May
30

‘Tis the Season: Coop Financial Statements Released in May Part 2 of 3

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In Part 1, we discussed the General Principles of a Coop Corproation and the Telltale signs of a GOOD Building.  This post will discuss what to look for in Coop Financials.

Basic Items to Focus on in a Cooperative Financial Statement
  • Liquid Assets.
  • Underlying Mortgage(s).
  • Total Income
    • Maintenance Income
    • Miscellaneous (Other) Income
  • Total Expenses.
  • Income from Operation before Depreciation.
  • Income from Operation after Depreciation.
  • Notes to the Financial Statement.
Liquid Assets
  • Cash and cash equivalents. These constitute money that can be spent irrespective of prepaid items and mandated escrow funds. Cash typically exists in a in an operating account, savings account or is designated as a reserve fund.
  •  A building’s cash accounts should equal at least 2-3 months’ maintenance charges.
Underlying Mortgage(s) 
  • The overwhelming majority of coop corporations have an underlying mortgage as well as a subordinate mortgage. The latter generally appears in the form of a credit line that can be drawn upon as need presents itself.
  • Underlying mortgages are generally 7-15 years in length with the final payment in the form of a balloon payment. These mortgages are considered commercial mortgages and are subject to higher interest rates than found in a conventional mortgage and are subject to pre-payment penalties. Additionally, mortgages of this type are commonly interest-only mortgages and seldom self-amortizing mortgages.
  • When the purchaser of a coop applies for a mortgage, the lender needs to ascertain to what extent the purchase price of the unit relates to its pro rata share of the underlying mortgage. Most often the pro-rata share of the underlying mortgage is usually less than 20% of the purchase price, and in such case, there is no resistance from a lender to lend.

To determine the pro rata share of the underlying mortgage: divide the amount of the underlying mortgage by the total number of shares issued which equals the amount of mortgage per share and multiply that number by the number of shares allocated to the unit in question.

For example:

$8,000,000 (underlying mortgage) / 22,000 (total shares) = $363.63 per share x

147 (unit’s shares) = $53,454 (pro rata share of the underlying mortgage)

$53,454 / $650,000 (purchase price) = 8.22%

Total Income
  • Maintenance income is sometimes referred to as rental income. It represents the sum of money paid to the corporation by the shareholders. Maintenance can be stable, it can increase from year to year, and in some instances, it can go down.
  • A maintenance increase of up to 5% over the previous year would be considered normal whereas an increase in the vicinity of 10% would be considered high; however, every maintenance increase must be looked at within the context of the overall financial condition of the building.
  • Miscellaneous income is income received from non-maintenance sources such as assessments, tax refunds, interest, dividends, flip taxes, proceeds of un-sold shares, commercial income, and laundry income. In most instances, income from non-maintenance sources should not exceed 20% of a building’s total income otherwise it will be a breach of the 80/20 rule and create a tax consequence for the building. In some instances where a building is receiving too much miscellaneous income, it has become necessary for the building to increase their maintenance to comply with this rule.
    • In the past year or two, the 80/20 rule has been made more flexible to allow exceptions to the rule if certain conditions exist. One such condition would be when no more than 20% of the building is allocated to non-residential occupancy, the building may receive more than 20% of its income from miscellaneous sources.
Total Expenses
  • This is the sum of money the coop spent for such items as debt service, utilities, repairs, insurance, service contracts, real estate taxes, management fees, legal fees, and salaries etc.
Income from Operations before Depreciation
  • This is the difference between total income and total expenditures. Ideally,the total income should be equal to or slightly more than the expenditures. Realistically, the income flow might be slightly more or less than the expenditures.
  • The significance of a negative cash flow before depreciation must be assessed in relationship to the existing maintenance level, the level of cash assets and the anticipated need for additional income. A negative cash flow of 5% or more would cause concern if it were the result of normal expenditures and not an extraordinary event. At times a coop may purposely budget a negative cash flow in order to absorb substantial cash reserves, and in doing so, would eliminate the need for a maintenance increase which might have a negative impact on values.
Income from Operations after Depreciation
  • Income after depreciation is a “phantom number” and has no significance as long as it remains a negative. Should it be a positive number, the coop will be liable for federal income taxes.
Notes to the Financial Statement
  • Pay notice to any items that might impact the coop’s need for additional cash flow or asset accumulation such as:
    • Terms of the underlying mortgage(s).
    • Land lease escalations.
    • Rental income variances.
    • Tax liabilities.
    • Late shareholder payments.
    • Assessments.
    • Capital improvements.
    • Impending lawsuits.
Miscellaneous Items
 Sponsor Ownership
  • Ideally, a low percentage of sponsor ownership is preferable to a high percentage of sponsor ownership. The latter places the possibility of a material default in the hands of a single shareholder and restricts or even inhibits a bank’s willingness to lend in the building.
  • In cases where a sponsor or investor entity owns 10% or more of the shares, New York City mandates that such entity provide an annual affidavit that illustrates the differential between the rental income received (if any) and the maintenance due on the units in question.
  • Other issues aside, the essential concern of shareholders is “Does the sponsor pay his maintenance in a timely manner?” The answer to this question is yes in 99% of the situations.
Future Repairs
  • Coops seldom conduct a study to determine the remaining useful lives of the building’s systems and major components. Additionally, coops are seldom required (if ever) by their governing documents to accumulate funds in advance of the need of such repairs.
Ground Rent
  • Ideally, it is better for a coop to own its land rather than to have to lease it. Leasing land is never a positive situation but not necessarily the reason to forgo purchasing in such a building. When evaluating a land lease building; notice the remaining term of the land lease, rent escalations, and renewal options. Pay particular note to when the property is going to be re-appraised for purposes of determining future ground rent.
  • Land lease buildings do not necessarily have high maintenance charges, although they usually do.
  • Land rent does not contribute to the tax deductibility of the maintenance.
  • A “too short” land lease term (15 years or less) with no renewal option would severely impact the values of units in the building. In such an instance, a unit’s value could be defined as the difference between the fair market rental value, less the maintenance charge, multiplied by the number of years remaining on the land lease.
  • It is always advisable for a purchaser to have an attorney review the land lease prior to signing the contract of sale.
Obtaining Updated Information from the Managing Agent
  • Most financial statements reflect the state of affairs on December 31st of the preceding year. Such statements are usually issued between March and May of the following year.
  • It is advisable to obtain updated information with regards to maintenance increases, assessments, and capital improvements when the purchase is to be made between June and December, otherwise, the buyer would be relying on information that is 6-12 months old.
High Maintenance / Low Maintenance
  • Too often, buyers and brokers are apt to state an industry standard for the cost of maintenance in terms of $X.00 per square foot. This way of thinking is erroneous because there are many variable items that comprise maintenance and the amount of people that share in these expenses varies from building to building. For example: a building with 250 shareholders has the same expense for a 24-hour doorman as a building with 25 shareholders.
  • Other variables include:
    •  Terms of the underlying mortgage: amount, interest rate, interest only payments vs. amortized payments, amortization term.
    • Improved building systems versus the status quo.
    • High service versus low service: concierge, elevator operator, lobby attendants, handymen, porters, resident manager.
    • On-site amenities versus no amenities.
Reserve Fund

The lack of a reserve fund, or cash cushion, is not necessarily a negative condition. Having money in reserve is relative to the need of having money in reserve. If there is high need, then a reserve fund is important. If there is low need, then a reserve fund is not as important.

Additionally, money can only be accrued if the coop takes measures to create such a fund from the following sources:

  • Positive cash flow (income over expenses prior to depreciation).
  • Assessments
  • Cash-out refinance of their underlying mortgage,
  • Secondary financing or credit line.
  • Flip taxes.
  • Sale of un-sold shares (if any).
Assessments
  • Assessments are a viable means to create needed cash to pay for improvements or supplement cash flow in lieu of increasing maintenance or borrowing money. Assessments tend to be considered single events (sometimes ongoing) in which case they are less likely to inhibit values as does “too high” maintenance frequently does.
  • Unlike a maintenance increase, an assessment accrues towards the building’s cost basis and in doing so adds favorably to the building’s ability to depreciate against income.
  • Many coops choose not to accrue such funds until the actual need for such funds arises. Coop documents typically do not impose mandates on the accrual of such funds.

In Part 3 we’ll discuss Assessing a Coop’s Financial Condition.

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