In the world of real estate investing, many properties are purchased using debt financing. An investor who takes on debt to finance a transaction should understand what this means for their monthly cash flow. One of the most important concepts for investors to understand when they are taking on debt financing is accrual accounting and how it factors into the interest expense they will see at the end of the month as their payment date draws near.
In this article, we will explain what accrued interest is, why it is important for investors to understand, and how to keep track of payables during the accounting period.
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Accrued Interest Definition
Accrued interest is used in accounting to measure the amount of interest incurred by the borrower but not paid to the lender as of a particular date. Accrued interest can be applied to many asset classes, including student loans, credit cards, savings accounts, certificates of deposit, and real estate debt. Regardless of the asset class, the concept of accrued interest basically works the same way.
Every day throughout the month, interest accrues, or accumulates. This is known as daily interest. At any given time throughout the month, the borrower can calculate how much accumulated interest they have for the month, and this is their accrued interest amount as of that date. Typically, at the end of the last day of the month, the financial institution from which they borrowed will send a statement showing the accrued interest payable, plus any principal amount due. The borrower will make this payment to stay current on their loan.
How Does Accrued Interest Work in Real Estate?
In commercial real estate, it is common for an investment property to be purchased using a combination of debt and equity financing. The equity portion is usually cash the investor contributes to the deal upfront, while the debt portion is often a loan the investor takes from a financial institution or private lender. Either way, the investor will make a monthly payment to the lender for the agreed upon loan term. The monthly payment will consist of an interest payment and a principal payment.
Throughout the month the investor accrues interest on a daily basis. The amount of the accrual is based on the interest rate attached to the loan. For the investor, this amount represents an accrued interest payable, while it represents an accrued interest receivable to the lender.
Why is Accrued Interest Important For Real Estate Investors?
In commercial real estate investing, revenue is generally earned by leasing space to a tenant in return for a monthly rent payment. Owning real estate also comes with costs, one of which is financing costs. Investors need to understand the cost they will incur each month to finance the purchase of an investment property because this will determine the amount of cash flow left after paying the lender.
Accounting for Accrual Interest
As mentioned earlier, the accounting for accrued interest can be viewed from two points of view – the borrower and the lender. The accounting treatment differs for each.
Lender (Payment Recipient) Accounting
When a lender makes a loan, the loan becomes an asset on the lender’s balance sheet. This is because the lender will end up making a profit off the loan as long as the borrower makes the payments according to the repayment schedule.
From the lender’s perspective, accrued interest is a current asset, or an asset expected to convert to cash, usually within twelve months. As interest accrues throughout each month, the lender will record a journal entry in their books by entering a debit to accrued interest receivable and a credit to interest income.
Borrower (Paying Entity) Accounting
Accounting for a loan from the borrower’s perspective is basically a mirror image of the lender’s accounting. The loan represents a liability on the balance sheet for the borrower. As the borrower makes monthly payments, the balance of the liability will decrease over the loan term.
For the borrower, accrued interest stands as a liability because it is expected to be paid, usually within twelve months. The liability will increase throughout the month as the unpaid interest due to the lender accumulates. This is represented by a journal entry to debit interest expense and credit accrued interest payable.
On the first day of the month (assuming the loan payment is made) the lender and borrower make reversing journal entries to reflect this. For the lender, the accrued interest accounting entry would be reversed by entering a debit for interest income and a credit for accrued interest receivable.
Similar to the lender, upon making payment on the first of the month, the borrower reverses the journal entry by entering a debit to accrued interest payable and a credit to interest expense.
Difference Between Accrued Interest and Regular Interest
We have explained the accrued interest is interest that accumulates throughout the month and is recorded on the financial statements for both the lender and borrower.
Regular interest is a concept that is more familiar, even to those without an accounting background. Regular interest refers to the interest earned (by the lender) or paid (by the borrower). We often think of regular interest as the monthly interest earned on money in a savings account. But, regular interest can also be viewed as the interest revenue received in cash by a lender or the cash expense of an interest payment by a borrower.
In commercial real estate investing, investors are interested in what the regular interest amount will be each month. They can find this by using an interest calculator and plugging in the annual interest rate on the loan, the loan term, and the principal amount. Calculating the regular interest amount can help an investor to understand her expenses, build a proforma, and estimate the amount of cash flow left after paying expenses.
Summary of Accrued Interest in Real Estate Investing
When debt financing is involved in a real estate investment, interest accrues on a daily basis throughout each month of the loan term. The amount of the accrual is based on the interest rate attached to the loan. For the investor, this amount represents an accrued interest payable, while it represents an accrued interest receivable to the lender.
The borrower and lender make journal entries to keep track of accrued interest and make reversing entries upon making or receiving payments.
It’s important to understand that accrued interest and regular interest are defined differently. Regular interest can also be viewed as the interest revenue received in cash by a lender or the cash expense of an interest payment by a borrower.
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