A young auditor from a Big Four accounting firm once told me that real estate accounting is the easiest kind. It was the only kind of accounting I knew so I took him at his word. After many years of experience, I think he was right. But accounting may be the only aspect of real estate development that is easy.
For real estate development accounting you try to capitalize everything. To capitalize something means to convert your cash to another hard asset on the balance sheet versus having it be expensed and go against your bottom line. This is for a couple of reasons. First, the end all, be all of accounting principles is the matching principle. Match your expenses with your revenues. But what do you do when you spend money for 18 months to build some townhomes and then sell each unit in a day? Real estate requires you incur all your costs up front, over a relatively long time frame, and then sell the finished product (not just put under contract, but close escrow with the title company) in a day. Spend $400,000 evenly over the course of a year, sell and collect $500,000 in revenue in one day. The numbers are for example purposes, but you get the idea. Imagine the scale and time frames and dollars spent when building Manhattan’s massive residential skyscrapers or Florida’s sprawling master-planned golf communities.
Put all the costs in one pot and then try to match up the cost when you sell the finished product. In real estate development it’s impossible to match where every shingle went, where every electrician pulled a wire, where every unit of concrete was poured, so you pool all the costs and then allocate them relative to the revenue you expect to make overall for the project(s) for which the costs were incurred.
Phasing helps make this simpler. You can at least usually track the costs of a phase based on contracts. But how about that main road that’s going to access multiple phases. You’ll have to come up with some sort of reasonable allocation to spread those costs into the cost pools of each phase the road is going to serve.
There are some complexities, but like the industry itself, real estate development accounting can be a little like the wild west. In order to match those costs with future sales you must start with the assumption that you know the finished product will sell a year from now and have some idea of how much it will sell for.
The second biggest thing you’re likely to ever buy rolls off an assembly line in a day. The house, the office building, the tower takes years of costs to produce. And the accountant can lump them all together and make estimates about very large transactions that should happen in the future, sometimes years out.
But I think the auditor was right, real estate accounting is easy. That’s good, because nothing else about real estate development is.