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Transcript

The Four-Step Financial Analysis Framework for Real Estate Syndication

I have a four-step financial analysis workflow that I do for every real estate syndication that I look at. Having an actual formal process is critical. Understanding financial analysis is the backbone; it’s the only thing that’s going to make you truly successful as a real estate syndicator or a real estate fund manager. So I hope you find this useful.

I used to have a training program about two or three years ago called Altitude. That’s why it’s called the Altitude four-step financial analysis. This is still the same analysis that I use today on every deal that I look at.

It all starts with, as we talked about last week, basic facts and assumptions. We talked about how there is a range, and how in the very beginning of your analysis, it starts very fact-based with a little bit of assumptions. Then it changes from there. As we go from just needing an NOI to getting a pro forma or a five-year cash flow, we start getting more and more assumptions. There are some assumptions that we make along the whole process, and we’ll see that go on. But we also have assumptions that we determine at the very beginning.

After we determine our basic facts and assumptions, we then figure out our NOI and our potential value. I say potential value because there is a big assumption there in determining value. We’re applying a market cap rate; this property hasn’t been appraised, it’s just what we think it would go for.

After we’ve determined our NOI and our potential value, we then look at cash flow. Here again, it’s getting a lot more assumption-based. Finally, after we’ve determined what the cash flow looks like, we have performance.

These are the four steps. Under performance, I consider not only how the property is potentially doing and what those projections about return are, but I also look at how it would perform as a syndication. How do those measures line up? So performance is really tied into not only the regular IRR potential of the property but also those measures on whether this is even a good investment for us to look at.

Breaking Down Each Underwriting Step and Its Components

Under each of these steps are different pieces of the puzzle. Under basic facts and assumptions, we’ve got facts, assumptions, and market data. Under NOI and potential value, we’ve got rent roll (which also feeds into income) and operating expenses. Under cash flow, we have things like debt, capital expenses (which I like to call other expenses), reserves, and taxes. Taxes isn’t really something we consider very much when doing a syndication, but it is important to know the after-tax cash flow as well.

In performance, we consider the purchase and sale, equity, and measures.

Understanding Financial Levers That Impact Syndication Returns

The most important thing I’m trying to get across is that there are different levers that move each of the main functions. There are a series of levers that change our NOI and our potential value. We have our income amounts, like rent roll. A lot of those things start off as facts, but we also have some things like whether or not we’re choosing to do pass-throughs, what we’re using for a vacancy factor, what we’re using for a credit factor, etc.

Expenses are obviously a big lever. I’m specifically not saying that we can change what we consider operating expenses, because operating expenses are fairly objective. But what we choose to use as our measure for it has some assumptions built into it.

There’s other income, vacancy, credit risk, pass-throughs, and management. If you are doing management yourself, how much you charge for management is certainly a lever that could change the entire NOI, which flows all the way down to what your investors would be getting.

There are also levers for your potential value. We’ve got our NOI, our price, and our cap rates. Price equals NOI over cap rate, so any of those things can adjust what that potential value is.

Out of cash flow, there are also major levers. NOI changes our cash flow, so every single one of the levers within NOI is within cash flow. Every one of the levers in cash flow also has an effect on performance. But some of the measures in cash flow do not have a downward effect; they’re not affecting things within NOI.

For example, debt. Whether or not we change debt has absolutely no difference on NOI, but it sure is a lever on the amount of cash flow. We also have our CapEx, asset management fees, reserves, growth assumptions, and hold period.

Performance has its own levers. We have cash flow and NOI, the price we’re willing to pay and the projected sales price, sales fees, purchase and syndication fees, waterfalls, hold periods, and to some extent, our discount rate.

Communicating Underwriting Assumptions to Sophisticated Investors

When we’re doing financial analysis and ultimately underwriting, we’re putting together a package that we can show potential investors of how we’re expecting it to perform. By understanding the different levers that take place within that process, the more we can tune it to being an asset that will work for investors to be enlisted at all.

It’s also important to understand how it all goes together like this. When you’re having conversations with more sophisticated investors, it’s much easier when you’ve got the framework in your head to switch gears and know what they’re talking about. You can address their questions or issues more effectively.

That’s why we’re talking about underwriting and financial analysis at all in this program. Theoretically, you could just take the simple thing off of a sales brochure and use that for your underwriting. But if you have all these things in mind, you can have real conversations with investors about how everything works. You can also fine-tune it as it’s going and make determinations.

For example, maybe you’ve decided your reserves aren’t high enough. But how is that going to affect everything else? If you need to increase your reserves, that means you have less cash flow, which means that the timing of your distributions is going to get thrown off. This means that you will need to let your investors know that the overall return for this period isn’t going to be what you thought it would be because you really want to build up those reserves. You can have those kinds of conversations when you understand the model and can make changes on the fly.

Applying the Framework Using a CCIM Underwriting Model

Let’s switch to this spreadsheet. This might look a little familiar. This is the CCIM Underwriting workbook. I chose to start here, rather than using what we were using two videos ago, because a lot of people will be more familiar with these sheets. I’ve actually added some stuff into these sheets to make it a little bit more useful. I think it will give a little bit of a basis of why everything goes where it does and how it fits together when you see a different model. Then you can see how what I’m talking about feeds into that.

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I hope you found the four-step financial analysis process to be useful to you. Feel free to give me a call if you need help setting up a real estate syndication or real estate fund where you’re looking to raise money for your business, or if you’re a developer and you need additional capital. We’re the people to call when you’re doing a Regulation D Rule 506b or 506c offering.