Before you can proceed with a real estate project, you must identify how you will obtain funding and how you will spend those funds. Clearly, Sources and Uses (S&U) of funds is key to property development. Therefore, this article defines sources and uses of funds, where funds come from and how we use them. Next, we’ll explain the sources and uses table and the sources and uses template. Finally, we’ll conclude with the answers to some frequently asked questions about sources and uses of cash.
Video: LBO Model: Sources and Uses
What Are Sources and Uses of Funds?
Sources and uses of funds is an accounting concept used by all sorts of businesses. In this article, we’ll focus on sources and uses of funds for commercial real estate projects. Besides being a fundamental accounting concept, the sources and uses statement is one of the major accounting reports. Managers, investors and regulators pour over the latest S&U reports to help evaluate the health of an organization or project.
The S&U Statement
The S&U statement shows how project funding arises and where the capital goes. The primary rule for the sources and uses of cash statement is that the combined sources of funds must match the combined uses. The report itself can have a basic format. First, you list sources by line item and then total them. Next, uses receive the same treatment. Obviously, the statement reader can quickly verify that total sources equals total uses. In order to make the two totals match, the preparer may have to add a category. Specifically, that category plugs for the difference between sources and uses as follows:
- If sources > uses, plug with the use category “cash flow distribution.”
- If sources < uses, plug with the source category “additional equity required.”
Major Uses of Funds
The use of funds section is the first one you derive because it dictates how much money to raise. Typically, the project sponsor identifies project costs as price per square foot or price per unit. Also, sponsors can specify each item’s percentage of total costs. Normally, you group project costs by purchase price, hard costs and soft costs. Thereafter, you can break down each group into line items and/or roll up the costs to the group level.
There is no great mystery about purchase price. Specifically, it is the price the sponsor pays for the land and any improvements, such as infrastructure and buildings. If you don’t purchase the land, then the price includes the cost of the lease-hold interest on the property acquired. By specifying the cost per square foot, you can compare the price to comparable transactions.
Another major use of funds is to pay hard costs. Specifically, hard costs are items that directly add to property improvement, such as materials and labor. In addition, hard costs can include contingencies for direct cost overruns. By including unit costing, you can compare your costs to market averages.
Hard cost projections can tell you a lot about the project. To illustrate, suppose an investor must choose between two $20 million acquisition properties. In the first, the hard cost estimate is only $1 million, but the second one anticipates a $9 million hard cost. In the first project, the building requires little development or rehab. However, the second project requires extensive improvement. As an investor with specific risk preferences, you can use this information to decide on the right investment.
Hard Cost Line Items
A use of funds template might break down the category into line items. That is, the template might specify detailed costs, such as roof repair, new HVAC, sewage hookups and so forth. The breakdown of costs might indicate substantial deferred maintenance that the sponsor must address. Indeed, the cost to rehab the property will help the sponsor to keep existing tenants from moving to another property. On the other hand, the costs might indicate a desire to move the property upscale. For example, these might be costs like renovating the lobby, new landscaping, and bathroom renovations. Clearly, these costs aim to allow the sponsor to charge new tenants market rents or possibly even higher.
Soft costs arise from a project but don’t tangibly improve the property’s value. They include use of funds template items like:
- Organizational fees
- Purchase closing costs
- Legal fees
- Broker and leasing commissions
- Loan fees
- Acquisition costs
- Equity reserves
- Interest reserves
You improve the report’s usefulness by including soft costs per square foot and as a percentage of total costs. If the sponsor seems to be paying too much for soft costs, it could indicate incompetence or even bad luck. Furthermore, excessive reserves for equity and interest might indicate high uncertainty within the business plan.
Major Sources of Cash Flow
The sources of funding will resemble the project’s capital structure, with some important differences. For one thing, the sources of funds section will show in detail all sources of funds, not just capital providers. For example, sources of cash flow might include operations. That is, a portion of a property might yield rent revenue while another undergoes improvement. The rental income is a source of funds outside the capital stack. Other sources might include grants, donations and retained equity.
Nonetheless, the capital stack usually represents the bulk of cash funding. To clarify, the stack contains debt and equity, including common stock, preferred stock and warrants. Naturally, each source of funds has its own cost, which creates a weighted average cost of capital (WACC). Clearly, a project’s return must exceed its WACC by a minimum threshold to warrant funding. If not, it would probably be best to entertain another property investment.
The sources of funds portion of the sources and uses of cash statement adds an element of fund timing. For example, you will need some cash at closing, while you may escrow other funds for later use. Typically, if cash flow is a source of funding, you use it to pay future expenses. Importantly, lenders may release loans in installments as a project progresses. Frankly, these are details that the capital stack doesn’t reveal. Naturally, when loans are contingent upon events, they may not match the capital stack depiction. It’s important for planning purposes to understand the timing of debt sources, both short-term and long-term.
We should make clear that an S&U statement is not the best resource for raking over past mistakes. Rather, it is a forward-looking document, showing when and where funds will flow through a project. By examining the S&U statement, investors can quickly understand a project’s scope and complexity.
Sources and Uses Sample Templates
You can find reference a sources and uses template from several sources on the internet. For example, the Local Initiatives Support Corporation offers this sources and uses template. You can find other websites offering a use of funds template as well.
Sources and Uses Table
A sources and uses table is simply the tabular presentation of sources and uses. You can also think of it as the spreadsheet or database containing the data required for the S&U table. For example, see this S&U table from the Securities and Exchange Commission.
Frequently Asked Questions – Sources & Uses
How do you calculate sources and uses of funds?
The calculation occurs in two parts. First, you total all the uses of funds necessary for financing a project. Then, you do the same for all the sources of funds. Plug any differences with the appropriate category for future sources or uses. The final totals for sources and uses should match exactly to the penny.
What is a source and application of funds statement?
It’s one of several alternate names for the S&U statement. Other equivalent names include:
- Statement of changes in financial condition
- Statement of changes in financial position
- Funds statement
Note that the cash flow statement largely replaces the sources and uses statement in modern accounting.
What does application of funds mean?
It means to use funds for a project. Typically, you use funds to pay for the purchase price of a property, hard costs and soft costs. Furthermore, you can break down these categories to reveal more detail in the S&U statement.
What is IBO analysis?
An IBO analysis is an institutional buyout analysis. An IBO analysis occurs when an outside institution acquires control of a company. Typical institutional investors include commercial banks, venture capital firms, and private equity firms. Importantly, it’s one way to take a public company private or to directly purchase a private company.
What is an LBO?
An LBO is a leveraged buyout, the purchase of a company using borrowed money. Frequently, the company’s assets serve as collateral for the loan. The buyer services the debt by selling off assets, laying off personnel and, frequently, bankrupting the company. Typical LBO’s consist of 90% debt, 10% equity funding.
The sources and uses of funds statement plays an important role in the development of real estate projects. In terms of fund sourcing, Assets America® can arrange financing starting at $5 million with no upper limit. Contact us to learn how we can source the funding for your next large, commercial real estate project.