Balancing Capitalization Thresholds with Debt Covenants

Real estate funds charged with managing a complex portfolio of assets face all kinds of challenges. One particularly challenging issue for many funds is defining capitalization policies in a way that balances capitalization thresholds with debt covenants.

The IRS Tangible Property Regulations permit owners of real estate to expense certain costs rather than capitalizing them. These regulations can be favorable to taxpayers, allowing them to immediately expense many costs associated with operating their portfolio. However, if the property in question has debt financing, it’s important to ensure that leveraging these opportunities doesn’t result in your fund breaching the covenants of the debt tied to the property.

Because interest rates have risen in recent years, this issue now affects many real estate funds. In this overview, we outline the key factors that fund managers should consider as they evaluate their capitalization threshold policies.

Capitalization Thresholds and Debt Covenants Explained

Within the bounds allowed by the IRS Tangible Property Regulations, real estate funds set their own capitalization policies. A capitalization policy sets a threshold that dictates when certain costs should be capitalized and when they should be expensed. When these thresholds are high, a fund can expense many costs. This is favorable for tax purposes, but these costs impact the income of the property, commonly expressed as the net operating income (NOI).

If NOI drops too low, the fund may be in breach of the covenants of the loan on the property. A covenant is essentially a condition attached to a loan. More specifically, debt covenants govern the amount of income a property must produce in relation to its debt expense.

Consider the example of a fund that owns a multifamily apartment building. The apartment building is partially financed by a loan. The loan has a debt covenant that states the property must produce income in excess of the debt payments. This is known as the debt service coverage ratio (DSCR). A typical minimum DSCR is around 1.2, which means the property must produce income equivalent to 120% of the debt payments.

Let’s get back to our example. A toilet has to be replaced in one apartment — a capital cost that’s likely to be under the $2,500 De Minimis Safe Harbor provided in the Tangible Property Regulations. Therefore it’s eligible to be expensed.

If the fund were to expense the costs of the toilet repair, they would recognize these costs on their financial statements. Doing so reduces the property’s NOI by that amount, meaning the property may not produce enough income to satisfy the DSCR covenant.

While one toilet is unlikely to impact DSCR ratios significantly, these determinations are not made on a case-by-case basis. Funds must set a formal capitalization policy at the beginning of the year. This policy explicitly states the capitalization threshold — whether it’s $2,500 as allowed by the Tangible Property Regulations, a lower threshold or (in some instances) a higher amount.

How to Balance Capitalization Thresholds with Debt Covenants: Key Factors

Establishing formal capitalization policies is an issue that funds must consider proactively. Funds should discuss a wide range of inputs to this decision with their accounting and tax professionals before making a final determination. These are outlined below.

Debt Service Coverage Ratio

The primary variable real estate funds must consider when establishing their capitalization policies is the DSCR on the loans associated with each property. As noted above, many lenders require a minimum DSCR of 1.2. This assures the lender that the property has sufficient cash flow to cover repayments plus additional operating expenses.

If organizations choose to expense costs below a certain threshold, many of these costs will hit the bottom line and could potentially threaten the required DSCR. In recent years, rising interest rates have complicated matters further. As interest rates have gone up, so too have payments on many loans. So the asset has to generate a higher NOI to remain above the required DSCR.

Real estate funds must do this math proactively and make sure to stress test their forecasts for changes in interest rates, NOI and other important variables. These calculations can often be included in a property’s proforma.

Value-Add Strategies and Renovation Costs

Many real estate funds follow a value-add strategy. They buy Class B or C properties and increase their value through renovations like replacing old bathrooms or installing new kitchen cabinets.

Many of the costs associated with this are likely eligible to be expensed. But if funds aren’t careful in how they manage this, they might create problems for themselves. Expensing a lot of costs can cause a property’s NOI to drop significantly, potentially causing issues with debt covenants. This is particularly evident in the post-acquisition stage, when many of these value-add improvements are being made.

Tax Planning Considerations

For tax accounting purposes, real estate funds are incentivized to show as little income as possible to minimize tax exposure for them and their investors. For financial accounting, funds want their income to be as high as possible. This demonstrates to financing partners (as well as potential acquirers) that the property is valuable and reliably produces income.

These competing priorities are at the heart of all real estate accounting. One of the provisions of the de minimis safe harbor is that financial capitalization thresholds must match tax capitalization thresholds. In other words, a property cannot have a $10,000 capitalization threshold for tax purposes and a $500 threshold for financial purposes – they must be consistent.

When determining capitalization policies, fund managers should aim to strike a balance between these competing priorities.

Operational Concerns

A final concern, particularly for larger real estate funds, is the administrative burden associated with managing low capitalization thresholds. Larger funds, which deal with a greater volume of transactions, tend to have higher capitalization thresholds.

If a larger fund were to have a lower capitalization threshold, it would likely have to hire additional accounting staff to adequately track how relatively inexpensive costs were being accounted for.

James Moore: Experienced Real Estate CPAs

Determining appropriate capitalization thresholds for all of the properties in a real estate fund’s portfolio is an important task. Setting the capitalization threshold too high might put funds at risk of breaching debt service coverage ratio covenants. Additionally, it could impact the value of your property; in many instances, a multiple of NOI serves as the starting point for negotiations.

Generally, it’s considered best practice to break out the costs associated with fixing a unit of property and the costs associated with replacing it in separate line items on the property’s Profit and Loss Statement. While this doesn’t solve the challenge of abiding by debt covenants, it does create a clearer picture of the true operating expenses and income of the property and helps justify a higher valuation to potential acquirers.

Working with an experienced team of specialized real estate CPAs – like the team at James Moore – can help real estate funds address these issues and set appropriate capitalization policies. Our team of expert professionals has a proven track record advising real estate funds on a variety of accounting, assurance and tax planning issues. Contact an advisor today to learn more.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.