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Evaluating Real Estate Investments – Buyer Sources and Uses of Funds – JD Supra

When someone buys a ticket to a live concert, they may think they’re just paying to see musicians perform. But musicians don’t receive the entire ticket price. Rather, the musicians frequently receive only a tiny fraction, perhaps 15%-20% of the ticket proceeds.

Some of the ticket price goes to the concert hall, which has to pay for chairs, music stands, seating, lighting, sound system, building maintenance, stage crew, and ushers. Some of the ticket money may be paid to a promoter for marketing the concert. And there are the costs of programs, flyers, and advertising expenses.

Buying the ticket itself costs money. Nowadays, most concert venues have a website with software that provides real-time seating availability – all of which add to the cost of the concert. And if the concertgoer uses a credit card to buy their ticket, the credit company takes a share in the form of a use fee.

Like buying a concert ticket, real estate investors pay for more than just real estate when they invest in real estate. Although most of the money usually goes to purchase real estate, savvy investors should know where their money is going. This article is part of a series on Evaluating Real Estate Investments and discusses sources and uses of funds (Sources and Uses), focusing on real estate purchasers.

What is a Sources and Uses of Funds and What Real Estate Needs It?

A Sources and Uses is a financial report showing where investment money is coming from and how it is spent. A Sources and Uses can be retrospective or prospective (a forecast).

Sources and Uses usually focus on how an investor is paying for real estate or a major construction project. Sources and Uses typically don’t include operating revenue or operating expenses. Operating income and expenses instead appear on the real estate’s income statement.

Commercial mortgage lenders usually require borrowers to provide a budgeted Sources and Uses. This helps the lender evaluate whether the real estate will be profitable and the borrower will be able to pay back the mortgage. For a similar reason, private equity partners also require a Sources and Uses before investing preferred equity 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 Sources and Uses. Guide 5 isn’t mandatory for private placement real estate securities. But private placement memoranda (PPM) and offering memoranda (OM) for private placements still almost always have a Sources and Uses.

In short, all investment real estate should have a Sources and Uses. The Sources and Uses provides a valuable checkpoint where an investor or property manager can ensure that there will be adequate investment funds to support property expenses not covered by operating expenses.

What’s Included in a Sources and Uses of Funds?

A sources and uses should list all available funds and all expenses paid from those funds.

What Are Sources?

Real estate investments have two primary sources of funds: 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 contributed by the real estate owners. There may be only one owner – an individual or real estate fund. Or, there may be multiple equity classes, such as preferred and common.

The amount of the mortgage loan is usually easily determined. However, determining how much equity is necessary can be more complicated and requires considering the costs of obtaining the equity.

There also may be some cash paid by the seller to the buyer as prorations of rent collected by the seller before the closing. For example, if the closing is on the 15th of April and the seller has collected all of the rent for the month, one-half of that rent relates to the portion of April after the closing and should be paid to the buyer at closing. The seller also should transfer any tenant security deposits and other tenant deposits to the buyer at closing.

What Expenses Go Under Uses?

Uses of funds in a real estate investment are more complex than sources. Still, they fall under 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 also will be fund formation and offering expenses and sponsor fees. When there is a joint venture or private equity party, there will be costs associated with obtaining that equity.

Property Purchase Price: The property purchase price is usually straightforward. It’s the price the buyer pays the seller for the property.

Acquisition Costs: Acquisition costs include deed recording fees, transfer taxes, owner’s title insurance costs, survey costs, property due diligence expenses, attorney fees, initial insurance costs, and escrow fees. Although usually the seller pays the real estate broker commission, sometimes there also will be a buyer’s broker commission included in acquisition costs.

Financing Costs: Financing costs include all expenses associated with obtaining mortgage financing. These costs include mortgage recording fees and taxes, the mortgagee’s title insurance costs, lender due diligence fees, lender legal fees, entity formation costs (most lenders require that the borrower form a special purpose entity), and mortgage broker commissions.

In addition, most mortgage lenders require that the borrower establish reserves with the lender to ensure funds are available to pay real estate taxes, insurance costs, and repair and maintenance expenses for the property. These “financing costs” aren’t part of the cost of acquiring the real estate. Instead, they will be property expenses when paid. But they should be in a Sources and Uses since they represent cash the buyer must have available at closing.

Working Capital: The property will need cash on hand after acquisition to pay property operations expenses.

Security Deposit Account: If the buyer received tenant security deposits from the seller, these should be set aside. A separate tenant security deposit account is frequently established (and may be required by law) to ensure these funds are segregated.

Reserves: The lender usually will hold reserves for real estate taxes, insurance, and maintenance. The buyer may establish additional reserves for planned renovations or significant expenses it anticipates at the property.

Fund Formation and Offering Expenses: If several parties hold the real estate through a real estate fund, there will be costs associated with creating the fund, such as state formation and qualification fees. Also, the will be attorney fees for preparing the fund formation documents, such as the limited liability company operating agreement.

If a sponsor created and marketed the fund, there will be expenses, including legal fees for preparing the private placement memorandum and required filings under securities laws. In addition, the sponsor likely will be reimbursed for the cost of an online website, data room, or investor portal associated with the offering, and there may be broker-dealer commissions or advertising costs.

Sponsor Fees: The fund sponsor usually will receive an acquisition fee based upon the property purchase price. Sometimes, a sponsor will also receive a financing fee for putting together the financing or a guaranty fee (if the sponsor guarantees the loan). To learn more about sponsor compensation, read my previous article in this series about Sponsor Compensation.

Preparing the Sources and Uses

The Sources and Uses signed at closing is prepared in the last week before closing. Although the buyer will have its own Source and Uses, since funds flow between buyer, seller, and title company, those parties will also be involved in preparing the Sources and Uses.

However, the buyer should think about the Sources and Uses in its acquisition budget at the beginning of the transaction and should update it as the transaction evolves. This internal budget can be a checklist for the closing Sources and Uses. And by considering the “uses” in advance, the buyer can ensure it has sufficient cash “sources” at the closing table.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

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