While real estate deals are often quite complex and have many different factors, the actual accounting isn’t nearly as complicated as it seems. We break it down in today’s blog.
There are two key questions to ask yourself first in order to do the accounting properly for your real estate business.
Define the Purpose of Your Real Estate Business
- Are you developing a property for a future sale?
- Or, do you own the asset for rental income?
If you develop the real estate, your focus will be on the Balance Sheet of your financial statements.
If you develop or own real estate for the purpose of rental income, your main focus will be on your Profit and Loss statement.
To be clear, both types of real estate activities will have a Balance Sheet and Profit and Loss financial statements. However, the main financial focus will change based on the purpose of the real estate business you are running.
Real Estate Development Accounting
Real estate development accounting is about acquisition and asset (land or building) development or remodeling it for future sales or rental (both Profit and Loss activities). Developers use the balance sheet to keep track of their development costs (or renovation activities). The key accounts for a business focused on development are:
- Cash Accounts
- Deposit Receivables
- Construction in Progress (CIP) or Work in Progress (WIP) Accounts
- Accounts Payable
- Retainage Payable
- Short term Debt
- Long term Debt
- Equity Accounts
The company can establish profit and loss accounts once the property is completely developed and is either sold or ready for renting.
Key Balance Sheet accounts for Developers who are Building and Planning to Sell are:
- The sale of units or apartments (usually condo or retail space)
- Cost of Goods Sold
- Total Construction normally is broken down by square footage or actual cost
These are a few key examples of what you will see on a real estate developer’s financial statements. The two most important accounts will be the CIP (Construction in Progress) or WIP (Work in Progress) Accounts. Most developers rely on a job costing accounting system to track their work. The Construction Specifications Institute (CSI) publishes these codes. They are also known as the CSI codes.
What are the CSI Cost codes?
Originally, the CSI cost codes were broken out into 16 divisions. They were referred to as the 16 divisions of construction. Then, in 2004, CSI’s MasterFormat (a standardized format for describing construction specifications) was updated and expanded to 50 divisions. These codes are defined by the Construction Specifications Institute (CSI)’s MasterFormat. Above all, these codes are the most widely used standard for organizing specifications and other written information for commercial and institutional building projects in the U.S. and Canada.
The CSI codes provide a master list of divisions, and section numbers and titles within each division, to follow in organizing information about a facility’s construction requirements and associated activities. Most importantly, standardizing the presentation of such information improves communication among all parties involved in construction projects. Certainly, clarity saves money for everyone involved in the project. Additionally, clear specifications help with clear financial tracking.
Each one of these cost codes will be tied back to a general division of constructions. Some of these activities include demolition, excavation, foundation, the superstructure. These construction costs are labeled as hard costs. Hard costs should be linked to a CIP (Construction In Progress) Account on your Balance Sheet (normally Building Construction). Then there are the soft costs. For soft costs, you would expect to see cost codes like Architect, Consultants, Marketing, Legal and Accounting on your balance sheet.
Hard Costs Vs. Soft Costs
To summarize, in real estate development accounting, hard costs are construction costs associated with the actual physical construction of the building or project. On average, hard costs make up 75- 80% of the total new construction costs. However, it is worth noting, hard costs on a renovation project are often higher. Some other hard costs include:
- Hazardous Material Abatement
- Doors & Window
- Finishes (Plaster and Drywall, Flooring)
- Equipment (Trash system, Loading Dock Equipment and Conveying Systems (Elevators, Escalators)
On the other hand, soft costs are part of the overall development project but not tied to the actual physical production of the asset. They deal more with consultants and the planning of the project. In most cases, the soft cost is pre-constructions cost and the majority of the costs are incurred prior to the start of construction. Additional soft costs include engineering (mechanical and/or structural), permits & approvals, inspections, legal, and insurance.
The other time of “soft cost” paid at the beginning of the project and during construction are Financing Cost. During the pre-development stage of a project, some of the Financing Cost you will see on a Balance Sheet are Bridge Loans, Appraisal fees, Construction Lender Fees, Financing Fees – Brokers. Once a construction loan is obtained, some of the Financing Cost you will see are Mortgage Recording Tax, Construction Loan Interest, Exit Fees to name a few.
Balance Sheet Specifics for the Real Estate Developer
The Balance Sheet can be as detailed as you wish. Often, companies create a separate account for each type of Soft Cost (Architect, Consultants, etc.). Additionally, you will always want a separate account for all interest paid and Marketing Costs. Both interest and marketing costs can be deducted for tax purposes, depending on where you are in the construction process. So, you want to make it easy and isolate these costs.
The other two major accounts are your payable accounts and debt accounts (loans payable). Accounts Payable are monies owed to vendors. Vendor invoices could be payable either with terms or due upon receipt.
Retainage Payable – What is it?
Retainage Payable is the amount held back from a subcontractor during the construction process. It is important to track the retainage held from each subcontractor. Normally for each payment request from a subcontractor, 10% is held back until the contract work is completed. This is done to ensure that subcontractors complete the entirety of the work on the contract. Once the contract has been completed, a punch list is approved by the owner of the project and if everything is completed as per contract, the retainage is released to the subcontractor. You will maintain a running total of retainage for each subcontractor until their contract work is complete and approved.
Finally, the other major liabilities accounts are your loan payables or short-terms loans. These accounts are used to keep track of long-term debt or reoccurring debt. If you have a long-term mortgage on a property or a construction loan, the maintenance of these accounts is important to understand your real estate asset total worth.
On the Profit and Loss statements for the development, the property is different from a property held for rental income. If the property is a condominium project, then the Profit and Loss is used to record the sales of each unit and the cost associated with said unit. At the very beginning of the sales of the units, all the proceeds go toward paying the outstanding debt or to finish paying off the remaining cost of the project. After all the loans are paid off and all construction costs are paid in full, a profit can then be recognized which is then distributed to the partners of the project.
Real Estate Held for Rental Income
For real estate held or owned for rental income, the Profit and Loss is the focus of the financial statements. The Profit and Loss Accounts should be broken down into three key sections:
- Cost of Goods Sold (COGS)
- Operating Costs
Essentially, revenue is the rent you collect from your income-producing real estate. Next, COGS are the cost associated with earning said income. An example of COGS would be insurance for the building or the direct labor of the supervisor or manager of the building. Finally, operating costs are the other expenses related to operating the property.
On the Balance Sheet for rental income properties, the main accounts are:
- Cash Accounts
- Escrow Accounts
- Accounts Receivables
- Liability Accounts
- Security Deposit Payable
- Debt (Loan-term loans)
The Accounts Receivables account should be an easy account to maintain. Essentially, they are the rents paid. In a perfect world, no receivables should be past 30 days. And, importantly, receivables should tie out to your monthly rent rolls paid at the beginning of each month.
The maintenance of the tenant’s security deposit account is extremely important. That is to say, you need to keep these accounts as accurate and as detailed as possible. At all times you need to be aware of which tenants you are holding security deposits for and for how much. At the end of a lease, based on the condition of the property, some or all of the security deposit will be released back to the tenant.
The Liability Accounts are for accounts payable, loans payable or other short-term debt. Also part of the liabilities is the security deposit account. Importantly, we have called this out separately given the criticality of segmenting and tracking this account. Likewise, long term loans are the debt you have taken on from an outside entity and you are making regular payments on. The amount of that loan is evaluated against your monthly rent roll and value of the property. In brief, these metrics help you the owner, investors, and lending institutions understand the value of your property.
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Fit Your Accounting Needs to Your Business
In short, this quick high-level summary is meant to help you get started on your real estate accounting. Understanding the different focus for accounting structures for real estate development companies vs. real estate companies that are holding real estate for the purpose of rental income is a great place to start.
In conclusion, these are just the basic real estate accounting accounts. To sum up, you can get as detailed as you want depending on what your needs are as the business owner. Most importantly, know what accounting structure fits your real estate business so you can report out and track the information you need to run your business successfully.
Rick Diaz has more than 25 years of experience in financial, real estate development and construction accounting. As President and CFO of Franco Blueprint, Inc., Mr. Diaz provides his clients with strategic advice on financing, risk management, human resources and more. Additionally, Mr. Diaz is skilled with asset strategy, cash flow, cost/benefit analysis, value engineering, cost accounting for construction projects, and all functions essential to financially driving a company.
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