Audited Financial Statements for Co-op

Many buildings in the New York City area (particularly co-ops) get their financial statements audited and produced by an independent CPA on an annual basis. The purpose of this audit is to add some legitimacy to the financials being reported to the shareholders of the building. This report is usually between 17 and 25 pages and normally contains the following information described below. George Dimov, CPA has worked on over 100 audits of luxury Manhattan co-ops and condos.

• Cash balances (reserve fund)
• Performance of investments in investment accounts
• Due to/from accounts between buildings or between co-op and condo portion of building
• Performance of building vs. budget
• Assessments for repairs, taxes, etc
• Discussions related to conversion from oil heating to gas heating
• Legal cases the building may be involved in
• Mortgage maturity
• Line of Credit information and other loan amortization information
• Auditor’s opinion
• Expenses for utilities and general trend in utility prices
• Condition of portions of the building and possible capital expenditures
• Status of important leases of commercial space, such as retail storefronts and restaurants operating within the building
• Real estate tax assessments and potential disputes of assessed taxes
• Issues related to the super’s unit
• Real estate tax abatements for certain shareholders
• Large delinquent balances from tenants/shareholders
• Use of escrow accounts

Cash balances:

This describes the reserve fund of the building and the amount of money available to pay utilities, taxes, capital projects, and other operating expenses. The expenses for seemingly normal items can be a staggering portion of a building’s budget. I have seen $600,000 of electrical expenses in one invoice, as well as million dollar plus real estate tax bills. It is important to maintain a cash balance and compare that to the typical spending of a building. This should be a component of the annual budgeting process of a condo or co-op. The budget makes estimates as to the operating and capital costs of a building and attempts to determine if a maintenance increase will be required of the tenants/shareholders.

Performance of investments in building brokerage accounts:

Many buildings have funds that they would like to earn some interest and dividends on. In the current interest rate environment, it is increasingly difficult to find traditional “safe” investments for the building’s reserves. For this reason, many buildings choose to have investment accounts at common brokerages, some of which are actively managed. I have worked on buildings that have a half-dozen brokerage accounts which receive monthly statements from Merrill Lynch and other brokerages. These gains/losses from realized security performance are then booked on the building’s 1120 return and shown as income/losses on the building’s financial statements.

Due to/due from balances between condo and co-op:

This applies to buildings that have a condo portion and a co-op portion. In such buildings, there are two legal entities operating under one roof. The distinction is that co-op owners are “shareholders” in a building and thus own ownership “shares” of their building. Condo owners (condos typically cost more) own their unit outright and are less dependent on board approval or the whims of a board.

In these cases, one entity may pay expenses on behalf of another, frequently causing an accumulation of due to/from balances between the entities. A common example has to do with utilities spending out of one particular operating account. For example, the co-op portion may have an operating account which they use to pay all of the electric and gas to Con-Edison for the whole building. However, this includes a portion that is the responsibility for the condo to pay. This will create a “due from” increase in the books of the co-op and a “due too” increase in the books of the condo.

It is very important to keep careful track of these balances – I have seen instances where one entity is having trouble meeting cash needs for basic repairs and maintenance because their entire operating account is drained from making large utility payments.

Performance of building vs. budget:

Each year, a budget is created by either the building’s treasurer, board, property management company, or accountant (or a combination of these entities). This budget is approved by the board and is used to plan cash expenditures for the following year (some buildings plan a few years ahead, if there are capital projects). Typically, monthly/quarterly financial reports will show how the building is doing vs. budget. This information is used to guide the building’s board on how to allocate expenses to avoid a cash shortfall. The performance of the building vs. the budget is sometimes mentioned in the footnotes to the audited financial statements and can be an indicator of the health of the building and the competence of its management.

Assessments for repairs, taxes, capital projects, additions, retail space, etc.:

There are quite a few reasons why a building may need to increase its maintenance charges to tenants. One reason is general inflation and increase in the salaries of the doormen, super, handymen, porters, etc. These increases can be expected. There are, however, also instances where one-off occurrences can trigger a call of a “special assessment.” This can happen when a building has aging infrastructure and needs to replace capital items. A capital assessment will occur in order to raise funds for large-scale repair of a roof, for example. Another type of assessment may be necessary to convert the building from oil/fuel use for heat to a gas system. These conversions can cost $300k or more, so reserves may need to be replenished if a building chooses this option. An interesting situation is described related to this in the next paragraph.

Capital projects may be necessary to renovate a commercial space, for example. I had a building once that had a long-term low-cost tenant was leaving the building as their lease had expired. The market rent was five times larger than what they were paying, and the decided to leave. The building (located in the UES) took this as an opportunity to search for high-margin tenants. The entire area in the Upper East Side was experiencing a transformation where many of the luxury department stores normally found in the east 50th (think Gucci, Prada, Louboutin) were opening branches uptown to serve portions of their client base. The building seized this opportunity to lease out the space for over $170 thousand per month. The prior lease was only $20 thousand per month. and took out a multi-million dollar loan and issued a special assessment to finance the upgrade of the retail space. The increase in rent revenue was then used to both pay off the revolving line of credit as well as curb future maintenance increases to the tenants.

Discussions related to conversion from oil heating to gas heating:

There was a period of price-rises in fuel, which triggered many Manhattan buildings to convert from burning oil for heat to using gas, as it was thought that this would be a lower-cost option and would “pay for itself” after five years due to savings in fuel. There were also some tax breaks and incentives involved. However, some unlucky buildings found themselves in a situation where their cost savings were eliminated due to the sharp drop in fuel prices in 2014 (see chart below). Therefore, their entire “break even analysis” was rendered obsolete, and buildings were stuck with loans and large expenses related to the gas conversion project. There are still, however, other types of conversions that may or may not produce favorable results.

Legal cases the building may be involved in:

Sometimes, a building is involved in a lawsuit. Footnotes to financial statements, according to Generally Accepted Auditing Standards, should include a portion discussing potential positive or negative outcomes to a lawsuit. Some examples include litigation related to noise from nearby construction sites, damage from explosions or other accidents related to nearby construction sites, right-of-way issues, and disputes with the city related to city property vs. building property. The likeliness of a loss and large financial settlement should be included in the footnotes, as this is information that is relevant when reviewing financial statements. However, due to the principle of conservatism in accounting, any likely settlement wins should not be reported in the footnotes.

Mortgage maturity:

A building may be built on top of land that has a mortgage. This mortgage may mature soon, at which point it will need to be refinanced. There are some costs associated with the refinancing, but this process is nothing to worry about. However, details regarding the mortgage maturity, legal fees, and interest rate paid may be discussed in the notes to the audited financial statements.

Line of Credit information and other loan amortization information:

The building may have a revolving line of credit used to finance capital expenditures or short term deficiencies in operating cash flow.

Auditor’s opinion:

Each audit is issued along with an opinion by the auditors whether the financials represent accurately the the co-ops financial position within Generally Accepted Accounting Principles. There are four types of audit reports: Unqualified, Qualified, Adverse, and Disclaimer. A “clean” opinion is one that is unqualified – no material misrepresentations were found. This is the type of opinion that you want your statements to have. I have worked with property management companies in the past that did not make certain information accessible to the auditors – when this happens to a material extent, a clean opinion cannot be issues.

Expenses for utilities and general trend in utility prices:

The footnotes of the audited financial statements may discuss utility costs, possible conversion projects, and possible strategies being implemented to address utility issues

Condition of portions of the building and possible capital expenditures:

There are non-numerical issues that must be discussed in GAAP-compliant financial statements in order for them to accurately represent the true financial position of the building. Some of these were mentioned earlier in the article and include large pending lawsuits, possible compliance issues, etc. Large projects looming in the not-too-distant future may have a substantial effect on cash reserves and should be planned for accordingly. One strategy to address is is capital assessments, where the maintenance expense for each tenant is increased and funds are placed in an escrow account. Another strategy, if the building is flush with cash, is to start making monthly installments into an escrow account that will be used for this purpose. Large property management firms in New York City, such as FirstService Residential and AKAM know to set up escrow accounts and encourage this for their clients. Escrow accounts can be set up for Real Estate Taxes, as well, and will be discussed further in this article.

Some examples of possible capital expenditures include: roof replacement, boiler replacement, window replacement, renovation of common areas, sidewalk replacement, basement work, electrical overhaul, etc. Such projects should be mentioned in the footnotes of the condo/co-ops audited financial statements and budgeting strategy should be discussed.

Status of important leases of commercial space, such as retail storefronts and restaurants operating within the building:

Pending expiration of leases are important – if a large tenant is leaving, this can affect the cash situation in a building. Some buildings greatly rely on commercial tenants occupying the retail portion of the Manhattan co-op/condo. The footnotes to the financial statements should mention pending lease expiration if such events are deemed to be material to the building. On a side note, any building expecting events like this should begin searching for an agent or other strategies to fill the commercial space.

Other times, a lease expiration may be time to celebrate. Certain leases that were negotiated years ago now fall heavily below market in New York, which means that the next lessee may bring in far more money to the building. Again, as previously mentioned, positive comments in the financial statements should be suppressed out of the principle of conservatism in accounting.

Real estate tax assessments and potential disputes of assessed taxes:

Real estate tax bills for Manhattan buildings may be in the millions of dollars. Missing a payment can accrue thousands of dollars in penalties. It is extremely important that you know your BBL (building block and lot) and that you check how often the taxes are due. These taxes are due twice per year for buildings of a certain tax amount. I have seen penalties in excess of $18,000 for failure to pay these taxes, which were incurred after only several days late. Real estate taxes can be such a large portion of a co-op’s budget that they must be planned and escrowed for. I recommend having an escrow account where funds are deposited on a monthly basis to plan for these tax payments. Look up your BBL history and the planned increase percentage of assessments and then use this information to plan for next period’s real estate tax obligation.

Issues related to the super’s unit:

Many buildings have a super’s unit within the building. However, some Manhattan Co-ops and Condos have found an arbitrage opportunity using the super’s unit. This has to do with the market rent that can be received from renting out the super’s unit and then placing the super in a nearby, less-expensive building at a much lower rent than can be received for the original super’s unit. For example, I have had luxury buildings that make $6,000 per month renting out their super’s unit, then pay only $3,400 per month for a nearby apartment for the super. This sort of activity may be mentioned in the notes to the audited financial statements.

Other issues related to the super’s unit include renovations to super’s unit, expenses associated with the super’s unit, real estate tax obligations, etc.

Real estate tax abatements for certain shareholders:

There are several programs that decrease real estate tax obligation for certain units within a co-op. There include the STAR exemption, the veteran abatement, senior citizen programs, J-51 exemption, 420c, 421a, 421b, 421g. These have the effect of decreasing New York City real estate tax obligations due and should be budgeted for accordingly. Some are subject to a phase out, so updated numbers should be obtained from the city for you BBL each year. These phase-outs are unlikely to be a material component of a building’s finances, so it is unlikely that this discussion will make its way to the audited financials, but it is worth mentioning here.

Large delinquent balances from tenants/shareholders:

Some buildings have large accounts receivable issues related to delinquent clients. These issues may be accompanied by a lawsuit seeking to obtain these funds. Large accounts receivables can signal several possible problems with a building. Having a large amount of non-paying tenants can obviously affect the financial health of the building and place strain on the other tenants to meet the building’s financial obligations.

Large A/R balances can signal other problems: your property management firm may be at fault. Accounts receivables departments at some of the largest property management firms are notoriously disorganized, mired with high turnover and low motivation. Balances are sometimes miscalculated or not billed appropriately. Funds received are sometimes not posted to the correct account. If there are issues with accounts receivable at the property management firm and the tenant is billed incorrectly, they may not be paying this billed balance and may be in the process of a dispute. It is important that the property management firm or outsourced accounting firm is properly managing receivables and properly posting payments. Late fees may be assessed on shareholders/tenants posting late payment. Also, sometimes tenant expenses are paid by the owners from overseas accounts, which may cause confusion in the back office as employees attempt to match up unrecognized information to tenant bills.

Discussions related to the property management firm employed, accounts receivables issues, and other tenant payment issues may be discussed in the notes to financial statements, if significant.

Use of escrow accounts

Escrow accounts are important to planning for large capital expenditures, cold winters that may necessitate higher-that-average spending for heat-related costs, large real estate tax payments, settlements for large lawsuits, etc.

Income from non-tenant sources:

Some buildings receive income from sources entirely unrelated to the management of the building. Such sources include movie income, interest income, income from rental of space for laundry units / vending machines, rental of vacant units, etc. Movie income occurs more often than you would imagine, especially due to the volume of movies being filmed in New York and the historial significane and architecgural appeal of certain buildings. These movie fee income checks can be substantial for very minimal time spent in the lobby or common areas of the building.

Many buildings have an agreement with a third party for laundry facilitates within the building. These contracts may include profit sharing, where all income generated from the machines after a certain base amount is split between the building and the company that services the machines. This applies also to other types of vending machines within the building.

George Dimov, CPA is available to consult on any of these topics and can send sample audited statements upon request from george@dimovtax.com