Off Balance Sheet Liabilities
In the past couple weeks we’ve talked about some costs that don’t always appear on the income statement; opportunity costs and sunk costs. Today, I’d like to talk about some liabilities that don’t appear on the balance sheet. The technical term for them is “off balance sheet liabilities” and they are something to be very wary of as an investor.
When you think about investing in a business, whether it is a public stock you can buy via Schwab, or a mature business you are acquiring with debt financing in a leveraged purchase transaction, or a growth company you are investing in, or even a young startup, you should take a close look at the balance sheet. You should see what obligations that company has built up over the years and how they compare to the company’s assets. When the liabilities are large and the assets are not and if the cash flow is weak or non-existent, then you should be extremely cautious because those liabilities can sink the company. We talked a bit about this in the post I did on financial statement analysis and the balance sheet.
But sometimes companies don’t put all of their obligations on the balance sheet. There are at times valid reasons for this, but there are times when the company is just trying to pull a fast one on the investor community. Enron is a classic business case story about this. What Enron did was create investment partnerships where they transferred assets and liabilities. But those partnerships had close ties back to Enron and at the end of the day, they did not eliminate the liabilities, they just took them off their reported balance sheet. When those partnerships blew up, Enron came crashing down. Billions were lost and executives went to jail.
Even if the company you are looking to invest in is totally clean and honest, there will be likely be liabilities that are not on the balance sheet. Let’s say you are looking at investing in a company that does mobile software development for big media companies. Let’s say they have just signed a three-year contract to develop mobile apps for one of the largest media companies in the world. Let’s say they got paid upfront $1mm to do this work. That $1mm will appear on the balance sheet as deferred revenue and that is a liability. But what if the company misjudged the amount of work it will take and they will ultimately lose money on the deal? What if it will actually take them $1.5mm in costs to do this work? The $500k of losses is an additional liability but it doesn’t appear on the balance sheet anywhere. But those losses could sink the company if it is thinly capitalized.
Real estate liabilities are a particularly thorny issue. Back in the early part of the last decade, right after the Internet bubble burst, I spent almost all of 2001 trying to negotiate a bunch of companies out of real estate liabilities. These companies were all growing like crazy in 1999 and 2000 and they signed five and ten year leases on big spaces (like 10,000 square feet or more) with big landlords. Many of these leases had rent concessions in the first year or 18 months and when those concessions came off, the companies instantly faced the dual reality that they could not afford the leases and that they were not going to raise more money with these huge lease obligations in place. But those lease obligations were not on the balance sheets. The annual rent expenses were on the income statement, but the future lease obligations that ultimately sunk a few of these companies were only disclosed in the back of the footnotes.
The footnotes are where you have to go to see these off balance sheet liabilities. If the Company is audited, then their annual financial statements will have footnotes and this kind of stuff is likely to be in there. If the company is publicly traded, it will be audited, and the footnotes will be in the 10Ks and 10Qs that the company files with the SEC. But many privately held companies, particularly early stage privately held companies, are not audited. So if you are going to invest in a company that is not audited, you need to diligence these unreported liabilities yourself. You should ask about lease obligations and any other contractual obligations the company has. Read the leases and the contracts. Understand what the company is obligated to do and how much money it will cost. Make sure those funds are in the projected cash flows.
Balance sheets and income statements are important to understanding a company. But they do not tell the entire picture. They don’t tell you if the team is solid. They don’t tell you if the product is any good. They don’t tell you if the market is big. And they don’t even tell you about all the costs and they don’t tell you about all the liabilities. So you have to dig deeper and understand what is really going on before putting your capital at risk. That is called due diligence and it is critical to investing. And looking out for liabilities that aren’t reported on the financial statements is an important part of that.
From the comments
JLM added regarding real estate deals:
You raise important points about managing the contingent liabilities associated with real estate. Here are a couple of suggestions:
First, free rent in a long term lease should be accounted for by averaging the rent over the entire term of the lease and expensing that average cost during the term of the free rent. That is a GAAP [Generally Accepted Accounting Principes] concept which should be respected for every company.
Tenant improvements should be depreciated over the initial term of the lease.
Leases should be carefully negotiated as it relates to the default provisions and the Landlord’s remedies. It is not unreasonable to negotiate a 6 months liquidated damages provision in the event of a Tenant monetary default and the application of any security deposit to that liquidated damages provision.
Real estate is state law and most states provide that the Landlord is entitled to recover the NPV of your rental stream minus the NPV of a replacement tenant plus the cost of eviction and reletting (including tenant improvements and leasing commissions). The Landlord is typically unlikely to be entitled to collect all of the rent you owe. You have to know the law cold.
As to term, sign short term leases with lots and lots of renewal options and limitations on how much the rent can be hiked at the time of renewal. A CPI [Consumer Price Index] mechanism is not unreasonable.
As to how lease are configured pertaining to who pays the operating expenses:
Gross leases — fixed amount of rent, Landlord pays everything
Base year leases — Landlord pays base year expenses and Tenant pays all increases thereafter
Net leases — Tenant pays its prorata share of all operating expenses
It is very, very important to define “operating expenses” beyond the obvious property taxes, insurance, utilities and maintenance. The devil is in the details.
Last comment — binding arbitration in the city where the real estate is located is a good way to solve disputes. It is less costly, less cumbersome and it is easier to reach the equities of a situation.
OK, here is the reason why real estate owners and developers are willing to provide “free rent”. Shhh, it is a secret.
When you give free rent, you are, in effect, averaging down the real cost of the lease but for financing purposes once the free rent period has expired, you are financing or selling a rental stream which has a higher capitalized value.
This is also why real estate owners and developers like to have a gradually increasing rental stream over the term of the lease. They are going to sell or refinance the property when the rental stream is higher and thereby recognize a higher capitalized value.
Example — 12 month lease @ $100 per month w/ 2 months free
Total cash flow = $1,000 ($100 x 10 months)
Average rent payment = $83.33
Assumed cap rate = 6%
Capitalized value of average rent payment = $1,388.89 ($83.33/0.06)
Capitalized value of last month’s rent payment = $1,666.67 ($100/0.06)
Increase in capitalized value = $277.78 or 20%
You rent up the office space or apartments providing a spot of free rent and then you go to the market and finance or sell after the free rent period has expired.
On a $20MM property you create 20% incremental value by being patient and knowing how to market the property to tenants and are rewarded with an additional $4MM in your pocket.
The game is even juicier if you have a built in escalation such as —
Year 1 rent = $100
Year 2 = $103
Year 3 = $106
Year 4 = $109
Year 5 = $112
Now the values look like this —
Year 5 capitalized value = $1,866.67 ($112/0.06)
Increase in capitalized value = $477.78 or 34.4%
Again, your nominal $20MM building is now worth $26,880,000 and in the interim you have manufactured a bit of depreciation and interest deduction.
This is how developers get rich by giving out free rent. This is the mildly advanced real estate finance course but not very.
And now you know why free rent isn’t free.
Don’t tell anyone.
This article was originally written by Fred Wilson on August 2, 2010 here.