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 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.
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. That’s supposed to be a clock in case you can’t tell. And that other one’s supposed to be a camera. So we’re trying to say what is it going to be in the future?
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.
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. So they’re either optimistic or conservative. Because that’s generally the terms that we use in the industry, we don’t generally say pessimistic.
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. Because when you’re predicting the future, there’s obviously a huge range between very unlikely to happen to unlikely to happen. And they probably go on some sort of bell curve in how they actually play out. So if this is our bell curve, our optimistic is probably at this end of the spectrum. And our conservative is probably at the center of the spectrum. So they’re just within that bounds of like, but they’re on opposite ends of each other.
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, because that’s never gonna happen. But you also don’t want to predict that the moon is going to fly into the building and destroy it and melt it all down and it won’t be an insured loss. Both of them I suppose could happen in some world, just not very likely in ours.
Let’s go through kind of how this range happens between fact and assumption. We start with the facts on this side. We start with the assumptions on this side because that’s really what they come out of each other. Facts for any property, somebody want to name a fact? Go for it. What’s a fact?
Size. Great. Yeah, it’s gonna be a certain size. Absolutely. Maybe you have plans on growing it, but that’s an assumption whether that’s gonna happen. What else? Price? I think lot size. Well, yeah, certainly lot sizes. I don’t think price is a fact, which it’s not done yet. You know what they’re asking, but you don’t know what they’re actually going to get or what it’s going to be at the end of the day. So I think it’s still a little bit gray. FAR sure stands for floor area ratio.
So we have size, I’m gonna put location here because it’s kind of a big topic. We have existing tenants, right? They exist, they’re in your building. And that’s not going to change that they are in the building at the moment that you’re taking that snapshot. What you don’t know is their rent next year, if they are on CPI. And we’ll talk about that more, probably not in this call, but another time. But if their rental increases are pegged as something like the consumer price index, you don’t know what Consumer Price Index is going to be. You probably are using a figure like 2% or something different to figure it out. But it’s an assumption that you’re making.
You don’t know what the default rate is going to be. You don’t know if those tenants are going to default on their lease or not. Or what kind of credit risk they are. You know that they are in existence, but you don’t know the likelihood of that actually happening. So there is a chance that’s going to happen. And that percentage that you apply is a question mark. You don’t know the likelihood of renewal. That’s a guess that you’re gonna make.
Other facts that you know: demographics at the given time is absolutely there. But you don’t know in the next 10 years if it’s growing or shrinking. Something can happen. Is it gentrifying or not? So I’m going to put it over here too. Because the demographics in the future, you’re gonna make some guesses. And those all have an impact on ultimately your market. And maybe it’s gonna be how your market sees it in the community. So maybe it would change your cap rate, or maybe it’s going to change your rents. But certainly demographics and how they change is going to have a pretty profound impact on what your property’s going to do.
You’ve got operating expenses. Now, you’ve got operating expenses that are historical, but you don’t know what they’re going to necessarily be in the future. Let’s take property tax. So in California, we have a more set system, but we’re very much in the minority in the way we do things. Most of the country has what the assessed value is going to be and then that assessed value can change. It can go up or it can go down. And similar in California, there is still ambiguity here. Prop 13 could go away. It was on the last election to eliminate Prop 13 for commercial buildings. It didn’t pass but it could have made it so that was also assessed value for commercial buildings. So it’s not a… It’s an assumption that you’re going to make whether it’s going to stay or not. Now, you probably are going to assume it. But it’s still in that realm.
You have a management company. But you don’t know if they’re going to continue or raise rates. You don’t know whether, if you’re doing it yourself, your costs of doing the management are going to go up. So that make it so that you’re going to need to change your management fee or not.
Utilities is a huge one. So I’m going to put these together actually: utilities, contract labor. And by this, I mean things like your gardener, porters, pest control, etc. Anyone that you’re hiring that isn’t part of your regular workforce is contract labor, and then we’ll put repairs and maintenance. So all three of these you are gonna guess on what the growth rate is going to be. Most of the time, I’m guessing it’s gonna be 2%. But that’s probably a little bit on the optimistic side, because I want that expense to be less, where 3% would probably be more conservative. Certainly on utilities in California, guessing on a low growth rate of 2% is probably very optimistic.
Then we’ve got a whole other category of your market leasing. And your market leasing is something is a fact that what does exist is your market and historical terms, your market and historical rents, how long it takes to turn it. And commission amounts, things like that. So I mean, all of these things can change, because you have no idea what the future terms are going to be. You have no idea what future rents are gonna be. You have no idea how long it’s going to sit on the market.
You don’t know if commissions… if those greedy brokers are going to start demanding more commissions or not. And if you’re doing your own commission, I mean, if you’re doing the leasing on the property yourself, you still don’t necessarily know what you’re going to charge. Because you may want to charge the other side. And we’re looking at all of this through the lens of really the whole investment itself, not just your pocket, obviously, but building out projections for your investors. So each one of these things has an impact.
And then capital expenses, obviously. Who knows, right? Who knows what’s going to happen on that? An HVAC system may explode, and suddenly you need to replace it. The roof may suddenly cave in and you need to replace it. Something can happen. You’re making an assumption on, “Well, I think this is going to need to be replaced or be repaired at this point in time,” but you don’t know. And so those all go into your pro forma.
So again, the reason that we’re talking about it here and in this context is because all of these things are part of that snapshot that you’re taking right now. But to build that pro forma, those are all assumptions that become the overriding thing. To that drive your number at the end of the day. It’s very easy to make a property look stellar, and it’s very easy for a property to look horrible. All in how you’re painting the picture. It’s really up to you to decide where on the bell curve you are going to put those assumptions. I mean, if you’re gonna put them here, or here, or here, or here, whatever, it’s up to you to make that decision. And when you do make that decision, just know that you’re making that decision.
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 over here that the broker is going to be painting their assumptions, and they’re being much more conservative on what their projections. So they don’t want to see it, it’s not even worth their time. They’ve got their own assumptions that they’ve decided are what they’re going to base everything off. And it would also behoove you to act in a similar manner, start figuring out what your assumptions are going to be about.
What things do I mean? Likelihood of renewal is… how do I do this? So CPI always set at 2%. It’s in general around there over the past 20 years. Default rate, somewhere between 5-10% if we are talking in a generally normally affluent area. Likelihood of renewal is really up to the tenant, it’s more of a feel thing. It’s somewhere between 50% to 90%, maybe 95% if you’re really, really comparable. Demographics, I mean, you’re probably paying attention to demographics as it went in. And whether you thought it was an area that’s gentrifying, you’re probably more likely to be interested in it. Whereas if it’s an area that you think is going to go downhill, and you think it’s going to tank, I don’t think you’re going to be putting investor money there.
Your property taxes you’re going to be doing based on either kind of figuring out where you were historical for assessed value, or if you’re in California, you’re using 2%, because that’s what Prop 13 says the maximum rate is. For management, you’re probably going to keep it consistent. For the growth rate, I tend to use 2%. For these, if I’m making a projection for what I’m going to tell investors, 2% is a reasonable rate. But it is probably a little bit optimistic. Certainly when it comes to things like utilities.
Market leasing assumptions. Now, here’s where you probably are going to base things mostly on history. So unless you’ve got a great deal of familiarity in the market, and kind of have a feel for where everything should go, you’ll probably pull a bunch of lease comps or ask other agents for lease comps, and base everything around that. And then your capital expenses, you’re gonna be relying on your inspectors, your property managers, people who have that industry knowledge who can say, “Well, you’ve probably got another seven years left in this roof.” And then you’ll figure that out.
So I’m going to pause here. Are there any questions on this part so far? Is that okay? Good. Was this too fast? Was it a good pace? It was too slow. I think I’ve pretty much got that part. Okay, good. Alejandro, Anthony. Good to go? Okay, good. Was it a good pace? Anthony, tech? Yeah. Okay. Perfect.
All right. Now, the next part I want to talk about, and this probably is going to be kind of review but I want it to be… It all kind of builds on itself. So this is the way that I see it. We’ve even got a little diagram built in and ready to go. This is the way that I see it. The very basic calculation of how cap rate works. So, and I’m going through my vision of it, because I think the way I see it kind of sets up how IRR works better and isn’t exactly the same way that they teach in the real estate courses, etc.
So, at some point in time, you buy this machine, call it machine, which is the property and you paid cash for this machine. And so that is your cost. So, we’ve got a series of gears that are all kind of going to get… Now this gear’s turning around. This is your… This can be thought of as your income. Nice big gear. They go in opposite directions because they’re gears. This gear is your expenses. Actually, let’s just call it expenses, because I don’t want to get too deep. And then out of that comes your… And we’ll have it go all the way out, that comes out your cash flow. Or in this case, let’s actually… So let’s say that this is your… So this will be operating expenses just because we’re going to call this… There outcomes your NOI.
So now automatically in our machine, we’ve got everything we need in order to calculate our, you know, what our cap rate is. And the cap rate is just… All it is it’s just a performance metric. It’s just a performance metric of how that machine runs. And so it’s just simply the NOI over your cost is your going-in cap rate for the building. And it’s… But all it really does, it doesn’t mean anything more than just a simple performance metric to give you an idea of how this thing works.
So as things change over time, you know, as income goes up. So hopefully expenses come down. Your NOI is going up. And then for that same cost, your cap rate’s going up. Now if it costs you more obviously then it’s going to be degraded. So I put it in that context just to set the frame for how the cap rate works.
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.