An Investor’s Guide to Reviewing Quarterly Reports

By Eli Macanian, Vice President, Asset Management

The goal of this article is to help guide investors when reviewing quarterly updates to their real estate investment. What should an investor focus on when reviewing a property financial statement? What metrics should an investor look for? How can an investor accurately assess property performance?

Reviewing Property Financial Statements

Two of the important sections of the property’s financial statement are the balance sheet and income statement. A balance sheet shows the property’s assets and liabilities. One number that investors may pay special attention to on the balance sheet is how much operating cash is available. Operating cash is different from security deposits and escrows because operating cash is available as ownership desires while the other cash accounts are typically restricted. Sponsors normally maintain an operating cash balance of two to three months of operating expenses, but may hold more or less than the typical amount depending on the current stage of the business plan.

The income statement is the property’s profit and loss statement. Investors may want to pay specific attention to how income is trending from acquisition to present. While operating expenses are predominantly fixed (excluding properties that are mis-managed), income can be dependent on execution. For example, assume most apartment buildings in a suburb of Dallas have similar operating expense per unit. However, those same apartment buildings may have wide-ranging income levels per unit. Some properties might have renovated units while others only offer classic units, properties operate at different occupancy rates, properties offer different concession packages, etc. Ideally, investors want to see income growing over time. It may be important to note that income can be light during the peak of the value add period: if there is construction underway, it can negatively affect retention of existing tenants and the ability to attract new tenants.

What Metrics Can An Investor Focus On?

Quarterly reports include an abundance of information, some of which is not necessarily imperative to investors, (i.e. general ledgers and trial balances). Investors may want to focus on the following metrics when reviewing quarterly reports:

1. Is the sponsor achieving projected rents for renovated units?
   • We believe, this is an important metric because as opposed to other metrics that are controllable or one-time variances (i.e. high Q1 utility costs during the winter months), achieving projected rents for renovated units is typically the key measurement for proving business plan execution and can be a positive sign that the market can support higher rents.
2. Are unit renovations and exterior improvements being completed on time and within budget?
   • Sponsors have different approaches to unit renovation pace. Some sponsors may start renovations right away and get as many done as possible in a short time period, while other sponsors may start slowly and ramp up unit renovations as exterior improvements are completed. Both approaches may have positive and negative aspects. For example, completing unit renovations faster than the business plan can result in higher vacancy and lower initial rents, but the fast pace may also result in increasing rents earlier than the business plan and potentially shorten the hold period if the units are renovated faster and the sponsor decides to sell. An experienced sponsor understands the market’s leasing cycles and may try to match the unit renovation pace to that market. Lastly, completing unit renovations above budget usually negatively impacts distributable cash flow.
3. How are occupancy, income, expenses, and net operating income trending quarter-over-quarter? How do they compare to at acquisition vs. present? How do they compare to proforma?
   • As mentioned above, investors want to see income growing over time as the business plan is being executed. Also, comparing the present net operating income vs. at acquisition can give investors a rough idea of how the property’s present value compares to the original purchase price. Investors may want to wait for several quarters of ownership before making a meaningful comparison as net operating income is typically reduced during the value add period.
4. How much cash is sitting in the operating account?
   • The operating account is directly linked to how much cash is available for distribution. It’s important to note that, in many cases, the lender reserves cash for capital improvements that the sponsor draws upon via draw requests. As a result, sponsors sometimes have to pay contractors out of the operating account for timing reasons and then get reimbursed by the lender. In such instances, the net operating account can be actually higher than what is stated on the balance sheet.
     

How Can an Investor Accurately Assess Property Performance?

First and foremost, real estate equity investments are usually a long term investment. It can take months, and sometimes years, to complete construction and renovations, re-brand a property in the market, increase rents for existing tenants, remove undesirable tenants, cut expenses, and burn off concessions. With that in mind, investors may be cautious not to assess a property’s performance too quickly after acquisition.

Over time, the typical way to assess the property’s performance is to compare actual financials and distributions to the original proforma. A proforma reflects the business plan’s property cash flows and investor returns. A proforma typically makes dozens of assumptions, such as market rent growth, terminal cap rates, and real estate tax increases. These assumptions are made based on a) the property’s trailing financials and b) market data from third parties (i.e. Costar) and independent research (i.e. contacting similar properties nearby the subject property for lease comps). While comparing financials to proforma is the typical technique to judging performance, it’s important to know proformas’ limitations:

1. Proformas are not meant to be an exact science.
   • Proformas are inevitably wrong: market rent growth may stagnate or accelerate, market cap rates may move up and down, or construction costs can come in below or above budget. A proforma is simply meant to be a benchmark for comparing property cash flows and final investor returns.
2. An original proforma is prepared at acquisition, but typical hold periods vary between 3-5 years.
   • As a result, investors may be comparing property financials to a proforma prepared several years ago. Though the proforma is still a correct and important measurement, investors should be aware of this limitation. Sponsors may compare property financials beyond year one to the operating budget. An operating budget is prepared each calendar year by the sponsor and the property management. Typically, RealtyMogul will have operating budget appoval rights for deals that RealtyMogul investors represent a majority of the equity.
3. Investors seek to receive distributions at or above proforma.
   • Investors seek distributions at or above proforma, however there can be legitimate reasons why distributions are below proforma or even suspended temporarily. An example of a good reason why distributions are below proforma is that the property is currently in the peak of the value add period and the sponsor is conservatively reserving cash. Typically sponsors reserve cash during this period because they prefer to maintain a healthy reserve in the event that any unforeseen events take place (i.e. budget busts, real estate tax increase, etc.) rather than distribute all available cash and then make a capital call. An example of a bad reason why distributions are below proforma is poor property performance (i.e. not hitting projected rents, occupancy struggles, continuous outsized expenses). However, investors may be aware that whether the sponsor distributed last quarter’s distribution at a 5% annualized distribution rate instead of the projected 7% may not have an impact on final investor returns. Raising rents and other income, limiting vacancy, completing the capital improvement plan within budget, controlling expenses, interest rates, and the terminal cap rate may have more of an impact on final investor returns.

All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.