When doing financial analysis for real estate syndication or funds, there are many different “levers” which can change the outcome for your investors and for you. In this blast from the past, we’re going to look back at a video I made about two years ago that talks about cash flow and what those levers are in cash flow. We’ll see how syndicators think about these levers and what they can manipulate to give the best return possible to investors, ultimately making more money for the syndicator or fund manager, and keeping everybody happy.
Let’s talk about our levers again. We’ve got our assumptions, which are actually straight facts and assumptions. These lead to our calculation of NOI (Net Operating Income), which leads to our calculation of cash flow, which in turn leads to our metrics and equity.
We’ve talked about facts and assumptions and how we calculate those things ad nauseam. We know what facts are, we know what our assumptions are, and we know that as we get further out from where we are today, we make more and more assumptions about what’s going to happen.
For example, when Anya and I were looking at a house for $174 a square foot, we made an assumption that turned out to be absolutely wrong. We assumed that $174 a square foot was a fair price for that house, and that in one year, similar properties would maybe be $200 a square foot. That assumption was wrong. There was no way I would have guessed that it would go over $200 a square foot in just six months, but it did.
Now, let’s talk more about cash flow. Cash flow really starts with NOI. There are two kinds of expenses: above-the-line and below-the-line costs, which we’ll call discretionary expenses. Cash flow is our NOI minus our discretionary expenses, and for our purposes, it’s cash flow before tax.
What are these discretionary expenses? The biggest one is debt service. When we’re looking at financing the property, we generally make more money when we put debt on the property because we need less equity. However, as a syndicator, I tend to make less money if I put debt on it, but most of the time you need debt to make the deal work.
Debt service includes principal and interest. In a syndication of a reasonable term, I would prefer to do an interest-only loan. The reason is that I’m making money off the spread between where I bought the property and where I’m selling it. If I’m reducing the principal by paying the bank back, I’m not getting great value on that compared to the big wins from the increase in property value.
Other discretionary expenses include leasing costs, tenant improvements, capital expenses, asset management fees, and reserves. All of these are subtracted from NOI to get your cash flow before taxes.
Now, is there anything that gets added to increase cash flow? Not really, at least not in the real estate game. Once you start doing that, you’re talking about the hedge fund world, which is a different ballgame.
I’m always trying to look at how I can “game the system” and improve various aspects: plus one my NOI, minus one my assumptions, plus one my facts, and double plus (or plus two) my equity. You should be thinking the same way. How can you increase cash flow? How can you reduce leasing costs or debt service?
As an aside, I’ve had recent conversations with several syndicators about hard money loans. While I understand the appeal due to timing and available funds, I can’t really see the point given how cheap money is right now and how many people are looking to invest. The interest payments and penalties on hard money are huge.
Regarding other expenses, it’s tricky to reduce tenant improvement costs in a hot market. This is not a good time for capital expenses either, as construction costs are high. Asset management fees are mine to decide, and I want to keep reserves as low as possible to give as much money to my investors as possible while still maintaining necessary reserves.
I hope this video was useful for you if you’re looking at putting together a syndication or fund. While this video was in the real estate context, financial analysis applies to any kind of security you’re putting together.
If you need help putting your security together, give me a call. My name is Tilden Moschetti, and I’m a syndication attorney with the Moschetti Syndication Law Group. We can help you with legal documents like private placement memorandums, operating agreements, and subscription agreements. We’re also here to answer specific questions about how to put things together and make your offering as good as possible. We’re here not only for the legal documents but to do whatever we can to help you be successful in your securities offering.