What Affordable Housing Sponsors Need to Know About Surplus Cash

4 min read

Veteran audit manager Joe Li on the importance of this often overlooked issue

Joe Li on Surplus Cash in affordable housing developments
Joe Li

Surplus cash calculation and distribution is one of the most interesting parts of the financial statements of affordable housing entities. It determines the amount of residual cash available to make fees, distributions, ground leasing and deferred loan payments.

Surplus cash distribution and the calculation itself are important to review during an audit because:

  • Lenders, lessors, sponsors and investors eligible to receive surplus cash distributions want their fair share;
  • Certain HUD-funded entities are required to deposit surplus cash in residual receipts reserve and are subject to be recaptured by HUD;
  • Accurate surplus cash calculations are dependent on proper use of the entity’s operating and reserve funds to pay capital costs and operating expenses through the year.

These various parties rely on the audited financial statements to understand the availability and uses of reported surplus cash. Surplus cash distributions generally repay deferred loan obligations to HUD, city, county or state lending agency, ground lease to lessor, and payment of fees to sponsors and investors in the form of asset management fees, partnership management fees, incentive management fees and capital distributions.

Before distributions take place, however, the audit procedures will identify if (a) the surplus cash calculation is correct and (b) interpretation of eligible distributions is in accordance with agreements as well as the laws governing them.

Issues with Surplus Cash Calculations

Misallocation of operating cash can affect the surplus cash calculation. Operating cash covers the mortgage and operating expenses for the property while the property’s replacement reserve fund typically can pay for capital improvements and eligible repair and maintenance expenses (usually with prior lender approval). If the property uses operating cash to pay for, say, a new boiler, appliances or flooring (when such capital improvements could be covered by a reserve fund) and management is not requesting timely withdrawals from the replacement reserves (i.e., in the same year), then the operating cash may not be available at year-end for distribution.

Some lenders have policies that require funding of capital improvements only from replacement reserve. In addition, they may also disallow certain operating expenses over the approved operating budget. If management uses operating cash to pay for capital improvements without request for replacement reserve withdrawal and/or to pay for disallowed operating expenses, the amount should be adjusted in the surplus cash calculation. Such practice may result in a deficit of operating cash, as the entity is paying the larger share of remaining surplus cash to the lender and also paying the capital improvement and disallowed operating expenses.

As standard practice, the parties responsible for managing budgets, monitoring surplus cash and lender reporting (such as the asset managers of the sponsors) should review all reserve eligible expenditures and request reserve fund withdrawals for capital improvements in a timely manner. They should also monitor expenses regulated by the lender’s approved budget. Accurate and timely monthly financial statements will also help management to identify issues sooner and take appropriate steps to maintain accurate surplus cash calculation at year-end.

Interpretation of Surplus Cash Distributions

In some situations with more complex financed projects, there may be a difference in interpretation regarding the surplus cash available among lenders, ground lessor, sponsor and investors. Auditors will review all terms and agreements that regulate the surplus cash distribution, which include the partnership agreements, ground lease agreement and lenders’ loan and regulatory agreements. Agreements among various parties may not be drafted uniformly. During the first-year audit, the audit team must interpret these agreements to identify each party’s share of surplus cash distributions.

After the auditors review the various agreements, they will provide an interpretation for distributions in the footnote of the financial statements based on their best interpretation and experience with the various parties. The goal of the auditors is to formalize an approach to surplus cash distribution that will satisfy all the parties. When reviewing the financial statements in the subsequent year, a lender may sometimes disagree with the auditor’s interpretation and provide an alternative approach. The auditors will review the lender’s calculation and may refine the surplus cash distribution accordingly. The final approved approach will apply to all future audit years.

Note: Due to COVID-19, certain lenders may allow the entity to maintain the lender’s share of surplus cash to be used for other purposes. HUD also has various rounds of “COVID Supplemental Payments” available for HUD projects. Management should keep open communication with the lenders and check on the latest policies to determine a course of action.

For questions regarding surplus cash calculations or distributions, consult with your CPA and audit team.

Joe Li, CPA, is a senior audit manager with Lindquist, von Husen & Joyce, LLP

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