Author: edmorgan1

I am an accounting and finance professional focused in the real estate development sector in the North Lake Tahoe and Reno area. I have managed the accounting and financing of large master-planned communities in high end resort areas with complex arrangements for large public companies and for private asset managers. I am experienced in GAAP financial reporting, business plans, cash forecasting, variance reporting, audits, treasury management and tax. I have helped companies grow and downsize during the real estate cycle and have a proven ability to manage diverse teams through real estate matters. In my current role I am managing a 900 unit master planned community through a change in ownership and am seeking new residential development opportunities in Northern Nevada.

The Capital Stack (Part 1)

You’ve got a project you think makes sense. It makes sense for your team, for the community, for the ultimate end users (the buyers), and your financial model says it will generate positive cash flow in an amount that justifies the investment.  The next step is to figure out how to pay for it.

Just like real estate developers are always looking for the next deal, they’re also always looking for funds.  Only large and well-established real estate companies (think Trammell Crow in office or Toll Brothers in housing) have enough cash within their organization to start and finish projects with their own money.  The typical developer will have just enough cash to prove to others they have some skin in the game and they think the project is good.

The capital stack defines how the project will get paid for and how the parties that invest in the project will share in the financials rewards (or losses). 

If you have a mortgage on your house, you have a capital stack.  You likely had to come up with some portion of the purchase price to buy your home.  That was the equity and that was your way to prove you believe in the value of the house.  You own it, but if you have a mortgage then there is a bank that also has a stake and is part of the stack.

Banks are not in the business of owning houses for long periods of time and trying to make money when they sell five or ten years down the line.  They are in the business of lending money and collecting interest payments on that money.  They’re part of the capital stack required to fund your home, but each party has their own purpose, their own defined financial rewards and risks, and their own protection.

You own your house and your name is on the grant deed recorded with the County, but the bank has a deed of trust recorded on the property that says they can take it from you if you don’t perform.  They want you to pay interest and pay them back the principal over time.  If both parties act as agreed, you end up owning your house and the bank makes decent interest on their loan.

The real estate development business operates under the same principles.  The owner is usually going to put up the first money to buy the land and start the development.  Then you hope to have a bank fund the balance of the project.  However, real estate development is different from a residence because the owner is likely to be a partnership, perhaps an LLC with multiple members, each with different responsibilities and obligations.  Those owners must have an agreement about who is going to fund the upfront dollars and who is going to get money back after any debt is paid off.  The capital stack is often defined in a partnership or operating agreement.

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Cash is King

Most real estate developers and investors don’t care much about Generally Accepted Accounting Principles aka GAAP.  It’s not that people in the industry don’t respect accounting standards and the creation of accurate and timely financial reports, it’s just that cash is king. 

GAAP requires the preparation of a balance sheet, income statement, and statement of cash flows on a regular basis.  All real estate developers want to review and use as a decision-making tool is a cash flow forecast.  In my many years of accounting and audits I’ve taken pride in preparing accurate financial reports, even with use of some key estimates as discussed in the last blog.  But cash is all that matters. 

Every project is evaluated from the beginning with a model, almost always in Excel, based on how much cash will be spent to acquire, plan, build, and sell a project.  On the back end the model will forecast sales. The timing and the price of sales will be the great unknown, based on best estimates after understanding the market, the local economy, and demand for housing. 

Real estate development is different than other businesses in that we’re not going to make the same thing(s) or provide the same service(s) over and over again.  Every project has an end point, when the last house or lot is sold.  If you’re making Coca-Cola, you’re going to keep doing that for as long you can, occasionally rolling out new products based on what you’ve been doing in an effort to grow revenue, while always analyzing the costs to make sure you’re efficient.  Likewise, if you’re an attorney, you may practice in different fields and cases come to end, but you can anticipate what your future work will be.

Real estate developers will build houses repeatedly, but every time it will be different, and every time there will be a finite end.  That’s why real estate developers are always looking for the next project.  There is a certain expertise that can be developed about the process, but building 500 homes in Fresno is different than building an apartment in Miami and is different than building a golf course community in St. Louis.

The basics of looking for available land in a desirable location, understanding local law which governs how the land may be used, estimating the costs of design and construction, and then figuring out how to communicate to a target audience will be similar.  But the details for each project will be very different.  Every locale will have different laws, different labor markets, different attitudes towards development, different local engineers and contractors, and different costs for materials.

To be successful in real estate development you must be able to take all those factors into account. You’ll need to build a financial model that quantifies all the many estimates and assumptions about dollars and timing, then convince someone to fund your project based on bringing in more than you’ll spend, and ultimately manage the many elements in a way that successfully achieves your paper plans.  Who can worry about GAAP financials with all this at stake?

Real Estate Development Accounting

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.

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