The House the Nonprofit Built
May 1, 2008 12:00 AMPractical Considerations for Nonprofits Considering Building or Buying Facilities
By James D. Cole, CPA
“Let’s just build (or buy) our own facility — our problems will be solved. “
“If donors truly believe in our program, then we can raise money to build it.”
“That other nonprofit just had a venture capitalist pay for their building. Surely someone will do the same for us, because we do a lot more good for the world than they do.”
Most people who have served on a nonprofit board of directors have witnessed a similar discussion. Almost every CPA who has nonprofit clients has heard at least one involved in a similar discussion. But what does this critical decision mean for the financial viability of the nonprofit entity?
The popular movie “Field of Dreams” adds Hollywood glitter to the belief that “if we build it, they will come.” Of course, in the case of nonprofits, the “they” being sought with a new building is donors bearing gifts, not all-star baseball players stepping out of a cornfield to play a ball game.
Unfortunately, the title of the movie hints at the reality of the situation for many nonprofits. An inappropriate decision could turn expected dreams related to a new facility into operational nightmares.
Approach the Decision Carefully
As is often the case, board members and the professional advisors of nonprofits do not always utilize the same business-like approaches in this decision process as they would in their own businesses. Often, the well-founded desire to support the worthwhile mission of the nonprofit overwhelms what might otherwise be sound business decisions.
For example, not every CPA firm owns its own building. There may be several sound reasons for this, including but certainly not limited to:
- A desire to avoid the “headaches” associated with property management
- A determination that for a particular facility, leasing is more economical than owning
- An unwillingness to tie up needed capital
- Uncertainties related to future space needs
- Uncertainties related to future revenue sources
Certainly, these reasons and others might also apply to nonprofit organizations. Board members and the CPAs who serve nonprofits must ensure that major decisions such as the purchase or construction of a facility are undertaken with sound economic and strategic judgment.
Clearly, the purchase or construction of a suitable building can, in some cases, be a great choice for nonprofit organizations. A wise decision could generate financial savings and perhaps additional rental income that can be used to support or expand the mission of the entity. However, an unwise decision could result in donor dissatisfaction, loss of focus on the nonprofit’s mission or the shifting of resources from critical programs.
It is not unusual for a board member or nonprofit employee to suggest the purchase or construction of a facility. Sometimes, this discussion arises because of the availability of a new or different facility. Other times, a contractor may sit on the board and suggest that it would be easier to build rather than to continue to lease. These discussions often arise during the annual budgeting process. At other times, the landlord may require the nonprofit to vacate its space, or the nonprofit may desire or need improved or additional space.
Whatever the motive, the decision must be approached carefully. This process may well be the most significant financial decision ever faced by the nonprofit. Certainly, a realistic financial projection for the operation of the proposed facility must be undertaken. CPAs are uniquely qualified to assist in this part of the process. Unfortunately, nonprofit staff often overlooks some of the basic costs that will be associated with owning a facility. A review of some of the issues normally faced by nonprofits during these decisions may be instructive.
First Considerations
Almost every entity considering ownership of a building desires to increase the available space. Valid arguments can be made that it is “better to build now what you might need in the future.” However, a source of revenue must be identified to pay for this additional space.
If the entity decides to lease out the extra space, then the nonprofit staff just effectively agreed to become landlords and property managers for other tenants. The entity must decide if that will be an appropriate use of their time, versus work on mission-specific programs and fundraising.
The entity must also determine when it will realistically need the additional space. It is also important to understand the local real estate market to verify if the extra space could realistically be leased out to appropriate tenants. Further, the entity must discuss if there are any possible tenants that would not be suitable.
While not all nonprofit organizations are charities, many are organized as such and are able to generate revenue from donations. Unfortunately, fundraising for facilities is often misunderstood.
First, a rule of thumb is that gifts in support of a building must be primarily in hand or at least firmly committed before the facility is built or, in the case of a purchase, occupied. Why? The fundraising argument generally attempts to “make the facility (dream) a reality….” That means that once the facility is there, it becomes significantly more difficult to raise money for it. Why? Donors can see it, therefore it is already a reality.
Donors assume that a facility would not have been built or purchased if the organization did not know how to pay for it in advance. The only thing harder than raising money for building operations is raising money for debt on a building. Intuitively, most donors know that banks and financial institutions would never lend money to anyone unless they were convinced that he or she would repay the loan. Therefore, nonprofits that borrow money for facility construction/purchase are in effect communicating to their donor base that they have already identified an income stream to repay the debt.
The nonprofit must carefully consider any plan to use a portion of the entity’s “regular” donations to repay building or debt costs. Not all nonprofit entities can be assured that their donations will not be reduced in the future, or that other programs might not need portions of their donation revenues.
For example, studies have shown that even in years when national giving trends increase in total dollars donated, many charities see a decline in their donations. Why? The dollars of donors are sent to other good causes. After all, the number of charities has been and will continue to increase every year. That means increased competition for donor dollars.
Outlining Costs
Additionally, many nonprofits overlook the costs associated with building ownership. For instance, tenant insurance is often far less expensive than property insurance, which is intended to replace the facility, not just its contents, and to insure against accidents and other liabilities. Building owners pay real estate taxes and nonprofit organizations are not automatically exempt from such taxes in Virginia.
Proper research must be conducted with local taxing authorities to determine the correct answer to this particular issue.
As tenants, nonprofits may not have had separate utility bills, but property owners are responsible for all utilities, unless they can find suitable tenants to pay their own utilities. In addition to utilities, what about the upkeep of the surrounding grounds? Who will remove the snow from the parking lots? Who will pay for and supervise the custodial staff? Who will pay for and keep up with the trash collection?
An entire series of issues can arise that just might cause the “field of dreams” seem to be more of a bramble thicket.
The best strategy is to calculate all costs associated with purchasing or constructing a building. In purchasing an existing facility, a prospective buyer could ask the owner for copies of the records of historical expenditures. Alternatively, a CPA or board member could easily provide the various categories of expenses that should be considered, and then the nonprofit staff could investigate sound estimates for each cost category.
For example, I have worked with several charities to calculate a long-term financial projection for proposed facilities. Such projections must include all sources of cash inflows, estimated on a conservative basis. All cash outflows should be estimated based on a reasonable basis, with a built-in inflation factor, as all costs can be expected to increase. While the cost of maintaining and operating a building can vary greatly, the following annual costs, based upon per square foot of building space, were included in an actual projection and are used simply as an example:
- Custodial of $1.00 per square foot
- Building maintenance/repair of $1.00 per square foot
- Grounds upkeep of $0.25 per square foot of building space
- Insurance cost of $0.15 per square foot
- Utility cost of $1.50 per square foot
- Management expense (new) allocated to the building of $0.60 per square foot
- Resulting in total costs per square foot before maintenance reserve of $4.50 per square foot
A maintenance or replacement reserve is an often-overlooked cost that must be funded regularly, if not annually. This is money that will be needed to replace the roof, repair major items such as the heating or cooling systems, repave the parking lot, etc.
The amount to be funded each year for a maintenance or replacement reserve can vary. It depends on many factors, including the age and quality of the structure and its intended uses. If this reserve is not funded, then the building is essentially a ticking time bomb. At any time, the heating system, roof, plumbing, etc. could have a major problem. Prudent planning would suggest setting aside at least 1 percent or so of the building’s value. After all, setting aside only 1 percent a year assumes that the entire structure and its improvements will last for a hundred years at historical cost (which, of course, is quite a stretch).
Following our example projection, the annual cash cost of owning the building, not including the cost of capital, seems to be $4.50 per square foot plus 1 percent of the cost of the building (construction or purchase). If we assume a very conservative construction or purchase cost of $100 per square foot, then we arrive at a cost of $5.50 per square foot (1 percent of $100 = $1.00 plus $4.50), at least in this example, to own the building. That means the cost to own is conservatively, on a cash basis, 5.5 percent of the building’s initial value ($100 per square foot). This of course assumes that a donor already wandered into the nonprofit’s office and donated the purchase/construction price, resulting in no acquisition or annual debt cost.
So, as a rule of thumb, whenever a nonprofit discusses owning a building, it is best to understand that the conservative approach would be to find twice the purchase/construction cost in ready cash. Why? If you need $1 million to buy a building, you would need, up front, another $1 million invested to return (at an annual rate of 5.5 percent) the money needed each year (averaged over a long term) to maintain and operate the facility, at least as outlined in our example projection of costs.
Construction Considerations
Most nonprofit managers have not supervised construction projects. When opting to construct a facility instead of buy an existing structure, nonprofits should be mindful of the following:
- Beware of construction contracts that are not absolutely fixed, such as “time and materials.” These require closer monitoring by the nonprofit.
- If the nonprofit is expanding its space, money will be needed to outfit and furnish the additional space.
- The nonprofit will likely incur additional legal and possibly accounting and other fees associated with the construction project.
- If debt is involved, the interest costs during the construction period are often overlooked.
- There will be insurance costs during the construction period.
- Remember that “change orders” also change costs.
- If donations will be used to pay for the construction, the timing of pledge payments will be critical and must be monitored.
- Because nonprofit staff are often not experienced in construction management, board members may need to be directly involved.
- Always expect to pay more than originally anticipated. It happens.
This article is not intended to discourage the purchase or construction of facilities by nonprofits. The projection used in this article was used for an entity that has established one of the most successful research parks on the east coast. The same model was later used for a highly successful retirement community. Great decisions to purchase or construct facilities can be made when done in a thorough and proper manner.
Many would argue that real estate is a great investment. However, like all investments, as the last year has shown, real estate can have its downturns as well.
In general, nonprofit entities have little experience managing property, supervising construction or participating in speculative real estate investment. The success of nonprofit organizations is very crucial for our society. Therefore, prudence must guide this critical decision — so for this reason, CPAs, with their experience and forecasting abilities, are uniquely suited to aid this vital sector of our economy.
With the wise counsel of CPAs, the “dreams” can be fully realized.
James D. Cole, CPA, is CEO of the Masonic Home of Virginia in Richmond. His 27 years of experience with corporations and nonprofits include roles as a founder, officer, consultant and auditor. He regularly speaks and writes on nonprofit topics, and he is a member of the VSCPA Editorial Task Force.
| |
Comments