New Perspectives in Analyzing Real Estate Developer Financial Statements
Boykin, Dan, The RMA Journal
This article, the sixth in a seven-part series, originally ran in the November 2002 RMA Journal but its insights into analyzing real estate developer financial statements are as valid today as they were then. The author has made some minor changes to reflect circumstances in 2011.
DEATH AND TAXES are said to be the only two certainties in life. While we all prefer to avoid both for as long as possible, lenders in real estate have to grapple with taxes frequently and in many ways. The tax code itself has so many real-estate-specific rules that it has created an industry of individuals who prepare, file, and otherwise deal with the litany of tax regulations and issues faced by real estate developers and investors.
In addition, tax regulations sometimes create incentives for otherwise uneconomic transactions. The tax laws of the early 1980s created just such incentives, and numerous transactions were pursued solely for the potential to save money in taxes. Somewhat simplified laws have since sought to avoid creating incentives that induce building that is inappropriate for the underlying economy.
The lender's concerns remain the same:
* What is the source of repayment?
* What can affect the source of repayment?
* How do we deal with deviations from the "expected" outcome?
We all make loans fully expecting that the project will proceed as planned. Recall from the first article (July/August 2010 issue), our objective in analyzing the business is to determine:
1. The degree of flexibility a developer has retained in the business as a whole.
2. The financial strategy and what it means for the lender.
At issue is the liability or potential liability related primarily to income taxes due on appreciated property assets. Real estate businesses are somewhat complex in this regard--not so much for the complexity of the tax laws as for the manner in which business is conducted.
We began this series of articles by looking at some of the various entities developers use to pursue projects. These entities are nearly always flow-through entities--any of the income (or losses) and the resulting tax consequences flow through to the individual owners, based on the ownership agreement.
For example, if an LLP earns $1,000 from manufacturing widgets, the profit is reported on the owner's (individual partners', in this case) tax return. The owner pays the tax, if any, depending on his or her total earnings, deductions, losses, and so forth. While the economic reality of the taxes exists, they are paid outside of the financials of the actual business entity. So, when analyzing a business that is an LLP (or that has made a subchapter-S election, or that is otherwise taxed at the owner's tax return level), we will not see any explicit allowance (expense) for income taxes.
This is important because the invisible--or not so invisible--hand of the government always lays its claim; indeed, government is considered a priority payment in most analytical models. As this tax claim is owed by the individual, it can and does have a material effect on strategic decisions and can create an incentive for otherwise uneconomic behavior.
Ramifications of Tax Liability: An Example
Let's look at a typical real estate partnership transaction and the economic ramifications of this often unstated tax liability. Again, our objective is to adopt the point of view of an analyst and lender. This example will incorporate the most aggressive assumptions possible to illustrate the point and will use current tax regulations as the basis. We assume the following, which is modeled after a real transaction:
* An apartment property is developed at a cost of $10 million.
* Of this $10 million, $2 million represents land costs that are not depreciable.
* A loan of $8 million is obtained, with a 7. …