Key Takeaways:
- Financial analysis and underwriting are foundational skills for syndicators, because projections in a PPM represent the sponsor’s reputation and guarantees to investors.
- Financial analysis evaluates performance, while underwriting reflects sponsor responsibility, meaning syndicators are effectively standing behind their assumptions.
- Underwriting shifts from fact-driven to assumption-driven over time, as future projections rely increasingly on judgment rather than current conditions.
- Optimistic versus conservative assumptions determine investment outcomes, and sponsors must consciously choose where they fall on the bell curve.
- Sophisticated investors and REITs never rely on broker pro formas, instead applying their own standardized assumptions to stress-test deals.
Transcript
Why Financial Analysis and Underwriting Matter for Syndicators
Financial Analysis and underwriting is an absolutely critical skill for syndicators and fund managers to know like the back of their hand. I used to coach people on how to syndicate real estate in a program that I used to have. Today, we’re going to take a look back at one of what I would call a rapid implementation call. It was taking that information and background experience I have, and putting it to use and making it available to the people who I was coaching through the process. This is an excerpt out of one of those calls. It’s a deep dive into the machinery itself, how the gears fit together, primarily also between the facts and assumptions and how they all work as part of this big machine in order to generate money to pay for investors. I hope you find it useful.
Financial Analysis vs. Underwriting: Understanding the Difference
Financial Analysis is the process of evaluating businesses, projects, budgets and other finance-related transactions to determine their performance and suitability. Obviously, that’s what we’re mostly concerned about right now. So this is the evaluating piece that really is what we’re trying to do, trying to identify if this is something we want to do, if this something that makes sense. It’s that evaluation that we’re doing. But at the same time as syndicators, I would say we also do this underwriting piece as well, because underwriting is to finance or otherwise support or guarantee something. So I would argue that as syndicators, we are basically supporting the overall thing. When we come up with our projections that we’re putting in our PPM, we are actually saying, “This is what we are putting our name behind and putting our reputation on.” So to me, that is underwriting.
I think it’s just important to set a framework that we talked about them in the same thing, and I probably will keep saying them synonymously as well anyway, because it’s habit. They aren’t actually the same thing. So you may want to call it out when you’re talking to investors. It’s probably better to say financial analysis, because that does kind of cover your underwriting as well. If somebody is a stickler for those definitions, they may call you on it. I fortunately haven’t been yet, but I could be.
Snapshot Analysis vs. Forward-Looking Pro Forma
So what are we doing when we are doing financial analysis? There are two phases to this. The first phase is we are taking a snapshot in time. As of now, what does that property look like? What are its characteristics? If we look at all the things that go into the bucket of the financial analysis, we’ve got the most important thing for the now analysis: facts. We’re trying to say these are the facts about the property right now. We’re going to go into those in a little bit more detail. But that’s the main thing that we’re trying to do today. And then much smaller than that, that impacts how we look at that and changes this picture that we’re taking with this camera, is our assumptions.
It’s small because assumptions are not as big or important at this now stage. But what are we trying to do when we’re trying to do an analysis and build projections or a pro forma which I really consider to be the same thing? We’re trying to set up something for the future.
How Assumptions Overtake Facts Over Time
When we’re looking to the future of what this looks like, the facts that we have become much less important. Because time erodes all those things, leases start expiring, and maybe they’ll renew and maybe they won’t. Taxes may go up, or they may go up a lot. And it’s our assumptions that start ruling the day. So we go from big fact to little fact and little assumption to big assumptions. And these are what change.
Now, the further you go out, the bigger this effect is, because you’re going to have to make more and more assumptions. And the more things change, the more those assumptions that you made in the very beginning will do it.
Optimistic vs. Conservative Underwriting Assumptions
This process is building your pro forma. The reason we are even talking about this right now is because it’s important to have in your head that either the pro forma that you get from other people, or even the pro formas that you do yourself for your own investments, there’s two ways of looking at that pro forma, and how you’re going to use those assumptions. You have a way that is let’s call it optimistic and then we’ll call it conservative.
We can use assumptions that are very optimistic, and they’re still true and based in have a foundation for choosing them. But they’re not necessarily the most likely to happen.
You wouldn’t want to go all the way to this end and be so optimistic that you’re predicting that you’re going to 10x the rents every year for the next 50 years. But you also don’t want to predict catastrophic scenarios that are equally unrealistic. Both extremes are unlikely.
Identifying Facts vs. Assumptions in Real Estate Underwriting
Let’s go through kind of how this range happens between fact and assumption. We start with the facts on this side. Facts for any property include size, location, existing tenants, demographics at a given time, historical operating expenses, and current market conditions.
What we don’t know are future rent increases, default rates, renewal likelihoods, demographic shifts, expense growth, management costs, utilities, contract labor, repairs, and capital expenditures. All of these become assumptions that must be modeled.
Expense Growth, Leasing Risk, and Capital Expenditures
Utilities, contract labor, repairs and maintenance, market leasing terms, commissions, and capital expenditures are all areas where assumptions dominate projections. These are often estimated using historical data, inspections, and professional judgment—but they remain assumptions.
Capital expenses in particular are unpredictable. HVAC systems fail. Roofs need replacement. These unknowns must be accounted for in reserves and projections.
Why Sophisticated Investors Ignore Broker Pro Formas
This is the same reason that a sophisticated REIT doesn’t just take a broker’s pro forma, because they know that it’s always going to be painted optimistically. Instead, they apply their own conservative assumptions. It would behoove you to do the same and define your own underwriting standards.
Visualizing Cap Rate as a Performance Metric
Now, the next part I want to talk about is the way I see cap rate working. Think of the property as a machine. You buy the machine at a cost. Income and expenses are gears inside the machine. Out of that comes NOI.
Cap rate is simply a performance metric. It’s NOI divided by cost. It tells you how efficiently the machine is operating at a given point in time. As income rises or expenses fall, NOI increases and the cap rate improves.
Hope you found that blast from the past useful. My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group. Now if we can help you put together a Regulation D Rule 506(b) or 506(c) offering, don’t hesitate to give us a call, whether you’re doing a business that you’re raising capital for, buying real estate, putting together a real estate fund or a private equity fund, or you’re a developer and developing real estate need extra capital. We’re the people to call.