Posted over 1 year ago

Real Estate Finance is an Oddball

It’s hard to believe that this time last year I was taking the GMAT (entrance exam similar to the SATs) and preparing my applications for graduate school. Once I completed and submitted those applications, the next several months seemed to almost drag, as I eagerly awaited the start of classes. Yet, now I’m looking back at the completion of my first semester. I knew that time would speed up once classes began, and it certainly has.

In this article, as I look back on the past semester, one of the things that I’m reminded of is how real estate finance is unique amongst its peers.

Finance vs. Accounting

Up until this past year, I was unaware that accounting and finance were two distinct fields. They may both involve a heavy dose of numbers, but how they look at those numbers is actually quite different.

Accountants, as their name suggests, take an accounting of financial transactions, analyzing and auditing; often emphasizing the reduction of tax obligations. Finance professionals on the other hand are more focused on cash flow and a company’s overall financial health; which is needed in order to make sound business decisions.

As an example of their differing foci, an accountant wants to (legally of course) make it look like a company made as little money as possible, so as to pay less in taxes. But a finance professional wants to see more money in a company’s account, because it provides more options to purchase needed goods and services, make distributions to shareholders, pay off debt, or partake in a new investment.

On a practical level this means that the two will sometimes need to “undo” the work of the other. For example, an accountant may include the depreciation of a building. This means that you can decrease the value of the building to take into account the fact that it’s aging. When it comes to paying your taxes, you can deduct the amount of depreciation in the same way you would a business expense. The more expenses you pay over the course of the year, the less in taxable income you’ll have. Similarly, using depreciation lowers the amount of taxes owed.

That being said, depreciation is not a true expense. There is no money actually paid out, even though the IRS allows you to list it for tax computing purposes as though it were an actual expense. As a result, when a financial analyst steps into the picture they may add the amount of depreciation back, so that they have a better idea of how much money is actually available in the business.

An Absence of Standardization

Another way that accounting and finance, and real estate finance in particular, is different, has to do with standardization. Accountants use what they call Generally Accepted Accounting Principles. This assures that every accountant uses the same system or framework, making it really easy for one accountant to review the work of another.

But just as every city, property type, neighborhood, and building are unique in the world of real estate, so too seemingly, is every real estate financial report.

There are often several synonyms used for the same thing that can make reading someone else’s report feel more confusing than it should be. What one person calls effective gross income may be known as realized rental income to another person. What one person calls “property before tax cash flow” may also be known as “equity available for distribution”. If you’re not familiar with a term used by someone else, you may not realize that it’s just a synonym, and wonder if there’s something you don’t know. Other times specific line items or expenses may be laid out differently in a financial report. For example, one person may separately list variable and fixed expenses, while someone else may not. Still, someone may lump physical vacancy (empty space within a building) and credit losses (defaults in incoming rental payments) together, while another person lists them together.

Generally, with some time, patience, and practice, you should be able to decipher the work of a colleague. However, being made to take the extra time and attention to understand how someone else chose to put something together, and perhaps translate it to the format you’re more familiar with, takes time and increases the likelihood of making mistakes.

Some people may use this lack of standardization to their advantage to “hide” the negatives and emphasize the positives. It can also make it more difficult to compare the reports of two similar properties side by side, if their financial reports are not formatted the same way.

To be fair, there are certain items such as net operating income that have a generally standard definition, though just because it may be a little more standard doesn’t mean that it necessarily includes all of the important financial considerations that need to be properly examined and understood.

Comparisons between properties are often made using net operating income because it has a more consistently defined definition. But that also means that major expenses such as capital expenditures or debt financing are initially left out. Depending on what you’re looking for and how you’re using the data, you need to know when to include or omit such items. In my opinion, this is a big reason why many people find finance difficult. The answer to most questions is “it depends”.

Financial Software

Many real estate analysts will use a spreadsheet such as Excel that allows them to customize their financial reports to the unique attributes of their property. But Excel begins with a blank page, which means that everyone creates their own report and layout. This naturally feeds into the fact that everyone seems to have a different preferred style.

There are alternatives to spreadsheets, including programs like Argus Enterprise. Argus is a database program where users input data and the system generates a report. By doing this, every report that Argus generates will look the same. Comparing two different properties from two different companies is guaranteed to have the same formatting. Even if Argus doesn’t format things the way that you may be most familiar, its biggest asset is the establishment of standardization that makes it easier to compare apples to apples.

As the World Grows Smaller

The world is growing and populations are increasing, yet with technology our world is also shrinking. We can travel much more quickly than ever before in history and often we don’t even need to travel to communicate and work together with others.

Historically, when two countries or two cities were geographically distant, it was totally reasonable for them to do things in whatever way made most sense to them locally. It didn’t matter what terms, abbreviations, or styling a given city used in their reports, because only people local to that area would see those reports.

But today, you could have investors in the Pacific Northwest contributing capital to a project in the Deep South, organized by syndicators in the Mountain West, who are using a lawyer from New England, and a financial firm from a Mid-Atlantic state. If all these parties aren’t on the same page, things could get really confusing and messy. They could be talking about the same issue and not even realize it, mistakenly assume that something critical is missing, or dismiss something as insignificant, all because they don’t fully understand how things are done differently in another region.

I suspect that over time, real estate finance will become more standardized. That is, eventually we’ll come up with some standard procedures, and a common set of terms and definitions that everyone is familiar with. But until then, we need to be mindful and careful about the prevalence of such differences and ask questions, even when we think we know the answer, just to make sure that we’re all on the same page.