Do Distributions Compromise Repayment?

A business can pay an owner two different ways, by either paying the owner a salary or awarding the owner some of the profits via distributions. It is not uncommon for a business to pay an owner both a salary and distributions. We generally accept that an owner’s salary is an operating expense like a manager’s salary that would need to be paid, regardless if the owner is actively involved with the business.

The treatment of distributions, which is when owners are paid cash for simply being an owner, is an underwriting question that a few institutions have inquired about recently. The main concern is whether distributions to owners should be considered a drain on a business’s cash flow. I think it depends, and it gets to be quite philosophical to explain.

From a pure accounting standpoint, yes, payments to owners is cash leaving the business. But, is a business weaker for having paid the owner? Take for example an apartment building, where rental cash flow is stable and recurs monthly. If a real estate investor borrowed money to purchase the apartment building, then he/she will use the rental income to pay the mortgage. If there is money left over after the mortgage payment, should the investor be allowed to take that money as profit, or should the investor be forced to keep it in an account for future apartment related expenses? This is a tricky question. The prevailing strategy is to make the investor save some of the money, typically called a capital expenditure reserve, but then allow the investor to take what profits are left after contributing to the reserve.

In the apartment example, we consider the cash flow available to pay the mortgage as the net income less the capital expenditure reserve. Some people believe the cash flow to pay the mortgage should be considered the net income, less the capital expenditure reserve, and less any cash the owner took. The latter method creates interesting reporting issues. If the investor takes all the profits, then the property looks like it is only achieving break-even cash flow. Or, if the property accounts have extra cash from earlier periods, and the owner takes this cash out, then this can result in the appearance of a cash flow deficit, even when the property is generating sufficient money.

In real estate lending, our collateral is primarily real estate, and the value of that collateral will not be seriously impacted by how much excess rental income an investor pockets as profit. For this reason, we tend not to limit owner distributions for commercial real estate loans. This is notably different than a commercial enterprise that has a line of credit secured by inventory or receivables, or a business borrowing for equipment or intangibles. When real estate is not the collateral, our security is “chattels,” which are items that can potentially be moved or liquidated without the lender’s knowledge. In this case, we care much more when a business owner wants to distribute money to him/herself. Now we rely heavily on the balance sheet strength for likelihood of repayment, and so we want to make sure the business retains cash to deal with fluctuations in revenue or expenses, and retains liquidity to make their debt payments!

What this boils down to are some general differences in structuring loan covenants. For commercial real estate, the collateral and ability for repayment have little to do with how much cash is being moved out of the business entity. The real estate holds value regardless of movement of cash, so we tend not to subtract distributions from cash flow we measure. Whereas, with a line of credit that is secured by accounts receivable, we want to prevent the borrower from collecting the receivables and distributing the cash, instead of first paying off outstanding debts. That is why in non-real estate transactions we count distributions as a negative impact to cash flow, because the distributions can significantly impair repayment of our debt.