Real Estate Syndication: Beware of Red Flags in Income Statements
You’ve invested as a passive investor in a real estate syndication. Distributions roll in every quarter, and income is outperforming the sponsor’s projections. This reminds me of the 1980s television series “The A-Team,” when the character Hannibal used to say, “I love it when a plan comes together.”
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Maybe the plan is coming together. Or maybe this is more like the 1980 movie “Airplane!,” where Dr. Rumack, played by Leslie Nielsen, repeatedly entered the cockpit and told Ted Striker, “I just wanted to say good luck and we’re all counting on you,” as the untrained Striker was struggling to control the pilotless plane.
How do you know if your investment plan is coming together or if you are just flying to the scene of the crash?
Many passive investors confuse distributions with performance, so if the distributions are coming, the plan is coming together. Bernie Madoff’s investors probably thought that, too.
But by now we’ve surely learned that distributions and investment performance are two completely different things.
Distributions & Performance as Distant Relatives
It’s entirely possible for the real estate investment to be performing just fine, but there are no distributions at all. Such could be the case in a deep value-add deal where everyone knew going in that the cash flow would be thin for the first year or two.
Another example might be a long-term hold that needs a major capital improvement, such as a new roof, and extra cash flow needs to be set aside for that purpose. Even though the income is fine, distributions are affected, at least for the short-term.
But is it possible for distributions to be made when performance is suffering?
Not only is it possible, it happens—and you might not even be aware of it. In my previous article “Real Estate Syndication: What Is a Preferred Return?,” I covered a practice where sponsors make distributions in excess of the property’s cash flow and outlined the reasons (right or wrong) why they may do so.
But there is another top-secret trap that syndication sponsors can use to mask a property’s true performance from their unsuspecting audience. Before I tell you what it is, let’s lay a foundation first.
Different Ways to Count Money
There are two different methods of accounting: cash and accrual.
Cash accounting is simple. If you collect $1,000 in rent, you have $1,000 in rental income and a $1,000 bank deposit.
There is also a concept in accounting called “double entry.” This means that a single transaction has two accounting entries. In this example, $1,000 to income and $1,000 to cash. You not only know what the money was for (rent), you also know where it went (bank).
Accrual accounting isn’t as clear-cut, and you guessed it, most commercial real estate operations use accrual accounting. There are more reasons for it than just giving you a headache, but that’s not important right now (another “Airplane!” movie reference).
In our cash accounting example, we collected $1,000 rent (one transaction) and made two accounting entries. In accrual accounting, this would require two transactions and four accounting entries.
Here’s how that works: On the date that rent is due, let’s say the first of the month, an entry is made for the rent that is due. This is one transaction, and the two entries are $1,000 to rental income and $1,000 to accounts receivable. Accounts receivable is a parking place—somewhere to keep track of an exchange that isn’t complete yet. The rent was charged but hasn’t yet been paid, for example.
Now let’s say that the resident pays the rent on the fifth. This is the second transaction, and the two entries are $1,000 to the bank and $1,000 is deducted from accounts receivable.
But what if the resident doesn’t pay the rent? What happens then?
The Trap Door
While some passive investors gauge their investment’s performance by the distribution they receive, many sophisticated investors investigate further, examining the income statement and looking at the property’s gross income, expenses, and net income. That’s a good first step, but this is also where the trap door opens.
Remember our accrual sequence?
The rental income is booked on the day that rent is due. Look at the income statement, and you’ll see the rental income, no matter what. If the rent was never paid, the rental income will still show up on the income statement.
If rent isn’t paid, a second accrual accounting transaction should still take place, but this is sometimes overlooked or just plain ignored. Once it is obvious that rent is uncollectable, such as after an eviction has been completed, the uncollectable rent should be reversed by subtracting the unpaid rent from accounts receivable and allocating it to bad debt loss.
Bad debt loss shows up on the income statement as a deduction from gross income, meaning the property’s income is reduced by the amount of rent that was not collected. If you do not see any bad debt loss on the income statement, it might be possible that the sponsor is overstating the property’s income by not charging off uncollected rent.
To find out, take a look at the balance sheet.
Look for a line-item called “accounts receivable” or “rent receivable.” By itself, the dollar amount shown for accounts receivable tells you very little, because there will likely always be a balance due from someone.
Now look at the balance sheet from the previous quarterly report. And the one before that. And the one before that. Does the amount in the accounts receivable item continuously grow larger from quarter to quarter? Fluctuations are normal, but a steady climb that does not subsequently fall is a problem.
If you see this, it is likely that the sponsor is stacking up bad debt on the balance sheet and not writing it off as bad debt. What this means is that the income statement is showing more income than is actually being collected. If you look only at the income statement, you’ll think that the property is performing better than it is.
If you suspect this is occurring, you can ask the sponsor for a “Receivables Aging Report.”
An aging report will show you how much of the “receivables” are from the current month, how much of it is over 30 days late, how much is over 60 days, and how much is over 90 days. If there is a very large amount of delinquency over 90 days, that is another clue that the sponsor might be stacking bad debt on the balance sheet and overstating the property’s performance on the income statement.
The good thing about being a passive investor in a real estate syndication is you get to invest in real estate without all the hassle. The bad part is that the syndication sponsor can hide things from you. Your best defense is to carefully review your reports and stay aware of what is going on.
Watching the bad debt is one thing you can do to ensure that the investment is performing as you think it is.
Let’s discuss below.