There are countless war stories told by real estate brokers of deals that fell apart because the buyer felt that the building's financial statement contained negative information. There is no question that it is essential to review the financial information on a co-op corporation or condo association prior to buying. However, it is equally important to create reasonable criteria for making a good evaluation. All too frequently buyers analyze financial reports on co-ops and condos in the same manner they would any other financial investment, and this is fundamentally wrong. In any other economic investment the analyzer searches for economic opportunity to create greater profit; however, in purchasing a co-op or condo apartment, economic opportunity is not an element. Rather, the analysis is oriented to ascertaining ongoing stability.
Under New York State law, every co-op corporation and condo association must issue to the board of directors, and to shareholders or unit owners, a financial report prepared by an independent, certified public accountant within four months of the end of its fiscal year. The buyer and his financial adviser have the right to review this document at any stage of the buying process. In every financial report there must be a letter signed by the accountant passing an opinion on the financial condition of the building. There are three types of opinions normally rendered.
In the "clean" opinion, the most common type of report, you will find the words: "Presents fairly in all material respects"¦" A clean opinion means that the accountant found no objections. In the "subject to" opinion, the accountant has identified some reason for concern over possible future economic exposure leading to a maintenance increase. An "except for" qualified opinion means that the accountant believes there was some element of the review where the material examined was inadequate or not satisfactory to pass a clean opinion. An "except for" scenario can include any vague item on the balance sheet - such as $20,000 for building repairs or a large sum owing from a tenant/shareholder - that can't be verifed.
In the event that a building's financial statement presents either of the two "qualifying" statements, there is reason for further investigation and review by the buyer. In many instances the reason for this qualification may turn out to be immaterial; but in some cases, if the amount of the unverifiable item is significant, it could affect the future stability of the monthly fees.
The balance sheet is a snapshot of the financial condition of the building at a specific point in time. It consists of three primary parts: assets, which is what the building owns; liabilities, which is what the building owes; and stockholder's capital, which represents the building's wealth. Assets and liabilities are segregated into current and long-term. The defining point for current is whether or not the item will be converted to cash received or paid, in the ordinary course of business, within a period of one year.
The buyer needs to look for several things on the balance sheet. Adding together all cash balances and investments including certificates of deposit, treasury bills, bonds, etc., he wants to see a balance that is approximately $3,000 per apartment. This assumes that the building displays no signs of disrepair. If the number is less than $3,000 there may be a significant risk of a future assessment.
In the accounts receivable category, which is also called "tenant arrears," you do not want to see a large number. If tenant arrears comprise five percent or more of the total annual maintenance collection revenue, there is a serious problem. In such event, there is significant risk for litigation between the co-op and the party in arrears and future assessments of residents to cover legal costs as well as the unfulfilled mortgage collection to cover operations.
The statement of operations, also referred to as the income statement, describes the flow of activity within a defined period of time, normally a 12-month period. Basically it consists of funds received and funds expended except for borrowings and purchases of assets having a useful life of more than one year. The standard is for a building to spend 25 percent on real estate taxes, 25 percent on mortgage interest and 50 percent on operating costs. However, this standard is frequently violated.
In analyzing the statement of operations, the buyer should look for a net loss for the year after depreciation. If a building is operating at a profit, it is subject to taxes and, in most instances, is being mismanaged. By taking the net loss and adding back depreciation and amortization, the building should have a positive cash flow of at least three percent of maintenance collections. A lower amount is acceptable if the reserve fund balance is significant. Normally, if a building does not adequately fund reserves on a yearly basis, it will deplete existing reserves and not be able to cover future contingencies.
The financial statement also contains notes displaying explanatory information relating to the statistical data contained in the report. These explanations are critical in order to understand what's going on behind the scenes. For example, any information on litigation will be more clearly defined in the notes. It is key for the buyer to identify if there are any special conditions relating to the underlying mortgage, the amount of the mortgage payment and the maturity dates. If a mortgage is coming due within three years, it must be assumed that the loan is to be refinanced. In such case, an evaluation must be made on the effect of this refinancing, given currently available interest rates and loan terms.
The CPA preparing the building's financial statement is responsible for identifying any subsequent event - such as reducing the mortgage or litigation - of which he becomes aware during the time of engagement, even if this event is after the date on the financial report. If there is a significant event, it will be portrayed as a "subsequent event," which is the last note on the financial statement.
When shopping for a co-op or condo apartment, a good deal is one where the maintenance charge appears stable for the long term and where increases are a function solely of general inflationary factors. There is nothing wrong with a high maintenance or mortgage. Indeed there is nothing wrong with an inadequate reserve fund. All these components are merely variables in an effective negotiation with an effective broker and a knowledgeable buyer. A good buyer will view problems in a financial report as an opportunity more than a problem.