The Art of Budgeting

Preparing this critical tool for the upcoming year is an exercise in forecasting incomes and expenses

What is most important for investors in any apartment budget is the cash flow generated from the apartment property. Indeed, cash flow—the bottom line after expenses, debt service and taxes have been deducted—is a key indicator for investors.  “The investor always goes to the second page, bottom right,” quips John Moritz, co-president of Countryside Asset Management Corp., a 30-year-old asset management company in Boulder, Colo.

The art and science of the asset manager lies in making that number as accurate as possible so that asset managers can monitor the property’s performance against a benchmark in the new year, property managers will not spend beyond the asset’s means, and the investors have the right information to make their investment strategy decisions.  As such, budgets are a critical tool for a variety of players in any apartment investment.

“The budget tells many different stories to different people—the asset manager, the on-site manager and the investor,” comments Moritz. With the completion of the budget, property managers will know how much money they have available for expenses, and what rent and occupancy level targets they should strive to achieve. And cash distributions to investors and asset values can be calculated from the net operating income numbers.

The elements of an apartment property budget can incorporate a combination of income/expense, balance sheet, cash flow, and capital improvement plan statements. The budgets adhere to Generally Accepted Accounting Principles (GAAP) standards, and may also comply with various industry standards such as the Real Estate Information Standards (REIS) if the apartment property is being asset-managed for institutional investors. Normally, the apartment property budget will show the projection for the following year’s expected income, as well as expense, net operating income, pre-tax income, cash flow and needed capital improvements outlays.

Process of budgeting

Asset management companies often start preparing their budgets in September. “This is when we collect the bulk of the information. The process is completed by October or November,” says Joseph W. DeMatteo, president of JDM Capital Corp., a New York-based real estate investment, asset management and special servicing company. For JDM Capital accounts, the bulk of the information, both macro and micro, is collected in September, and the preliminary budget is completed by October and finalized by November.

Asset managers stress the importance of close collaboration with personnel at the operations level in the process of budget preparations.  For Countryside Asset Management, the budgeting process for the new year begins by getting together with the on-site property managers. “In September or October, we start asking our on-site staff to write down the necessary improvements to keep the property in tip-top shape,” says Moritz. “We then bring property managers and the owners together, and we sit down to talk about what is needed to meet the expectations of the owners.”

To determine the income and expense items for the following year’s budget, some asset managers may use the past year’s numbers. But Kensington Realty Advisors Inc., Chicago, a SEC-registered investment advisor that provides investment management services to institutional investors, prefers to begin the process with a “zero-based” budgeting concept, says asset manager Kelley J. Smith, principal at the company. “We take a fresh, brand-new look at the property every year, as opposed to relying on past performance,” says Smith. “We are trying not to be complacent and saying, ‘That’s what we did last year, and that is what we’ll do this year,’ without maximizing the numbers.”

Income and expense

In determining the income line items, Kensington Realty Advisors begins with the rent rolls for the latest month, that is, August of the current year, and projects forward from there. The occupancy levels and rental rates projections are determined on a month-by-month, unit-by-unit basis. Rather than averaging the rental rates, Smith achieves a unit-by-unit projection based on unit types, with consideration given to projected leasing rates, renewal rates and rent levels for different unit types. To determine the forecast numbers, future economic conditions, market activity, seasonal fluctuations and renewal probabilities are taken into account.

Using operating history, existing expenses are generally easier to forecast than income. “If you have a familiarity with the property, you can make a pretty good forecast on what the operating expenses of a property will be,” explains Moritz. Very often, asset managers also take this opportunity to renegotiate or re-bid the contracts to obtain lower prices from vendors.  “If we can make deals including three or four properties, we can generally obtain better prices for everyone,” notes Moritz.

In forecasting the expense line items, asset managers also need to forecast the capital improvement needs for the next year, and this task can be tricky. Countryside Asset Management generally conducts a “Component Analysis of Assets.” The asset manager goes through the capital components of the apartment property, such as the HVAC
system, roofing, exterior and pavement, and determines how much capital needs to be set aside for that item in preparation of it becoming obsolete.

As an example, if the roof is supposed to last 20 years and there are 10 years left of its life expectancy, the asset manager will calculate how much is needed to be set aside per unit each year in reserves to prepare for that capital improvement, says Moritz.

Market forecast challenges

“Budgeting for capital expenditures ultimately depends on the strategy and positioning of the property in its respective market,” Smith says. And, during the year, in the rare event a capital expenditure need occurs that was not accounted for, the investors will have to be brought in to invest additional equity for that item, says Smith, who advises that the asset manager would always want to be “cognizant of not putting in more capital expenditure items than the property is worth. … You are investing in order to provide an investment income. You are looking to maximize income and also value,” she says.

One of the primary challenges in preparing a budget for apartments in the current economic environment is the difficulty in predicting the rental income, and in budgeting to maintain the property and its customers in the face of weak rental collection expectations, especially in struggling markets such as those in the Midwest. When occupancies and revenues are hit, it is harder to sustain the lifestyle of the property, notes JDM Capital’s DeMatteo. DeMatteo calls such difficult situations facing apartments “tsunami scenarios,” in which macroeconomic factors are overwhelming otherwise well-run properties in good condition.

“Macro-economic factors are really a weight on everyone’s shoulders,” says DeMatteo. “Increases in job losses, unemployment levels and defaults lead to a rise in rent collection issues. Now the property will be hit with rent and performance issues. Lower tax collections will also place more pressures on states and counties and the services they provide. And you will also have a much more complicated exit scenario and turnaround plan.”

It is important, adds DeMatteo, to adhere to a schedule of reviewing the budget every month or every quarter in order to proactively manage the asset. For example, if the quarter-to-quarter or month-to-month occupancy is trending down, “you need to understand how and what your competitors are doing. And you need to look at what their occupancy rates are today—not 2008 numbers,” notes DeMatteo, who also monitors actual billed versus collected rents. “If billed rent is $100, but $60 is collected, there is a problem,” he says.

Investors seek returns

In the preparation of any budget, what is most important for investors is the property income and value for the property. Investors always want to know first what the current performance is, and second, that the investment is secure, says DeMatteo. Cash flow provides an indicator of current performance, and year-over-year performance tells the story about the security of the asset.

Additionally, investors are also often interested to know the cap rate for the market, which will enable them to calculate the value of the property. Accrual accounting enables the budget to take into account expenses for the year that may be paid the following year, in order to more accurately reflect the income/expense for the year. However, Smith says her company also prepares a cash flow statement, primarily for the purpose of enabling a calculation of the cash distribution to investors. At the end of the day, the more accurately income and expenses have been projected, the more reliable that number will be.

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