Investing in property

More than any perhaps any other sector, the importance of cash flow to property companies (as opposed to profit) needs to be emphasised. This is because of the diverse nature of property companies and associated accounting policies. For example, when a property company undertakes a building project, it will capitalise its construction costs (rather than charge them against income): it will also capitalise its interest payments on associated borrowings.

Let's say that a company is spending GBP 100 million annually for two years with associated interest costs of GBP 5 million per annum. At the end of two years, all going well, the company will have an asset in the balance sheet of GBP 210 million.

But, imagine if things didn't go well and the company became bankrupt. An investor focusing on profit might not have seen this coming because profits were effectively overstated by GBP 5 million for each of the previous two years. Analysis of the cash flow statement, however, would have shown this interest outflow and should have alerted the investor to a potential problem.

There are plenty of examples of property companies who ran into major cash shortage difficulties - Bredero, IMRY, Olympia & York - in spite of ultimately having extremely valuable assets on their books. For this reason, it's small wonder that major banks are among the biggest property owners in the UK.