Bad Debt and Your Investments Balance Sheet
No one can deny that the Covid19 pandemic has had dramatic effects on just about every part of our lives. Landlords and Tenants alike both know that it has had an effect on real estate as well. With eviction moratoriums in place across many cities and states and the possibility of these moratoriums being extended further, the “bad debt” line on your investments balance sheet has become one of the most important line items to watch.
Let’s back up for a second. What is “bad debt” in the first place? Bad Debt is a line item on a balance sheet that is subtracted against the gross income, or the gross possible income depending on if you’re reading a current balance sheet or a proforma. It is essentially an uncollected balance. In rental real estate, this usually comes in the form of rent not being paid.
At the beginning of the month, rents are charged to all tenant accounts. These rent charges are considered income for the property but are recorded in the “accounts receivable” category meaning they have been charged but not received yet. We don’t want to jump the gun and count those rents before they have been collected.
Hopefully all tenants pay and there are no issues, but as you invest in larger buildings with more units you will inevitably get a few tenants that don’t pay. This is to be expected and is not typically a cause for worry unless the number of tenants not paying increases to an unhealthy level (5% or higher)
Past due balances remain on the balance sheet as income until the situation is resolved. We often see this situation resolved in one of three ways
The tenant pays the past due balance in full
An agreement is made between tenant and landlord for the tenant to begin paying off the past due balance over a period of time, often through a payment plan
The tenant is evicted for failure to pay rent
If the tenant pays rent in full or begins a payment plan and sticks to it, there is no bad debt to write off. If the tenant is evicted, more often than not, there is no feasible way to collect the past due balance and it is not worth the time, money, or effort to pursue the tenant for the balance due. If this is the case, the unpaid rent would shift into the “bad debt” category.
On small properties it is pretty easy to know what your bad debt is and most small landlords don’t track bad debt at all (usually it is lumped in with “vacancy”). Hopefully you don’t have to deal with much bad debt at all on a smaller level as the loss of one or two months rent on a duplex or single family home is a significant blow to both your top and bottom line. With larger commercial properties, bad debt is a regular line item and is important to differentiate from vacancy or other losses.
If you’ve invested passively in a syndication, monitoring the balance sheet of your investment is a good way to make sure that your investment is on track. These days, with everything going on around rent freezes and eviction moratoriums it is important to keep an eye on the bad debt line and compare it to the account receivable lines. While eviction moratoriums do not absolve tenants of rent owed, the chances of collecting on 6-12 months of past due rent are highly unlikely and accounts receivable should not be counted as income until they are fully received. If you notice that your sponsor isn’t writing off bad debt or isn’t fully accounting for the actual rent received against the rent charged, it may be time to speak with your sponsor about their plan for making it through this difficult time.