How to Get Complete Financial Picture When Taking Over Site Management
If you're considering taking over the management of an assisted site, or if you've already agreed to do so, look carefully at the site's financial statements for signs of financial problems or challenges you may face once you start managing the site, says Seth D. Strongin, a CPA in Atlanta, Ga., specializing in the financial management of assisted sites. Knowing what problems may lie ahead can help you:
Plan how you'll manage the site;
Prevent small problems from turning into big ones after you take over; and
Decide whether it's a good idea to manage the site if the problems are too big to fix or not worth the aggravation.
While you need to familiarize yourself with many documents when taking over a site—see our June feature, “Gather Necessary Documents to Ensure Smooth Management Transition”—financial statements will give you insight into a site's financial position and current performance. We'll tell you what to look for in the financial statements and what signs may indicate financial problems you might not have anticipated. Depending on the problems you find, you may wish to speak with your accountant or attorney about what your next move should be.
STATEMENT OF CASH FLOW FROM OPERATIONS
What It Is
The statement of cash flow shows how the site uses its cash and cash equivalents to operate the site. Cash includes currency, checks on hand waiting to be deposited, and deposits in banks—except for certain restricted cash, like security deposits. Cash equivalents are short-term, temporary investments, such as Treasury bills, certificates of deposit, or commercial paper, which can be quickly and easily converted to cash.
What to Look For
Check to see if the site has a positive cash flow from operations. This means there's more cash (and cash equivalents) on hand or coming in from rent and assistance payments than going out to pay current expenses. If so, it's likely that the site can meet its current operating expenses and pay the interest on its debt.
If the site's cash flow from operations is negative, the site doesn't have enough cash coming in to pay basic site operating expenses and the interest on its debt. This may spell more cash problems down the line if the site is relatively new and is still operating with money from a construction loan.
Even if it's not operating with money from a construction loan, a newer site shouldn't be struggling for cash more than a year or so into operation, says Strongin. If it is, this means that the site could be having occupancy or other serious operating problems that you'll need to address once you take over managing the site, he warns.
What It Is
The income statement details the sources and amounts of a site's revenue and expenses and can show a number of problems with the site's financial condition and operations.
What to Look For
Look closely at both revenue and expenses.
Revenue. Check whether the site's income statement shows low revenue from rent and assistance. If so, you'll get similarly low management fees because most management fees are calculated as a percentage of site revenue.
A number of problems can cause poor rental revenue. Depending on the cause, you may be able to find ways to increase revenue once you take over. For example, low revenue may be caused by:
Prior management problems, such as not properly certifying and verifying resident income, not advertising for new residents, not submitting requests for available rent increases, not collecting back rent, or not keeping the site or units in good physical condition;
Site and location problems, such as an older building that can't compete with others in the area, an undesirable neighborhood, or a lack of local services; or
Changes in market demand, such as low interest rates, attracting renters to buy homes, too many large units in an area where most of the population is single, or not enough elderly in the area to fill an elderly site.
Revenue problems traceable to poor management are often easier to fix. It may just be a question of making sure you comply with HUD occupancy and billing rules to collect the maximum rental revenue or actively marketing for eligible residents. But other types of problems may need more creative solutions, such as seeking a waiver from HUD to permit people younger than 62 years old into an elderly site, getting additional financing for extensive rehabilitation, or performing expensive renovations to make the site more attractive or competitive. Sometimes, there may not be a way to get the site to generate enough revenue to earn the amount of management fees you were expecting. If so, you'll need to decide whether you want to manage the site after all.
Expenses. Look at the type and amount of site expenses to make sure they're reasonable for the size and type of site, says Strongin. You may be able to find opportunities to save money, such as by converting your utilities from a single metered building to individual meters in units. An older site will very likely have more maintenance costs than a newer one. But unusually high maintenance costs may point to deeper problems, regardless of the site's age.
What It Is
The balance sheet gives you a “snapshot” of the financial health of a site.
What to Look For
Here are several items contained in the balance sheet that you should look at carefully.
Bank and Escrow Accounts. When you take over a site, the previous managing agent will transfer control of the site's funds in its bank accounts. So it's important to make sure that the amounts you get match the site's and the bank's records and that the site is complying with HUD accounting and other financial requirements, says Strongin. You should also make sure that the site is investing its money in the accounts when required and whenever possible to maximize investment income, while complying with HUD rules and any restrictions in its regulatory agreement, Strongin suggests.
Also, look carefully at these specific bank and escrow accounts:
Security deposit accounts. Make sure the security deposit accounts are fully funded and, specifically, that the balance in each account is equal to the amount of the security deposit payable in the liability section of the balance sheet. If not, the site could be improperly spending security deposits that it will have to repay and could end up in big legal trouble for violating HUD, as well as state and local, security deposit rules.
Tax and insurance escrows. Maintaining tax and insurance escrows spreads the burden of paying large tax and insurance bills equally over 12 months and ensures you have enough money on hand when it comes time to pay them. If these escrows aren't fully funded, the site may not be generating enough income to fund them and may not be able to pay them once they're due, says Strongin. This problem is becoming increasingly common in these days of skyrocketing insurance costs, he notes.
Replacement reserves. Make sure the replacement reserve accounts are adequately funded, as HUD rules and the site's regulatory agreement require. You'll need the site's reserves to fund any significant upcoming repairs and replacements. If there's not enough cash in the reserves to fund these repairs and replacements, the site is at risk of physical condition problems and poor REAC inspection results. Plus, low replacement reserves are a sign that the site may be having cash flow problems and using reserves to fund operations.
Also, if the site has made withdrawals from the replacement reserves, find out whether it got HUD's permission to do this and what arrangements were made to repay the reserves, says Strongin. If there are any improper withdrawals or outstanding loans from, or delinquent deposits to, the replacement reserves, you will have to repay those amounts into the reserves out of the site's operating account. This means you won't have as much money to pay expenses once you take over the site.
Residual receipts. Make sure sites that are required to have a residual receipts account (specifically, nonprofit and limited distribution sites) have one and that the account is funded properly based on the site's surplus cash calculations. And for limited distribution sites, make sure the site has followed HUD (and other applicable) owner distribution limits to come up with the amount to deposit into residual receipts before making any distributions of surplus cash. In either case, if the site didn't deposit the right amount, that could mean that the site has been making “unauthorized owner distributions,” which is a serious compliance violation. And as with replacement reserves, make sure the site got permission if it used residual receipts to pay any site expenses.
Rent and HAP Receivables. Look at the balances of the site's rent and HAP payment receivables accounts for signs of mismanagement and overstatement of revenue. For example:
Excessively high resident rent receivables may mean that the agent hasn't tried hard enough to collect back rent from residents or taken steps to evict residents for nonpayment.
If the receivables include back rent debts owed by residents who've moved or skipped out and who will most likely never pay, these debts should have been written off as “bad debts” and taken off the books. Receivables with too many accounts that should be written off as bad debts could be a sign that the site is overstating its rent revenue. And, of course, that means you may end up getting less in management fees than you anticipated when you agreed to manage the site.
Overly high HAP payment receivables means that HUD isn't making the HAP payments it agreed to make. There could be a host of reasons for this, many of which boil down to the fact that the previous agent didn't comply properly with HUD occupancy and billing rules. Review resident files to make sure, for example, that the agent performed annual recertifications for all households and properly billed HUD for rent and vacancy payments, says Strongin.
Prepaid Expenses. Expenses paid in advance show up as assets on the balance sheet. Some prepaid expenses, such as insurance, are acceptable. But sometimes you may see prepaid expenses for excessive or improper payments to the owner, prior agent, or a vendor. For example, some unethical owners may take improper advances and misclassify them as prepaid expenses. If you find questionable prepaid expenses, you'll need to make sure that those amounts are repaid to the site before you take over and, depending on the nature of the payment, reevaluate whether you'll want to do business with the site's owner, warns Strongin.
Accounts Payable and Other Obligations. When you take over a site, you'll need to negotiate the transfer of responsibility for paying existing payables and obligations, says Strongin. So look at the status of those obligations in the balance sheet. Excessively high accounts payable balances (that is, unpaid bills dating back to before the current operating period) may mean that the site has been incurring expenses that it can't pay—and you'll have to deal with the mess. For example, you may find signs of trouble in the following items, says Strongin:
Management fees payable. If a site is paying its agent's management fees on time, you can tell by the size of the management fees payable. Management fees are typically paid the month after they're earned. So you'll generally see a month's worth of management fees payable in the balance sheet. But if you see several months' fees accumulated as management fees payable, this could be a sign that the site is having trouble paying its bills and has put off paying the management fees to pay other vendors, warns Strongin. And this may not bode well for collecting your fees once you take over.
Mortgage payable. If the site is paying its mortgage on time, this balance should equal the balance due in the lender's amortization schedule, says Strongin. If not, this may mean that the site isn't paying its mortgage on time. Occasionally, there are valid reasons for late mortgage payments, such as delay of HAP payments while HUD processes contract renewals. But unexcused or multiple delinquent mortgage payments put the site at risk of foreclosure and HUD enforcement for not paying its mortgage, and generally threaten the site's ability to continue to operate, warns Strongin.
Property taxes payable. Make sure the site is paying its property taxes. Compare this year's property tax payable balance with last year's balance. If, for example, the balance has doubled from one year to the next, it may mean that the site didn't pay its property taxes for the prior year. Also, if the property taxes seem too high based on your experience, you may want to appeal them once you take over the site or possibly seek an exemption for a nonprofit site, suggests Strongin.
Operating deficit loans. If the site is more than a few years old and is still carrying operating deficit loans, this could be a bad sign. It may mean that the site's operating expenses are greater than anticipated and that the site needs money from the owner's general partner to operate. Often, when a site is first built, the owner's general partner guarantees to fund the operating deficit, but this obligation generally ends after a few years. If the owner's general partner's obligation to fund operating deficits is nearly over, or if its own financial condition is poor, this means that soon the site may not have enough cash to operate.
Other Sources of Financial Information
According to Strongin, it's also important to look beyond the balance sheet and review site records for any other financial obligations that the site didn't disclose so you don't get blindsided once you start managing the site. You can look for other potential financial obligations in leases, purchase or service contracts, and employee bonus arrangements.
Seth D. Strongin, CPA: Seth D. Strongin, CPA, PC, 704 Sharon Valley Ct., Atlanta, GA 30360; (770) 451-9998.