There’s plenty to think about before writing an operating budget.
With budgeting season upon us, it’s important to remember the fundamentals of good budgeting.
If you are writing numerous budgets for multiple properties, it is easy to get caught in the trap of just increasing everything 2 percent to 3 percent from the prior year and hoping for the best.
However, following are fundamental concepts that could make the budgeting process not only more accurate, but also more useful during the year.
WHAT TYPE OF BUDGET Is this budget a “normal” budget or a “stretch” budget. This is a key distinction. The budget preparer and asset manager need to have next year’s goals in mind, such as a possible sale, refinancing or even meeting the debt service coverage ratio (DSCR) tests for loan extensions. Corporate officers do not always communicate next year’s goals with the onsite staff and it is important for everyone to be on the same page.
ZERO-BASED BUDGET Don’t simply increase expenses by 2 percent or 3 percent across the board. A proper budget should be written from the ground up every year and should include detailed, legitimate reasons for changing historical numbers. All major service contracts should be competitively re-bid to ensure that the best price possible is secured. When managing multiple properties in the same area, use the high volume of business as a negotiating tool with the vendors. This should be effective for trash, landscaping, security, cleaning, painting, advertising, etc.
UTILITY COSTS Most utility companies will publish rates or estimates of rates for the upcoming year. Ensure that this is taken into consideration when budgeting. That way, unnecessary errors will be avoided had the budget blindly called for a generic 3 percent increase in water/sewer charges when the utility provider had forecast a 10 percent increase.
Tying back to the accounting methodology, many companies try to “smooth” out the seasonal effects in utilities through accruals. If your firm does this, make sure to account for that in the budgeting process.
REVENUE METRICS Look at city/county/area metrics on vacancy, rents, effective rents, etc., to determine if the community will trail, match or beat these metrics and why. If budgeting to beat these metrics, the explanation should not be just because “we try harder.” It needs to be based on historical trends or actual strategic changes.
HISTORICAL OPERATING TRENDS It’s important to look at historical move-outs, move-ins, applications, etc. (if possible) to see what to expect during the year. For example, many communities have a “leasing season” during the summer where leases, move-ins and move-outs occur in greater numbers compared to winter time. The seasonal changes will lead to changes in other income line-items such as application fees, lease termination fees, damage and replacement fees and expense lines such as turnover costs, leasing commissions, etc. Increased leasing, move-ins and move-outs during the summer may also result in higher payroll costs if seasonal, part-time help or temporary labor is necessary.
BUDGETING YEAR-ROUND Keeping a journal of all items that need to be budgeted during the year is helpful so that they aren’t forgotten the next time a budget is written. For example, a pool permit may be required in May that was originally not budgeted for. Once realizing this, add it to the list, so it is not forgotten the following year.
ACTUALLY USE THE BUDGET One critical mistake some make during the year is to complete the budget and then not actually use it. Using it does not mean running actual-to-budget reports every month. When there are substantial variances to the budget, an analysis must be done regarding how to improve operations at the property or possible adjustments required for the next year’s budget. The most effective way to meet a budget is to effectively manage the on site team. This can be done through bonuses and other perks, which can be tied to meeting or exceeding various budgeting sections.
METHOD MATCHING It’s important for the person completing the budget to understand how the financials will be created during the year. If the property’s financials are done using the accrual accounting method, then the budget should mimic that. For example, if an annual licensing fee is paid in October for property management software, there are two choices for how to account for it. Either one-twelfth of the amount can be booked each month or the entire amount can be booked in October (upon receiving it). Make sure the accounting method matches the budgeting scheme.
Reuben Berman is Founder of Entrada Partners, a full-service real estate multifamily investment and advisory firm headquartered in Los Angeles with a portfolio in excess of $50 million.