Flow Gently, Sweet Income

Mark Shernicoff is a partner in Zucker & Shernicoff, CPAs, a division of the Metis Group, CPAs.

What would you do if your building didn’t have enough money to pay its mortgage, payroll, fuel bill, or any other major expense? You could file for bankruptcy – but that isn’t a realistic solution since it would mean the building’s tenant-owners would lose their investments. To prevent this, you, as a board member, have to protect the building’s “income stream.” That said, what is the stream and how can you guard it?

An income stream is the flow of money from tenant-owners for maintenance or common charges (from here on, we’ll just refer to it as maintenance), assessments, storage fees, and all the other charges that are imposed on them, as well as the rents from commercial spaces, and laundry rooms. Like the flow of water in a stream, it can be measured by how much is flowing and its constancy. A building needs a flow that is both large and constant enough to ensure that it has the funds it needs to pay its bills as they come due.

Boards frequently get into trouble because they don’t understand the nature of the building’s income and how to ensure a continuous flow of income to maintain the building and provide the services the owners expect. The largest portion of the stream is the maintenance that provides the funds to run the building. In a property without commercial space, this frequently amounts to more than 95 percent of the income. In buildings with commercial space, the maintenance will account for significantly less than that but the combination will usually account for more than 95 percent.

To ensure the volume, you need to set the maintenance at a level that will cover the building’s needs for the year. To do this, you must prepare a budget that estimates income and expenses – including reserve contributions and contingencies – for the coming year.

For most proprietary leases, the difference indicates the “cash requirements.” That then becomes the amount of the maintenance needed for the next 12 months. Failure to prepare an accurate budget and set the maintenance appropriately will usually result in operating deficits. That will deplete reserves and/or increase the number of unpaid bills.

Watching the Wheels

Having set the maintenance at a level sufficient to meet the building’s needs, you now have to protect it. Doing this requires the regular and accurate billing of the maintenance, commercial rent, and other charges. Increases have to be billed on time and for the right amounts, as do rent escalations for commercial leases, transfer fees, late charges, sublet fees, storage fees, and other tenant charges. You should follow up promptly on late payments to prevent arrears from accumulating and endangering the regular flow of funds into the building’s accounts.

Billing and collection reports should be reviewed periodically to ensure that all charges are being billed and billed accurately. When a new budget is approved, check to see that the new maintenance is being billed correctly to everyone. Leases should be reviewed to determine if the following are being billed and, especially where calculations are necessary, are being billed properly: rent increases, including fixed and percentage increases, consumer-price-index increases, and escalations based on increases in expenses, most often real estate tax but frequently including insurance, heating, water, and other operating costs. After a purchase or sublease is approved, subsequent billing reports should be checked to see that the required fees are being billed properly.

Arrears can have a negative effect on both the volume of the income stream and the constancy of the flow. In both cooperatives and condominiums, arrears will have a negative effect on the constancy of the income stream and may have a negative effect on the amount of income if the arrears are ultimately uncollectible. The loss of income from the inability to collect maintenance arrears is much more likely in condominiums because a condo’s lien against the unit for unpaid common charges is inferior to the lien held by the unit-owner’s mortgagee. This is the opposite of the situation in cooperatives where the cooperative’s lien for unpaid amounts due under the proprietary lease is superior to the lien held by the lender who made the initial share loan to the tenant-shareholder. As a result, while it is unusual to see bad debt write-offs for unpaid maintenance and similar charges in a cooperative, it is typical to see write-offs for unpaid condo common charges.

Because of the significant effect failure to collect maintenance can have on the financial health of the building, arrears should be closely monitored and late charges imposed for failure to pay by a certain date. There should also be a procedure in place to ensure that arrears are not allowed to get out of hand. A timetable should be established for dunning notices from management and for referring arrears information to counsel for collection.

For example, if maintenance has not been paid on time, a late notice should go out informing the owner that they are late and a late charge has been imposed and will appear on the next bill. If the arrears have not been paid by the end of the month, another notice from management should be sent. This should inform the owner that the matter will be referred to counsel for collection if not paid by a certain date and that, under the lease or other pertinent document, they will be responsible for all legal fees incurred in the collection process. Buildings that impose enforceable late charges and have such a process usually have fewer arrears – and fewer problems collecting.

Remember, as fish in a stream need an adequate and constant flow of water to thrive, your building requires an adequate and constant flow of money. Buildings without that may survive, but life will be difficult. And an inadequate income stream could be fatal.

It is your responsibility as directors to establish and provide an adequate amount of income, monitor its flow, and take whatever steps are necessary to make sure it is constant.