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SKSP Insight: Deferred Maintenance in HOAs

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While some repairs can be put off for a short period, essential repairs that affect safety or the structural integrity of a building should never be deferred. Delaying maintenance can lead to higher costs, reduced property values, and increased liability risks. By implementing a comprehensive maintenance plan, HOAs can reduce the likelihood of deferred maintenance and associated costs.

As inflation continues to drive up costs for HOAs, it’s becoming more important than ever to find ways to reduce expenses without sacrificing essential services. While it may be tempting to defer maintenance projects to save money, it’s important to prioritize maintenance needs to prevent more costly repairs down the line. Focus on preventative maintenance to keep your property in good condition and avoid costly emergency repairs.

Deferred maintenance is the practice of postponing necessary repairs or maintenance to a later date, usually due to budgetary constraints. While it may seem like a cost-saving measure in the short term, deferring maintenance can actually lead to higher costs and more extensive repairs down the line. In this article, we’ll explore what can be put off, what can’t, the costs of delay, and more.

What can be put off?

While it’s generally not advisable to defer maintenance, there are some repairs that can be put off for a short period without causing significant damage or safety concerns. For example, cosmetic repairs like painting or replacing carpets can often wait a bit longer than essential repairs like fixing a leaking roof or repairing a damaged foundation.

What can’t be put off?

Essential repairs that affect safety or the structural integrity of a building should never be deferred. These repairs include things like fixing a leaking roof, repairing a damaged foundation, or upgrading electrical systems to meet safety codes. Delaying these repairs can lead to more extensive damage, safety hazards, and potentially costly legal liabilities.

The costs of delay

Deferring maintenance can lead to higher costs down the line. For example, a small leak in a roof that’s left unaddressed can lead to water damage, mold growth, and eventually, a complete roof replacement. Similarly, delaying foundation repairs can cause structural damage that requires more extensive and costly repairs.

In addition to the increased costs of repairs, deferred maintenance can also lead to reduced property values, tenant dissatisfaction, and increased liability risks. It’s also worth noting that many insurance policies require regular maintenance and repairs to be performed, and failing to do so can lead to denied claims or increased premiums.

The importance of a maintenance plan

To avoid the pitfalls of deferred maintenance, it’s important to have a comprehensive maintenance plan in place. A maintenance plan should include regular inspections and preventative maintenance to identify potential issues before they become more significant problems. The plan should also prioritize essential repairs and allocate resources accordingly.

By following a maintenance plan, HOAs can reduce the likelihood of deferred maintenance and associated costs, protect property values and tenant satisfaction, and mitigate liability risks.

SKSP Insight: Business Valuations

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How do you value a business? We’re going to dive into this complex process.

Valuing a business involves analyzing various financial and operational factors to determine the worth of the company. There are several methods used to value a business, and the most appropriate one will depend on the specific circumstances of the company you’re looking into. We should absolutely note here that this a challenging process and it’s important to consult with a professional business valuation expert to ensure a fair and accurate valuation.

Discounted Cash Flow Analysis

Discounted cash flow (DCF) analysis is a method used to estimate the present value of future cash flows that a business is expected to generate. The calculation takes into account the company’s revenue, expenses, and growth rate, as well as the cost of capital.

The first step in a DCF analysis is to forecast the company’s future cash flows. This typically involves creating a detailed financial model that projects the company’s revenue, expenses, and net income for a period of time, typically five to ten years. The model should take into account the company’s historical financial performance, industry trends, and any other factors that could affect the company’s future cash flows.

Once the future cash flows have been forecasted, the next step is to determine the discount rate, also known as the weighted average cost of capital (WACC). This is the rate of return required by the investors to invest in the business. The discount rate is typically made up of two components: the cost of equity and the cost of debt. The cost of equity represents the return that investors expect to receive for investing in the company’s equity, while the cost of debt represents the cost of borrowing money.

Once the discount rate is determined, the future cash flows are discounted back to their present value using the discount rate. The present value of the cash flows is calculated by dividing each future cash flow by (1 + discount rate) raised to the power of the number of years in the future that the cash flow is expected to occur.

The final step is to sum up the present value of all the future cash flows to arrive at the intrinsic value of the business. This is the value that the business is expected to generate for its investors over the forecasted period. It’s important to note that DCF analysis requires a lot of assumptions and predictions about the future, and it can be affected by the slightest change in the assumptions. Therefore, it’s important to make sure that the assumptions and predictions are well-informed and reasonable.

In detail: Weighted Average Cost of Capital

This is a metric that represents the overall cost of capital for a company. It’s the average cost of all the different types of capital that a company uses, including equity, debt, and any other forms of financing.

WACC is calculated by taking the weighted average of the cost of each type of capital, where the weight is the proportion of that type of capital in the company’s capital structure. The formula for is:

WACC = (E/V) * Re + (D/V) * Rd * (1-Tc)

Where:

  • E = the market value of the company’s equity
  • V = the market value of the company’s equity + the market value of the company’s debt
  • Re = the cost of equity
  • D = the market value of the company’s debt
  • Rd = the after-tax cost of debt
  • Tc = the corporate tax rate

The cost of equity (Re) is the required return on the company’s equity, and it can be calculated using different methods such as the Capital Asset Pricing Model or the Dividend Discount Model. The cost of debt (Rd) is the after-tax cost of the company’s debt and it can be calculated as the interest rate on the company’s debt multiplied by (1-Tc) to account for the tax shield provided by the interest expenses.

Once WACC is calculated, it is used as the discount rate in DCF analysis to find the present value of future cash flows generated by the business. The higher the WACC, the lower the present value of future cash flows, and thus the lower the value of the business.

WACC is a critical input in the DCF analysis and it’s important to use a realistic and appropriate WACC, as small changes in the WACC can result in large changes in the valuation. Additionally, it’s worth noting that the WACC is a forward-looking measure and it should reflect the company’s future capital structure and financing plans.

In Detail: The Capital Asset Pricing Model

This financial model is used to determine the expected return on an investment. It’s based on the idea that an investor’s required return on an investment is equal to the risk-free rate plus a risk premium that is proportional to the investment’s level of risk.

The formula for CAPM is:

Expected Return = Risk-free rate + (Beta * Market Risk Premium)

Where:

  • Risk-free rate is the rate of return on an investment with no risk, such as a Treasury bond.
  • Beta is a measure of the investment’s volatility in relation to the overall market. A beta of 1 indicates that the investment’s price will move with the market, while a beta less than 1 indicates that the investment is less volatile than the market, and a beta greater than 1 indicates that the investment is more volatile than the market.
  • Market Risk Premium is the additional return that an investor expects to receive for taking on the risk of investing in the stock market rather than a risk-free investment.

The CAPM model assumes that investors are rational and that they will only invest in an asset if the expected return on that asset is greater than the risk-free rate. It also assumes that the only risk that investors are compensated for is market risk, and that all investors have the same view of the market and the same level of risk aversion.

The model is widely used to estimate the cost of equity in finance and accounting, and it’s also widely used in portfolio management, security analysis and investment management. This is because of its simplicity and its ability to provide a benchmark for expected returns. The model does, howeverm have some limitations. For instance, it assumes that markets are efficient and that investors have access to the same information and that they are rational. It also assumes that basically the only risk that investors are compensated for is market risk, which is not always be the case. Therefore, it’s important to use the CAPM with caution and in conjunction with other methods to get a complete picture of the cost of equity.

In Detail: The Dividend Discount Model

This method is used to value a company’s stock by estimating the present value of the dividends that the company is expected to pay out in the future. The model is based on the idea that a stock’s value is equal to the present value of the future dividends that the stock is expected to pay out.

There are two main variations of the DDM: the Gordon Growth Model and the two-stage DDM.

The Gordon Growth Model assumes that dividends will grow at a constant rate indefinitely. The formula for the Gordon Growth Model is:

P = D1 / (r-g)

Where:

  • P = the current stock price
  • D1 = the next dividend that is expected to be paid
  • r = the required rate of return
  • g = the constant growth rate of dividends

The two-stage DDM is used when a company is expected to have a period of high growth followed by a period of lower growth. The formula for the two-stage DDM is more complex and it involves calculating the present value of the dividends for both stages, the high-growth stage and the low-growth stage.

Deeper Detail: The Two-Stage DDM Calculation

The model considers that a stock’s value is the present value of all future dividends. The formula for this model is this:

Intrinsic value = (D1 / (r-g1)) + (D2 / (r-g2))

Where:

  • D1 is the dividends per share in the first stage of the model
  • g1 is the growth rate of dividends in the first stage
  • D2 is the dividends per share in the second stage of the model
  • g2 is the growth rate of dividends in the second stage
  • r is the discount rate, which represents the required rate of return for the stock

The two-stage DDM is based on the assumption that a company’s dividends will grow at a different rate in the short-term and long-term. In the first stage, the company is assumed to have a higher growth rate, while in the second stage, the growth rate is lower.

It’s important to note when calculating the value, we assume dividends are the only source of return for an investor. The model’s accuracy depends on the assumptions made on dividends growth, discount rate, and dividends payout ratio. Always review your assumptions to determine if they’re realistic and if they make sense for the specific company you’re evaluating.

DDM is a relatively simple method for valuing a stock, but it has some limitations. One of the main limitations is that it assumes that dividends will be paid out in the future and that dividends will grow at a constant rate. This may not always be the case, as companies may choose to retain earnings or use them for reinvestment instead of paying dividends. Additionally, the DDM also assumes that dividends are the only source of return to shareholders, which may not always be the case, as companies may also issue stock buybacks. Therefore, it’s important to use the DDM with caution and in conjunction with other methods to get a complete picture of a company’s stock value.

Multiple Earnings Method

This method is based on the premise that a company’s value is directly related to its earnings. The valuation is calculated by multiplying the company’s earnings by a multiple that is determined by the industry and the company’s performance.

The first step in using the multiple of earnings method is to determine the appropriate multiple to use. This multiple is typically based on the industry and the company’s performance. For example, companies in a high-growth industry may have a higher multiple than those in a mature industry. Similarly, companies with strong earnings and growth potential may have a higher multiple than those with weaker earnings and growth potential. There are several ways to determine the multiple, such as industry averages, precedent transaction analysis or consulting with experts in the field.

Once the multiple is determined, it is multiplied by the company’s earnings to arrive at the valuation. The earnings that are used in the calculation are typically the company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) or the net income.

For example, if a company has an EBITDA of $1 million and the appropriate multiple for its industry is 8, the company’s valuation would be $8 million (1,000,000*8). It’s important to note that the multiple of earnings method is considered to be a quick and easy way to value a business, but it can be less accurate than other methods like the discounted cash flow (DCF) analysis. This is because the multiple of earnings method doesn’t take into account the company’s future cash flows or the cost of capital. Additionally, the multiple of earnings method is highly dependent on the multiple used, and a small change in the multiple can result in a large change in the valuation.

In Detail: How to Determine the Multiple

One of the most common methods is the comparable company analysis. This involves comparing the company being valued to similar companies in the same industry and using the financial performance and valuation of those companies as a benchmark. The multiple for the company being valued can be derived by comparing its earnings to the earnings of similar companies and adjusting for any differences in size, growth rate, or other relevant factors.

Another method is the precedent transaction analysis. This involves looking at the prices paid for similar companies that have been sold in the past, and using these transactions as a benchmark. This can provide a good indication of what buyers are willing to pay for similar companies.

Additionally, industry averages can also be used as a benchmark, and many professional valuators consult with industry experts to obtain an industry average multiple.

You should note that the multiple used in the multiple of earnings method can vary greatly depending on the company’s industry, size, growth rate, and other relevant factors. Therefore, it’s essential to use a multiple that is appropriate for the specific circumstances of the company being valued. Professional valuators often use multiple methods to determine the multiple and will adjust the multiple based on the specific circumstances of the company.

Asset-Based Method

This is a method of valuing a business based on the company’s tangible assets such as property, inventory, and equipment. This method is commonly used for companies in the manufacturing, retail or real estate industry.

The first step in using the asset-based method is to determine the value of the company’s tangible assets. This typically involves an assessment of the company’s property, inventory, equipment, and other assets. The value of these assets is typically determined by an independent appraiser or accountant, who will assess the assets and determine their fair market value.

Once the value of the company’s assets has been determined, the next step is to determine the value of the company’s liabilities, such as loans and other debt obligations. The value of the liabilities is subtracted from the value of the assets to arrive at the company’s net asset value.

It’s important to note that the asset-based method is relatively simple and easy to understand, but it’s often less accurate than the DCF analysis or the multiple of earnings method. This is because the asset-based method doesn’t take into account the company’s earning potential or future cash flows. Additionally, it’s also important to consider that the value of assets can fluctuate with time and some assets may have a limited life, which makes it harder to obtain an accurate value.

It’s also worth noting that the asset-based method is typically used as a “floor value” for a business, meaning that it represents the minimum value that a business would be worth based on its assets alone. In cases where a business has a strong earning potential, the value obtained through the asset-based method may not be representative of the true value of the business.