A CFO s Guide to Understanding Cash Flow Waterfalls from your Multi-Family Portfolio

Transcription

1 T o o l s & R e s o u r c e s G u i d e A CFO s Guide to Understanding Cash Flow Waterfalls from your Multi-Family Portfolio This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 1

2 T o o l s & R e s o u r c e s G u i d e Table of Contents EXECUTIVE SUMMARY... 3 KEY PROJECT DOCUMENTS TO BE CONSIDERED... 4 PLANNING FOR DISTRIBUTABLE CASH FLOWS... 6 THE FINANCIAL EXECUTIVE S ROLE... 7 EXHIBITS... 8 Acknowledgements STRENGTH MATTERS gratefully acknowledges the work of Chris Cherry, Chief Financial Officer from Homes for America in Annapolis, MD and Gayle Harrold, Chief Financial Officer for Madison Park Development Corporation in Boston, MA for their contributions to this paper. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 2

3 T o o l s & R e s o u r c e s G u i d e EXECUTIVE SUMMARY Non-profit organizations involved in the development and ownership (i.e. asset management) of affordable housing rental projects often structure their transactions to allow for cash flow to be paid to the parent (i.e. sponsoring) organization as well as other lenders, investors and stakeholders. These distributions of cash can take many forms and are most often referred to as surplus cash or distributable cash flow. Distributable cash flow payable to the parent organization may include deferred development fees, asset management fees, partnership management fees, incentive management fees, resident service fees and the like, as well as payments on mortgage and other notes payable. Distributable cash flow can also be payable to a lender (for instance soft debt holders), investors or any entity that is considered a stakeholder in the project for whatever reason. For purposes of this guide, cash flow waterfall is the amount of cash available for distribution and the recipients of that cash. The term waterfall is further defined as the priority of cash flow distributions (i.e. who gets paid first and in what amounts). There are several agreements associated with the financing of each project that contain the key components of each property s waterfall requirements. These documents include the following: Partnership agreements Regulatory agreements Note agreements Once the waterfall priorities are understood for each property within an organization s portfolio, the organization should periodically review financial operations during the year to understand projected surplus cash results and the resulting distributions that will be made. Projections are generally reviewed mid-year (e.g. at six months into the fiscal year) and a few months before year end (e.g. at nine or ten months). These reviews will allow the organization to take necessary steps to manage cash flows from their portfolio to meet organizational and portfolio objectives. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 3

4 T o o l s & R e s o u r c e s G u i d e KEY PROJECT DOCUMENTS TO BE CONSIDERED The documents to be reviewed to understand and chart each project s cash flows are the various organizing and financing agreements applicable to your project. Key terms and sections within these agreements provide the foundation for the charting and understanding of cash flow waterfalls. Partnership Agreements Standard partnership agreements between the developer and investor may contain the following sections that are useful in understanding cash flow waterfalls: Defined Terms Cash Distributions or Cash Distributions Prior to Dissolution Exhibits that may be titled Fees & Guarantees or Priority Uses of Cash Flow Gaining a clear understanding of the defined terms in the partnership agreement and how those defined terms are used in the sections of the agreement that describe the waterfall provisions can be helpful to clarify the intent of the parties. An example of the applicable sections within a partnership agreement can be found in Exhibit I and II. Regulatory Agreement Regulatory agreements often dictate the terms of distributions. For instance, HUD projects always contain regulatory agreements that restrict the amount of distributions of surplus cash. An example of the applicable sections within a HUD-insured mortgage regulatory agreement can be found in Exhibit III. Once surplus cash is determined, the amount will follow the provisions described within the governing documents (a partnership agreement, for example) per the waterfall cash flow priority. See Exhibit IV, which provides the determination of surplus cash and the waterfall provisions, as displayed in the project s annual audited financial statements. When working through the waterfall provisions of a HUD project, it should be noted that limits of surplus cash distributions are often involved. Exhibit IV contains just such an example. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 4

5 T o o l s & R e s o u r c e s G u i d e Note Agreements Note agreements associated with the soft debt financing of a project often contain provisions for repayment from surplus cash, as defined within your project s documents. The applicable amounts due towards the obligation is usually part of the cash flow waterfall. Exhibit V provides an example of the waterfall provision where payments on a note are due from distributable cash flow or surplus cash. Further, in this example the remaining balance after the payment towards the note obligation then falls further into the waterfall, where the terms of the partnership agreement apply. Be Aware: Project Documents Often Conflict Various documents governing cash flow waterfall payment priority are not always consistent and may actually contain different methods of calculating distributable cash flows. For instance, certain agreements may take a balance sheet approach for determining surplus cash; while other agreements may take an income statement approach (see sample documents). In the example in Exhibit V, the partnership agreement makes no mention of the surplus cash payment due within its waterfall provisions. In these instances, it is advisable to seek consensus from the various stakeholders as to priorities and then document this in a memorandum of understanding. Frequently, lien position holders will supersede investment holders, but confirmation of expectations will help clarify the interests of the various parties. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 5

6 T o o l s & R e s o u r c e s G u i d e PLANNING FOR DISTRIBUTABLE CASH FLOWS Once an organization understands the waterfall for each property within its portfolio, it can be helpful to design work papers for internal use that serve as a planning mechanism for projecting surplus cash distributions. As an example, a mid-year (six-month) projection can be done annually and then updated prior to the end of the year. In this fashion, any adjustments or changes can be implemented during the year to achieve portfolio distribution objectives. For instance, withdrawals from the reserve for replacements can be completed before year-end to replenish the property operating accounts, if the objective is to maximize cash flow. Or in the case of a limited distribution project, the objective may be the opposite and steps can be taken to minimize surplus cash. One such method would be to increase the repairs being made on a property using operational cash as opposed to replacement reserves. The footnotes to the annual audited financial statements for each project can be used to document the calculation of the surplus cash available for distribution and the actual waterfall of that amount in compliance with the applicable governing documents. However, there is no requirement to do so, per Generally Accepted Accounting Principles ( GAAP ). Each organization should determine the proper method of tracking and reporting cash flow waterfalls for the projects in its rental property portfolio. Planning for future years distributable cash flows coming into the parent organization is essential. Not only is it critical to project that amount of cash to be received by the parent, as the financial executive, you will need to know how to book the receipt of the cash within the parent s financial statements (i.e. revenue versus a payment on a note receivable). This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 6

7 T o o l s & R e s o u r c e s G u i d e THE FINANCIAL EXECUTIVE S ROLE Distributable cash flows are a significant component of annual revenues and cash flows for many organizations. There is an important role for the Financial Executive both from the inception of a new transaction to management of the cash coming from existing properties. For new transactions, the financial executive should work with executive leadership, staff from development and asset management to structure the project s cash flow waterfall to meet organizational objectives concerning the applicable property within its portfolio. These objectives could entail maximizing fees to the parent organization as early in the waterfall as possible. While the investors/lenders will have to concur, an organization can t maximize annual revenues over the life of the project without being proactive at this stage of the transaction. In order to budget annual revenues for both new and existing properties effectively, an organization s financial executive should be involved in all fiscal aspects of planning for and managing property operations. Whether an organization self manages its properties or manages its properties through third party property management companies, the financial executive should meet with those responsible for budgeting property operations as budgets are being developed for the upcoming year. As already discussed, there may be an incentive, depending upon who is receiving the surplus cash, to either minimize or maximize distributable cash flows and that will need to be communicated effectively to those developing and then managing the budget in the year ahead. The financial executive should then meet with key property management personnel periodically to avoid or manage any change in original expectations. When preparing/reviewing property projections, it is important that the definitions contained in key project documents are consistent with those used in the financial projections. As a new financial executive taking on responsibility for cash flows coming to the parent organization from existing projects in the portfolio, it is well worth the time to read through the project documents and analyze property waterfalls (start with those that are actually cash flowing). The individual within the organization that will prepare the waterfall calculation and ensure proper distribution on a timely basis should also be determined. While the financial executive is responsible in many organizations, asset management or other staff may also take on this responsibility. Lack of clear direction in this area could result in unanticipated results. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 7

8 T o o l s & R e s o u r c e s G u i d e EXHIBITS Exhibit I contains some of the sections of a partnership agreement that essentially lay out the waterfall provisions of cash flow. However, note that within the waterfall section of the partnership agreement a number of items are highlighted, which are further defined within the Definitions or Defined Section of the partnership agreement. It is very conceivable that following the waterfall provisions will lead you all over the partnership agreement for further clarification of provisions, as this partnership agreement clearly does. This is an example of an older partnership agreement, when the nuances of the deal structuring components embodied within the partnership agreement may not have been as clearly documented. Exhibit II provides another example of a more recent standard partnership agreement that follows a similar approach and ultimately lays out the waterfall within an Exhibit to the partnership agreement. Refer to the last page within Exhibit II (Exhibit II(h)), which pulls all the provisions together from the governing documents and details the amount of each provision to make up the cash flow waterfall for this project. This information is contained in the footnotes of the annual audited financial statements. Exhibit III provides an example of the HUD-insured mortgage regulatory agreement that outlines the parameters of surplus cash distributions. Exhibit IV is an example of a HUD project with a limit on surplus cash in accordance with the project s Interest Reduction Payment Agreement ( IRP ). Further, the amount of distributable cash falling through the waterfall as outlined in the partnership agreement is illustrated in the footnotes to the project s annual audited financial statements. Exhibit V is an example of a project with a soft note payment due from surplus cash that must be included within the waterfall calculation. Exhibit VI is an example of a mid-year projection of surplus cash available for distributions, as well as the applicable waterfall that applies to each project. This document is a product of STRENGTH MATTERS, a collaborative initiative among national and local organizations in the affordable housing field, co-sponsored by NeighborWorks America, Housing Partnership Network and Stewards of Affordable Housing for the Future. 8

9 EXHIBIT I (a)

10 EXHIBIT I (b)

11 EXHIBIT I (c)

12 EXHIBIT I (d)

13 EXHIBIT I (e)

14 EXHIBIT I (f)

15 EXHIBIT I (g)

16 EXHIBIT I (h)

17 EXHIBIT II (a)

18 EXHIBIT II (b)

19 EXHIBIT II (c)

20 EXHIBIT II (d)

21 EXHIBIT II (e)

22 EXHIBIT II (f)

23 EXHIBIT II (g)

24 EXHIBIT II (h) 1 st - 3 rd - 5 (a) - 5 (b)(ii) - 5 (b)(iv) -

25 EXHIBIT III (a)

26 EXHIBIT III (b)

27 EXHIBIT III (c)

28 EXHIBIT III (d)

29 EXHIBIT IV (a) 3 rd Priority - 7 th Priority - 8 th Priority - 9 th Priority -

30 EXHIBIT IV (d)

31 EXHIBIT IV (c)

32 EXHIBIT V (a)

33 EXHIBIT V (b)

34 EXHIBIT V (c)

35 EXHIBIT VI