When someone buys a ticket for a live concert, they may think they are only paying to see musicians perform. But the musicians do not receive the full price of the ticket. On the contrary, musicians often only receive a tiny fraction, perhaps 15-20% of ticket proceeds.
A portion of the ticket price goes to the concert hall, which must pay for the chairs, desks, seating, lighting, sound system, building maintenance, stage crew and ushers. A portion of the ticket money may be given to a promoter for marketing the concert. And there are the costs of programs, flyers and advertising expenses.
Buying the ticket itself costs money. These days, most concert halls have a website with software that provides real-time seat availability, which adds to the cost of the concert. And if the spectator uses a credit card to buy their ticket, the credit company takes a share in the form of user fees.
Like buying a concert ticket, real estate investors pay more than real estate when investing in real estate. Although most of the money is usually spent on buying real estate, savvy investors need to know where their money is going. This article is part of a series on valuing real estate investments and discusses sources and uses of funds (sources and uses), focusing on real estate buyers.
What is a source and use of funds and what property needs it?
A Sources and Uses is a financial report showing where money is coming from and how it is being spent. A Sources and uses can be retrospective or prospective (a forecast).
Sources and uses generally focus on how an investor pays for real estate or a major construction project. Sources and uses generally do not include operating revenues or operating expenses. Operating income and expenses appear on the property income statement instead.
Commercial mortgage lenders generally require borrowers to provide budgeted sources and uses. This helps the lender assess whether the property will be profitable and whether the borrower will be able to repay the mortgage. For a similar reason, private equity partners also require a source and uses before investing preferred stock in a real estate investment.
The Securities and Exchange Commission’s Guide 5, which governs registration statements for real estate limited partnerships, requires a use of proceeds, which is similar to a source and uses. Guide 5 is not mandatory for private placement real estate securities. But Private Placement Memorandums (PPMs) and Offering Memorandums (MOs) for private placements still almost always have a source and uses.
In short, all investment real estate should have sources and uses. Sources and uses provide a valuable checkpoint where an investor or property manager can ensure that there will be sufficient investment funds to support property expenses not covered by operating expenses.
What is included in Sources and Uses of Funds?
A The sources and uses must list all funds available and all expenses paid from those funds.
What is a source?
Real estate investments have two primary sources of funding: debt and equity. Most real estate debt is limited to a first mortgage, but occasionally there will be a second mortgage or construction loan. Equity is the cash provided by property owners. There may be only one owner – an individual or a real estate fund. Or, there may be multiple classes of shares, such as preferred and common.
The mortgage amount is usually easy to determine. However, determining the amount of capital needed can be more complicated and requires considering the costs of obtaining capital.
There may also be cash paid by the seller to the buyer in proportion to the rent collected by the seller before closing. For example, if the closing occurs on April 15 and the seller has collected all of the month’s rent, half of that rent relates to the April portion after closing and must be paid to the buyer on the fencing. The seller must also transfer all tenant security deposits and other tenant deposits to the buyer at closing.
What expenses go under uses?
The uses of funds in a real estate investment are more complex than the sources. Yet they fall into a handful of standard categories: purchase price, acquisition costs, financing costs and reserves, working capital, and sometimes capital expenditures. For a real estate fund, there will also be fund formation and offering fees and sponsorship fees. Where there is a joint venture or private equity party, there will be costs associated with obtaining that capital.
Property purchase price: The purchase price of a property is usually straightforward. This is the price the buyer pays the seller for the good.
Acquisition costs: Acquisition fees include deed registration fees, transfer taxes, owner’s title insurance fees, survey fees, due diligence fees, attorney’s fees, initial insurance and escrow costs. Although usually the seller pays the real estate broker‘s commission, sometimes the buyer’s broker’s commission is included in the acquisition costs.
Funding costs: Financing costs include all expenses associated with obtaining mortgage financing. These costs include mortgage registration fees and taxes, mortgagee title insurance fees, lender due diligence fees, lender legal fees, entity incorporation fees (most lenders require the borrower to form a special purpose entity) and mortgage broker fees.
Additionally, most mortgage lenders require the borrower to establish reserves with the lender to ensure that funds are available to pay property taxes, insurance costs, and home repair and maintenance expenses. property. These “financing costs” are not part of the cost of acquiring the property. Instead, they will be property expenses when paid. But they should be included in the sources and uses since they represent the cash the buyer must have at closing.
Working capital: The property will need cash after acquisition to pay for the operating expenses of the property.
Security deposit account: If the buyer has received security deposits from the seller’s tenant, these must be set aside. A separate security deposit account for tenants is frequently established (and may be required by law) to ensure these funds are segregated.
Reservations: The lender will generally hold reserves for property taxes, insurance and maintenance. The buyer can constitute additional reserves for the planned renovations or the major expenses that he anticipates on the property.
Fund formation and offering fees: If multiple parties own the property through a real estate fund, there will be costs associated with setting up the fund, such as state formation and qualification fees. In addition, there will be attorney fees for the preparation of fund incorporation documents, such as the limited liability company’s operating agreement.
If a promoter has created and marketed the fund, there will be expenses, including legal fees for the preparation of the private placement memorandum and filings required under securities laws. Additionally, the sponsor will likely be reimbursed for the cost of an online website, data room, or investor portal associated with the offering, and there may be brokerage commissions or advertising costs.
Sponsorship fees: The fund sponsor will generally receive an acquisition commission based on the purchase price of the property. Sometimes a sponsor will also earn a finance fee for arranging the finance or a guarantee fee (if the sponsor guarantees the loan). To learn more about sponsor compensation, read my previous article in this series on sponsor compensation.
Prepare sources and uses
Sources and Usages signed at closing are prepared in the last week before closing. Although the buyer will have their own sources and uses, since funds flow between the buyer, seller, and title company, these parties will also be involved in preparing the sources and uses.
However, the buyer must think about Sources and Uses in his acquisition budget at the beginning of the transaction and must update it as the transaction evolves. This internal budget can be a checklist for closing Sources and Uses. And by considering “uses” up front, the buyer can ensure they have enough “sources” of cash at the closing table.
This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.