Episode 68 – How to Evaluate a Real Estate Syndication Deal: The Four Steps to Mastering Financial Analysis

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.

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.

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.

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.

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.

Let’s go ahead and get started. I put these in order as well. So, of the four steps, this is step one. This is facts and assumptions. These are the assumptions that are taking place within the five-year analysis workbook. The facts are actually more built on the NOI page than anywhere else. But I think it makes a little bit more sense to separate them out. You’ll see when we look at the four-step tool that we use, the spreadsheet actually breaks it apart into all the different parts just to make it a little more clear.

Here are our assumptions. Ordinary income tax rate, capital gains tax rates, straight line on recapture. Is it 25? This is actually 20 as of today. These are here because they’re part of CCIM’s analysis. CCIM really focuses on the investor side and helping investors make good decisions, whereas we talk about is more on the syndication side. We will go through the taxes probably next week, just because it is something that you do need to know.

Here are the other assumptions. What is the vacancy rate going to be of your property? How does rent escalate? So year one, year two, year three, year four. Right now we have it in 3% annual bumps. Income and other income are escalating at 3% a year in what we’re going to be using today. We’re not going to be using other income. Actually, no, we will be using other income. So it escalates at 3% a year, and expenses escalate at 3% a year.

The other income that we’re talking about is going to be pass-through. So it’s good that those match. Cap rate used in the sale, I think those are a little bit too broad. So let’s bring them down a little bit. Let’s say our alternative is 6, 6.5 and 7, and our expense of sale, let’s keep it at 6%. That means 3% per side. Actually, six and a quarter. Now we’ll cover our escrow and title fees as well.

Lease analysis is the next topic that we’re talking about. I decided rather than just go right to the rent roll, this is a good time to actually talk about lease analysis. So let’s go ahead and put it in the right step category that we have. This is the NOI and potential value step.

Let’s say this is the name of the building: 123 Main. Our first tenant is Joe’s store. They are in suite 101. I like to have lease abstracts for every single property I do, every tenant. This really has everything that you would need. It has some of the things like right at the top, you need to know obviously the tenant, which is very important to know right at the top because when you’re sorting through them, that’s how you’re going to sort through them.

Date of lease is the date the lease was signed, the term is how many years it is, the rent is whatever that rent is. The expiration date is that. So let’s say this is June 1, 2021. So a five-year term, we’ll deal with rent later. And then this would be May 31, 2026. Let’s say it is a 2500 square foot building. And we are, you know, how many parking spaces they’ve been allocated. I’m assuming this is going to be just a two-unit building. And so we’ll just leave that blank. Term in months, 60. You can put the security deposit, the renewal options. You want to fill this out completely when you’re doing your full analysis anyway because then you’ve at least got it in one very nice easy to see area.

And this section over here where we’ve got the paragraph number, now that is for exactly where it is in the lease. So premises is often in paragraph 1.1, permitted use is oftentimes in paragraph 4.1. Square footage is often in 1.1. Parking is like in 1.4, I think. Term is normally in 2, and this is just from, you know, from having done this. Security deposit, I think, is in 3, but I don’t remember. And renewal options is oftentimes like in maybe 4.5 or so.

And now we’ve got a rental period. So let’s say we’ve got in year one, so let’s say it’s 6/1/2021. And then it is, say, through 5/31/2022. So dollars per month, let’s say that they are at $5,000 per month, which means that they are also at $60,000 per year, $2 a square foot. And then we can figure out what escalations are going to be. But I just wanted to quickly go, you know, how we do this.

It has a lot of other great ideas for, you know, putting in who pays for what and operating expenses. These are things that are very, very valuable to know where the different parts of a lease are. I looked like I left in some from a previous use. So you can see like the subordination clauses in paragraph 20, the estoppel letters in paragraph 21, those are all where they normally apply anyway.

So there’s our first one, we’ve got Joe’s store. So let’s do one more quick one. We’ve already filled that in. So let’s say this is Bob’s restaurant. And so let’s say just for fun that they started at the same time, and they’re both on five-year leases. So premises is in suite 102. Square footage is, let’s put him at 3500 square feet, so fairly good-sized restaurant. And so if he’s starting in there, we’ll put him at 6. And let’s put him at, let’s put him at a very different dollar amount. Let’s say he starts at 8000 per month. And now we’ve got him paying 96,000 per year.

Now this all feeds into our rent roll, which is also still part of the NOI and potential value, right. So we’ve got this, this is the monthly rent. This is the annual rent, we’ve got Joe’s store, Bob’s store, obviously we’ve got a 6000 square foot building. So we’ve now identified the main parts of our rent roll for the purposes of NOI and potential value.

Now this will change as we have escalations built in, and it’ll have what pass-throughs are really coming in. But let’s say that our pass-through amount is, let’s say it is $1 a square foot, we’ll say it’s $12 a square foot in CAMs times 5000, I mean times 25. And then that he is paying $12 a square foot also. Alright, so now we have other income as 36.

So now let’s look at the NOI sheet. Now this is the full sheet that is coming from CCIM, and I’ve just referred to a few things in here. So what we’ve got is how we look at income. So the way that we start looking at income is that all that money that’s contracted for is rent that is contractual, it’s likely to occur. And so we are basically counting on it. So that’s the potential rent that you can get in this period right now.

Now we also count vacancies that we think are going to have going as well. But you want to make sure to reduce the amount for vacancies back out in this vacancy and credit losses. So don’t make it less than what the actual dollar amount is, you want it to be higher. So here we’re using just a rough. So our total potential rent income is that 156,000, we are using a 7% figure, because that came from here, it came from this assumption. We change that, their vacancy and credits risk to say 5%, because we don’t really have any vacancy. And then suddenly, now we’re using 5%. That’s a much lower figure.

So that leaves us with an effective rental income. Now here is a big lever, right? So this is a lever. Because how we change that obviously changes this dollar. Now if I, let’s put it back, it’s 7. Okay, so let’s put it back at 7 just for fun. And then we’ll see that now, you know, it’s 145,080, versus where we just changed it to 148,200. So obviously, it’s going to change that amount of your income. And since NOI is your income minus your operating expenses, it’s levering the entire equation, it’s changing all those numbers. And so it’s clearly just a lever to keep in mind.

So ultimately, then that leads us to the topic of our sales. For those who came in late, the reason that we’re going through this, we’ll go back over it again in the beginning just to finish up. But we’re going through the fourth step financial analysis, the last step is the performance step. And this is what your investors actually care about more than anything else.

So we’ve got our cash flows, what it would look like, what a potential sale looks like. Nothing new or extremely interesting. Again, taxes isn’t really relevant to the conversation of syndication, it will be part, it is part of your sheets as well, just because it should be. And just so that you have that information. And so you can use it on just investment property sales, or you could use it in brokerage, or you can use it in syndication.

And now here, you’ve got ultimately your IRR returns. So you sell it at your nice middle, your before-tax is a 15% return, which is pretty good. So for this sample property, we’ve got a nice reasonable return for our investors over a five-year hold period.

Now, again, we have levers in here. So all of those things that took place here in cash flow, but also our debt, because this was part of cash flow, is a lever. We change that, it automatically is a major lever. Our sales price is a lever. And a lot of these, I mean, you don’t know what it’s going to sell for in five years. But we have to make assumptions. So this is one of the bigger assumptions that we have to make. So it should be a reasonable assumption and supported by evidence.

But then we have our cost of sale. And this is your broker fees, right. So this is the amount of money that you maybe are taking as a brokerage commission for half of the deal. So in this simple transaction, you’re making, you know, over $80,000 in a for the sale of the property. I say 80 because that’s half of 165. Splitting out both – it’s a very bad idea to double-end a deal when you are acting as the seller. So that’s why it’s half of that.

And then ultimately we’ve got, you know, the hold period is five years. And so we have a nice reasonable return as our result. And all of it was affected by all of those levers.

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.