Budgeting

A budget is an itemized projection of income and expenses over a specific period for a particular property, project, or institution. A budget is a tool management uses to plan and control a property’s operations. A budget report compares the projection to the actual results during the specified period.

Note some of the language of the definition:

• A budget covers a defined period of time (not necessarily a year).
• A budget estimates income and expenses.
• Finally, a budget is a forecasting tool and financial measure that offers information to management about performance.

Information from several areas of real estate management is used in budgeting and decision making. Note how the financial and managerial issues intertwine:

• The annual operating budget is prepared using the information gathered about leases and expenses—an area typically administered by the real estate manager.
• Because the real estate manager collects rents and verifies the receipt of goods and services for payments of expenses, information gathered by the real estate manager is a basis for examining and forecasting expenses.
• The real estate manager compares actual income and expenses to budget projections and produces reports on the differences, called variances, between what was forecast and what actually happens financially. Variance analysis is important in spotting trends and in assessing why financial performance may differ from expectations. 

The budget is the basis for setting measurable goals, planning to accomplish those goals, and assessing how well goals have been achieved.   

Types of Budgets

Different budgets serve different purposes and monitor different types of finances. They are described briefly here, divided into short-term and long-term categories:

Short-Term Budgets

• Operating Budget (Annual Budget): a one-year, detailed plan for managing a property.
• Cash Flow Budget: a monthly or other projection of the cash position of a business. It accounts for all sources of income and expected expenditures, excluding income taxes, over the next budget period, which often is as short as a month.

The purpose of budgeting for cash flow is to determine how much actual cash will be generated during the next budget period and how much cash will be needed for operations and debt service. Preparing a cash flow budget forces a real estate manager to plan ahead.

The focus of the cash flow portion of a budget is different from that of the operating budget. The purpose of the operating budget is to forecast annual NOI, while the cash flow budget attempts to ensure that funds are available in the month they are paid out. Also, the cash flow budget is prepared after the operating budget. Rents, vacancies, and operating expenses for the year must be projected before the cash flow can be forecast.

The cash flow budget has the same line items as the operating budget. The cash flow budget, however, forecasts actual cash income and outlays. For example, the operating budget may show the total fee for window washing as $12,000 a year. The cash budget would reflect when the money was actually spent, for example, $6,000 in April and $6,000 in October when the window-washing bills are actually paid.

The cash flow budget can show budgeted and actual cash flows (both in and out) for operating, investing, and financing activities. 

With the importance of REITs (real estate investment trusts) in today’s marketplace, budgeting—accurate budgeting—is even more crucial. REITs look at future quarters, so major financial decisions are made based on projections and their accuracy. That increases the accountability of real estate managers.

Long-Term Budgets

• Long-Range Budget: a long-term projection that estimates future expenditures and the return period. It involves methods for forecasting income and expenses more than one year into the future. A typical long-range budget forecasts one to five years in the future. It is used to decide when and if to increase rents, financing, when to sell a property, etc.

• Capital Budget: a projection that describes the sources of funds for building up capital reserves for capital improvements. The capital budget also describes how and when those reserves will be used. It can be a component of the operating budget or kept as a separate budget.
  
  Every building has a life cycle. Over time, the fixtures, appliances, decor, and the building itself become obsolete or wear out. Eventually, replacement is needed, and replacing and renovating parts of a building often entail large outlays of cash, which means cash reserves are needed. 
  
  When setting aside cash reserves, a long-term view is best. A real estate manager should consider planning for at least five years. Some owners request that cash reserves be deducted from the property’s cash flow and set aside for future capital expenses. If the owner does not wish to set aside reserves, capital expenditures must come from the property’s cash flow at the time of the expenditure, advances from the owner, new equity from the owner, refinancing, or additional financing.

One of the main differences among cash, operating, long-range, and capital budgets is the span of time considered: A cash budget is usually set up month by month, an operating budget encompasses a year, and a long-range budget covers from three to five years.