing & Taxes

• Managing the Budget Process

• Getting to the Bottom Line

• Analyzing Monthly Financial Statements

• Valuing Apartment Investments

• Maximizing Revenues

3

INTRODUCTIONS

Name Company Number of Units How Many Years In

the Business How long have you

been a multi-site supervisor?

4

GROUND RULES

Participate fully. Help us stay on track. Be on time Ask questions Offer ideas and opinions as

perceptions Have fun.

5

HOMEWORK REVIEW

6

Let’sCheckOurHomework!

2. APARTMENT INVESTMENT BASICS

7

WHY INVEST IN APARTMENTS?

Apartments have produced a higher total return, with less variance, than the average of all property types in the portfolios of pension funds and other large investors.

Apts. All Prop.1984-2004 9.3% 7.6% Total annual return

National Council of Real Estate Investment Fiduciaries

8

INVESTING IN APARTMENTS

Advantages Disadvantages

9

APARTMENT INVESTMENTS AND RISK

Business Risk Financial Risk Liability Risk Inflation Risk Interest Rate Risk Property Damage Risk Obsolescence Risk

10

WHAT ARE THE OWNER’S INVESTMENT GOALS?

Getting a specific rate of return Generating regular cash flow Refinancing Renovating or retrofitting the property Acquiring new properties Selling existing properties

??????

11

THE FINANCIAL STRATEGY Keep the owner well informed Factor the owner's goals into all

key financial activities Provide incisive and timely

financial analysis Recommend strategies and tactics Take decisive and effective steps Assess portfolio growth Communicate

12

3. MORTGAGES, FINANCING, & TAXES

13

WHY INVESTORS CHOOSE MORTGAGES

Need for additional funds to purchase or develop an apartment community.

Use a loan in order to free money to diversify their investments.

Take advantage of the tax benefits that allow mortgage interest deductions and asset depreciation.

Enjoy the benefit from financial "leverage"

14

WHAT IS LEVERAGE?

The use of borrowed funds to increase overall purchasing power Positive Leverage means borrowing money

at a lower interest rate than what the asset yields

Negative Leverage is borrowing money at a higher interest rate than what the asset yields

Leverage is a unique element to real estate investments, not present in investments like stocks and bonds

15

MORTGAGE NOTES

The document that establishes the existence of debt between a lender and a borrower. Key provisions: Amount borrowed Rate of interest Payment due dates Loan maturity date (when all remaining amounts are due) Reference to the real estate providing security for the loan Specific terms relating to defaults, grace periods, and early

payments Details on how payments will be applied, usually in this order:

(1) to late payments, fees, and penalties; (2) to interest; and (3) to principal

16

MORTGAGE CLAUSES: PROTECT LENDER

Pay monthly amounts for property insurance, real estate taxes, and if required, mortgage insurance premiums (PITI)

Pay all other taxes, assessments, charges, and claims that have priority over the mortgage.

Have hazard insurance coverage Keep the property in good condition Get the lender's approval for any new owner Assignment Clause

17

MORTGAGE CLAUSES: PROTECT BORROWER

Non-Recourse Clause

Prepayment Rights

Loan Assumption Conditions

18

TYPES OF MORTGAGE LOANS

Fixed Rate Loans Variable Rate Loans Balloon Loans Bullet Loans Other Loans

Rollover Loans Construction and Takeout Loans Gap Loans Wrap Loans

19

MORTGAGE FINANCING RISK FACTORS

Economic Conditions Inflation Default Risk Interest Rate Risks Legislative or Regulatory Risks

20

SOURCES OF MORTGAGE FINANCING

Commercial Banks Life Insurance Companies Pension Funds Investment Banks Mortgage Brokers Private Sources Syndications

21

GOVERNMENT FINANCING RESOURCES

Government Sponsored Enterprises (GSE’s) FNMA – Fannie Mae: Federal National

Mortgage Association FHLMC - Freddie Mac: Federal Home Loan

Mortgage Corporation FHA – Federal Housing Administration LIHTC –Low Income Housing Tax Credit

aka Section 42

22

LOAN ANALYSIS

LTV – Loan to Value: Expressed as % Formula: Loan amount/Property Value =

LTV Lenders prefer under 80%, may be 60%

DCR – Debt Coverage Ratio Expresses the property’s ability to repay

the loan Formula: NOI/ADS (Annual Debt

Service)=DCR The closer the DCR is to 1 the riskier the

loan

23

TAXES

Federal, state, and local taxes significantly affect the return on investment available to the owner.

A baseline understanding of the tax laws and practices affecting apartments will increase financial literacy—and gain greater insight into how to help the owner achieve property or portfolio goals.

Note: Tax laws are complex, and professional tax advice always needs to come from a tax attorney or tax accountant. Don’t give tax advice!

24

PROPERTY TAXES

Property taxes are one of the two largest expenses for an apartment community.

They provide the major source of funds to provide local government services used by apartment communities.

Property taxes—and sometimes water and sewer fees imposed by local government—usually have a lien priority, even over mortgages.

25

TAX BENEFITS AND RISK

Depreciation or Cost Recovery The Capital Gains Tax Rate 1031 Exchange The Concept of Basis

Adjusted basis Recoverable basis Original basis

26

4. MANAGING THE BUDGET PROCESS

27

WHAT IS A BUDGET?

A budget is an itemized summary of estimated income and expenses for a defined period of time, most often one year.

Provides the "window" on property operationsPrincipal source of information relating to a

property's financial performance.

There are three types of budgets: Lease-up budgets Operating budgets Renovation or modernization budgets

28

THE IMPORTANCE OF A BUDGET

Budgets monitor a property’s performance

By regularly comparing actual income and expenses to the budget, income shortfalls and expenses overruns can be spotted and corrective measures taken.

May also be used to evaluate the performance of personnel

29

BUDGET GOALS

A budget begins with the owner's operational and financial goals. Does the owner want to:

Receive a specific rate of return? Generate cash flow? Renovate or upgrade a property? Sell a property?

Goals must be understood BEFORE beginning to prepare the annual operating budget,

30

PREPARING THE OPERATING BUDGETStep 1: Forecast Income

Step 2: Project Anticipated Expenses

Step 3: Consider the “What if…?” Scenarios

31

TWO BUDGETING TECHNIQUES

Extrapolation: Estimating a number based on information you

already know. May be used for income or expense categories

Annualization: Estimating a number by averaging year to date

income or expense and multiplying to make a full year.

Care must be taken to exclude one time or unusual occurrences

Better to use historical data for the same months in the prior year instead.

32

TIPS FOR SUPERVISING THE BUDGET PROCESS

Start early Use property personnel Gather meaningful, specific

supporting documentation that must accompany budgets

Supply property team with the right budget tools

Consider holding a budget workshop

Distribute copies of the budget 33

5. GETTING TO THE BOTTOM LINE

34

ACCOUNTING VS. BOOKEEPING

Accounting deals with the entire system for providing financial information—from the design of the systems through its operation to interpretation of the data.

Bookkeeping is the routine, day-to-day recordkeeping that’s a necessary part of accounting.

35

ACCRUAL VS. CASH BASIS ACCOUNTING Accrual basis accounting.

All income and expenses in the period they are earned or incurred, regardless of when they are actually received or paid.

Gives a more realistic and controlled picture of net operating income in the period, and is the most common type of accounting used in multifamily residential management.

Cash basis accounting. All income and expenses when they are actually received or

paid, which causes widely fluctuating numbers. Cash basis accounting may give a distorted picture of

profitability at a given point in time. Is it more important to know when rent is incurred,

or just noting the cash received when it was paid?

36

OPERATING INCOME

Gross Operating Income (GOI) - all the money a property records, including rent and other income.

Net Operating Income (NOI) gross income less operating expenses.

37

OPERATING EXPENSES

Fixed Expenses Variable Expenses

Where should smart managers focus?

What are the two largest expense categories as a percent of Gross Potential Rent (GPR)?

38

THE INCOME STATEMENT

Often called the operating statement or profit and loss statement, Measures performance over a given period of time. Key indicator of a property’s financial positionDefines progress, trends, relationship to the competitive market place, and the continuing ownership strategy.

39

THE BALANCE SHEET

Shows the financial status of a property at a moment in time. Assets are all the cash on hand, the things the

property owns and the accounts receivable.

Liabilities are the debts and obligations owed, such as loans and the accounts payable at the property.

Equity is the sum of Assets less Liabilities

40

GROSS POTENTIAL RENT (GPR)

Gross Potential Rent, or GPR Total rent that would be generated from the

property if all the units were occupied. GPR combines the sum of occupied units at current

lease rates, plus vacant units at market rates. All income and expenses are measured and

evaluated as a percent of GPR. Gross Potential Rent is NOT Market Rent

Often called scheduled rent, which is the total annual income you’d receive if 100% of all units were occupied and paying market rents.

41

LOSS/GAIN TO LEASE (LTL)

A variance from Market Rent due to the Lease Rents residents pay at the time of move-in.

As market rents go up, loss to lease increases; as market rents are lowered, the loss to lease is reduced.

There will always be a gap between market rent and gross potential rent. WHY?

Market Rent less Gross Potential Rent) / Market Rent = % Loss to Lease

42

VACANCY, CONCESSIONS, AND COLLECTION LOSSES (VAC)

Total value of rent loss from vacant unitsCost of concessions givenCollection loss as a result of writing off bad debtTotal amount of rent loss from any non-revenue units.

43

EFFECTIVE GROSS INCOME (EGI)

Effective gross income (EGI) is the amount of gross potential rent (GPR) less vacancy, concession, and collection loss (VAC).

Effective gross income is also called net rental income or total rental income. It represents only rental income.

Formula: GPR - VAC = EGI.

44

OTHER INCOME Other income (OI) is any money

collected for items other than rent. Includes collections from

Laundry vending deposit forfeits

parking amenity charges late fees

pet fees application fees administrative fees

cable lease premium fees Other income can add up to an

additional 5% to 10% of the total property income.

45

GROSS OPERATING INCOME (GOI)

Total amount of all money the property collects.

Also known as Total Revenue or Total Income.

GOI is the sum of the Effective Gross Income (EGI) and other income (OI).

Formula: EGI + OI = GOI. 46

OPERATING EXPENSES (OE)

All expenses, fixed and variable, that are paid to manage the property. Typical expense categories are:

Salary and personnel costs Insurance

Taxes UtilitiesManagement fees Administrative costsMarketing Contract servicesRepairs and maintenance

Note: Capital expenses and replacement reserve payments (if required) are not typically considered

operating costs.

47

NET OPERATING INCOME (NOI)

Net operating income (NOI) is gross operating income (GOI) less operating expenses (OE).

NOI is the critical number on the operating statement. Income producing properties are valued based on a derivative of NOI

Formula: GOI - OE = NOI. 48

CASH FLOW (CF)

Similar to net operating income except that capital expenses (including replacement reserve payments) and debt service are subtracted.

Usually represents the property’s distributable cash.

A cash flow statement is another measure used to show financial performance.

Statements can include before-tax cash flow (BTCF) or after-tax cash flow.

49

CAPITAL EXPENSES (CE)

Capital expenses or capital expenditures (CE) are large property expenditures.

They include non-recurring major expenses, such as replacing a roof, adding a swimming pool, and otherwise improving the property in ways intended to add to its life.

Capital expenses have a “useful economic life.”

They are depreciated over an "expected" life rather than in a single year.

50

REPLACEMENT RESERVE ACCOUNTS (RRA)

An RRA is money set aside in a special account for the replacement costs of items that wear out and must be replaced periodically

carpeting roofs boilersparking lot repaving exterior painting.

Many lenders require that property owners set up a replacement reserve account (RRA) and make certain minimum payments.

51

DEBT SERVICE (DS)

Debt service (DS) is the mortgage or loan payment (principal plus interest)

Most fixed-rate loans have the same amount due monthly

Properties may have multiple loans or mortgages on the property

52

IMPORTANT FINANCIAL CALCULATIONSAlong with NOI and cash flow, other financial calculations indicate more about a property's financial performance. These calculations are: Break-Even Occupancy Percentage Break-Even Rent per Square Foot Economic Occupancy Percentage Rate of Return on Investment Cash-on-Cash Return Operating Expense Ratio

53

BREAK EVEN OCCUPANCY PERCENTAGE Break-even occupancy represents the

occupancy level needed to produce enough income to pay the operating expenses and debt service of a property—the minimal requirements to keep a property operating.

Formula: (OE + DS)/GOI.

54

BREAK EVEN RENT PER SQUARE FOOT The break-even rent per square foot

calculates the rent per square foot needed to pay the operating expenses and debt service of your property.

Formula: (OE + DS)/total square feet.

55

ECONOMIC OCCUPANCY PERCENTAGE Economic occupancy reflects only the

actual revenue being realized. Economic or physical for overall property

performance? WHY? Variances between physical and

economic occupancy/vacancy can be a measure of management efficiency, as well as one of overall market conditions.

Formula:EGI/GPR= EO%

56

RATE OF RETURN ON INVESTMENT (ROI) Measures the financial performance of

the investment. ROI is the percentage of return—or

yield—on the total amount invested for a given time period.

It does not take consider the time value of money—that a dollar today is worth more than a dollar tomorrow.

Formula: NOI/Equity Investment = ROI.57

CASH ON CASH RETURN

Cash-on-cash return measures the cash flow received against the original cash invested.

It’s a useful method of measuring return on investment for financial institutions and investors interested in purchasing or evaluating a property.

Formula: Cash Flow / Total Initial Investment. 58

OPERATING EXPENSE RATIO

Calculates the percentage of the gross potential rent needed to pay operating expenses.

Also known as expense-to-income ratio A tool to measure how well a property is

managed. Often compared to those of other properties

in the area—or national averages—to evaluate success.

Formula: OE/GPR

59

6. ANALYZING MONTHLY FINANCIAL STATEMENTS

60

CHART OF ACCOUNTS

The chart of accounts lists account codes for each income and expense item and defines what should be posted for each account.

The chart of accounts provides the basis for budgeting, variance reporting, journal entries, and financial statements.

A portfolio of properties may use one chart of accounts, or different ones, depending on owner entity and lender requirements.

61

THE GENERAL LEDGER

The general ledger is a group reporting of accounts that support the major financial statements. The formal record for all financial transactions for the

property Transfers journal data from the book or page where

accounting entries are posted. The sub-accounts (or ledgers) are assigned names or

numbers and provide details of financial activities that occurred.

These sub-accounts are often called the chart of accounts.

It is much like a check register of expenses

62

BUDGET VARIANCES

A variance is the difference between a budgeted income or expense number and the actual income or expense in a particular month or year-to-date. Best practices require: Keeping track of budget variances. Using them to prepare a new forecast of future

results. Analyzing and explaining variances to the

owner. Taking action when necessary.

63

EXPLAINING BUDGET VARIANCES

Analyze the variance: What is the source, what is the cause?

Explain the “reason” for the variance Explain what effect it will have on

future months Recommend action to correct the

variance Seek to see if this variance is part of a

trend64

BUDGET RE-FORECASTING

Re-forecasting allows you to: Assess how the property is expected to perform

for the balance of the year in relation to the original budget.

Determine whether you need to make further changes in income and expenses in future forecasts.

Understand your property and the impact of occupancy conditions on property performance.

Remember: The budget is not changing! The actual year-to date income and expense results are being projected for the remaining months in the year.

65

FINANCIAL REPORTS & PROPERTY PERFORMANCE

Financial reports can help evaluate team performance.

Can poor employee performance be part of the reason for not meeting budget?. Can strong employee performance be part of a reason the property performs well?Can a strong staff still not meet budget?

66

7. VALUING APARTMENT INVESTMENTS

67

PROPERTY VALUE FUNDAMENTALS

Understanding property value will aid in management decisions and analyzing and interpreting financial data.

What price to offer when buying a property. What price to ask when selling a property. Establish a basis for real property exchanges. What terms of sale for a proposed transaction. Estimate the value to get a mortgage loan. Estimate the value to refinance a mortgage loan.

68

THREE APPROACHES TO VALUING PROPERTY

Cost Approach

Sales Approach

Income Capitalization Approach

69

COST APPROACH

The cost approach estimates the current cost of reproducing or replacing the improvements (buildings), minus the loss in value from depreciation due to age, condition, or obsolescence. It also includes the value of land, but does so separately.

The cost approach looks at the current cost of the “bricks and sticks” to rebuild the property. This includes “Direct” Costs and “Indirect” Costs.

70

SALES COMPARISON APPROACH

The sales comparison approach assumes the market value of a property is directly related to the prices of comparable, competitive properties.

Works best when there are several similar properties in the local market that have been recently sold or are currently for sale. The key is to correctly identify "comparable" and "competitive," i.e. high-rise vs. garden-style.

71

INCOME CAPITALIZATION APPROACH

The income capitalization approach is the most common method for determining value for any income-producing property It estimates property value by applying a

current capitalization (cap) rate to the annual stabilized NOI

Higher earnings translate into higher value. The more NOI, the higher the property value

Income-producing property is often purchased as an investment.

72

INCOME CAPITALIZATION APPROACH

The cap rate reflects the investor's desired rate of return for that apartment investment and is expressed as a decimal or percent

The basic formula is I/R = V, where I is NOI, R is the capitalization rate, and V is the property value or cost.

Formula:NOI/Cap Rate = Value

73

DETERMINING CAP RATES

Ultimately the Cap Rate is determined by the purchaser, some factors that may

affect this are:LocationSupply and DemandInterest RatesHistoryDesired ReturnAlternative Investment Opportunities

74

ACTIVITY: CALCULATING VALUE

75

8. MAXIMIZING REVENUES

76

PRICING (OR RENT) STRATEGY

Rent typically accounts for 90%-95% of total property revenue.

There are two ways to maximize this most important revenue stream: (1) charging the optimal amount of rent (2) increasing the property's effective rent

77

THE FOUR P’S

Pricing Product

Promotion People

78

HOW TO INCREASE EFFECTIVE RENT

Give no concessions or reduce the amount of the concession given

Do not waive move-in day rent to meet an occupancy goal

Guarantee rent prices only for people on a deposit-paid priority wait list

Consider adding rent premiums Remember to keep advertising resources

up to date. (Web sites and others)

79

BALANCING OCCUPANCY AND RENTAL RATES

Looking for higher occupancy in the range of 97%-98% or taking lower occupancies with higher rents? Evaluate:

What is the current average occupancy in the market and submarket?

What are the trends in both the market and the submarket?

Is occupancy trending up or down? How do the properties’ current occupancies

compare to both the market and submarket? What occupancy is needed to make budgeted

revenue? How will you accomplish it? 80

ACTIVITY: BALANCING OCCUPANCY & INCOME

“The goal is not 100% Occupancy, it is to maximize revenue.”

81

SAMPLE OCCUPANCY PERFORMANCE LEVELS Target levels are determined by market analysis

economic conditions rental supply and demand, competitive properties desired occupancy goals to drive revenue.

Properties are expected to reach those occupancy levels and continue to move up to higher performance levels.

Level 1 performance might be 96%-98% occupancyLevel 2 might be 92%-95% occupancy Level 3 might be 87%-91% occupancyLevel 4 might be anything below 87%.

Action plans are required and based on the level at which the property should perform.

82

ACTIVITY: ANALYZING VACANCIES

“Every day an apartment home is unoccupied,

revenue is lost forever.”

83

BUILDING “OTHER INCOME” (OI)

Constantly seek opportunities to increase other income. In the 2010 NAA Survey, Other Income represented 7.1% of GPR.

Increase Fees, application, administrative, etc.

Charge for Services Such as Utility Sign-up

Parking Water, Sewer, Trash Amenities

84

AUTOMATED REVENUE MANAGEMENT Often called “yield management”

systems Came from the hospitality and airline

industries Uses databases of information to

forecast supply and demand Prices units “daily” to maximize the

yield The market on that day and at that

time determines unit pricing 85

9. ACTIVITY: FINAL EXERCISE

86

10. KEY TAKEAWAYS AND CLOSING

87

LEARNING OUTCOMES: FINANCIAL MANAGEMENT

• Apartment Investment Basics

• Mortgages, Financing & Taxes

• Managing the Budget Process

• Getting to the Bottom Line

• Analyzing Monthly Financial Statements

• Valuing Apartment Investments

• Maximizing Revenues

88

THE ACTION PLAN – PAGE 10-2

This plan is yours and yours alone You decide on which leadership areas

you want to work. You set the number of goals You decide on the action steps and

timeline.

89