Help… Distributions vs. Net Income?

Written January 24th, 2013 by


If you are invested in an apartment complex, you should be receiving monthly financial packages that show the net income generated by the property.  If you are like me, you quickly scan down to the net income to try and figure out what distribution to expect.  But, then you notice that the distributions made from the property don't match the net income over the period since the last distribution.

SAY WHAT?!

Cash Flow Distributions

First, properties can only distribute the cash they generate.  Yes, there are exceptions ... such as returning unneeded capital that was raised up-front, selling assets, or adding debt.  But, these are not the norm.  Typically, the property distributes the cash flow it generates to investors, after it saves up any necessary reserves.

The simplest way to see the cash flow is via the "Cash Flow Statement" in the financials.  These show the net income and then "correct it" to match the actual flow of cash.  More below.

Why can't I just look at "Net Income"?

First, net income is based off accrual accounting, which recognizes income and expenses when the corresponding event occurs (i.e. rent is due or a bill is received) and not when the actual cash changes hands. This is intended to provide a more accurate picture of the operations of companies, as it shows income and expenses closer to when the corresponding economic event occurs. But makes it difficult to really follow the flow of cash. For example, accrual accounting shows all rent is received each month, even if it isn't. Thus, it appears you received income now even though residents may not pay until next month.  And if they never pay, you have to write-off that income as "bad debt" in a future month.

Second, net income excludes capital expenditure (Cap-Ex) spending. Capital expenditures (i.e. stoves, roofs, etc.) last many years, and to more accurately account for this, these items are depreciated a little each year by our CPA (at the end of the year.) Nevertheless, we are spending money on Cap-Ex, and that is coming out of cash flow each month. Thus, you must remove cap-ex spending from net income to approximate the cash flow.

Third, net income excludes principal pay down on the loan. While this isn't impacting Woods yet, later this year it will reduce the cash flow of the property, as part of the net income will be applied toward paying down the loan (which will be recaptured to the investors when we sell or refinance the property.)

OK, so what is distributed?

Once you have determined the cash flow generated over a certain period, you are getting closer to the calculation of the distribution. Except... well... some of the data needs to be adjusted.

For example, you may have collected security deposits (positive cash flow) but some or all of them may need to be returned when the resident moves out. You don't want to distribute these!  Or, you may have a large tax bill or insurance bill that occurs once a year, that you need to build reserves up to pay. When calculating distributions, you must save up for these (reserves.)

DISTRIBUTABLE CASH

Typically, distributable income is calculated by an asset manager using the following formula:

CURRENT ASSETS - CURRENT LIABILITIES - RESERVES = DISTRIBUTABLE CASH

This equation comprehends the flow of cash as well as the necessary reserves to be built up.  But, the question of what to include in each of these terms is up to the discretion of the manager.

CURRENT ASSETS

  • Cash in checking accounts
  • Accounts Receivable(money we're owed that hasn't been paid yet)
    • Note: often this will never be completely received in the future, as some residents skip or are evicted without paying what they owe (and thus are written off as "bad debt" in the future).  As a result, the account receivable value could be discounted to account for this (it is up to the manager based on the specific property)
CURRENT LIABILITIES
  • Accounts Payable (money we owe that hasn't been paid yet)
  • Security Deposits(assuming they are held in the checking accounts above)
    • Note: arguably these could be excluded, as often these deposits aren't returned (they are applied towards fees, damages, etc.)
RESERVES
  • Working Capital(money used to pay bills and loan payments while waiting for all income to clear).
    • Note: There is no standard definition here, but it is often 1 month of expenses and loan payments (once the property is stabilized in occupancy.)
  • Escrows(if not held by the lender)
    • Insurance
    • Property Tax
    • Capital Expenditure (Cap-Ex)
  • Money saved up for future spending, and can be anything from:
    • Planned rehab that isn't complete
    • Cap-Ex reserve beyond the bank (to be more conservative)
    • Budgeted future increases in insurance, property tax, etc.
    • Any large and unusual upcoming expense
    • Future re-fi or sales expenses

Summary

The easiest solution to understanding distributions is to ask your asset manager to share the distribution calculation each time a distribution is made.  That provides insight into the reserves and checking accounts.  You can work that back to the financials using the cash flow statement and income statement, but it is a bit more complicated and not something you probably want to do every month.

HAPPY INVESTING

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