Financial Analysis and underwriting is a 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, and we're gonna go
back to one of what I would call a rapid implementation call, it
was taking that information that I have that background and
experience I have, and putting it to use and making it
available to the people who I was coaching through the
process. So this is an excerpt out of one of those calls, it's
a deep dive into the machinery itself, how the gears fit
together as primarily also a 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 business
businesses, projects, budgets and other finance related
transactions to determine their performance and suitability. And
obviously, that's what we're mostly concerned about right
now. So this is the you know, making see it's that evaluating
piece that really is what we're trying to do, trying to identify
if this is something we want to do it this something that makes
sense. So it's the 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, to
finance or otherwise support or guarantee something. So I would
argue that as syndicators, we are basically supporting that
the overall thing, when we come up with our projections that
we're putting in our PPF, we are actually saying, you know, 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 just to set a framework that we 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
to when you're when you're talking to investors, it's
probably better to say financial analysis, because that does kind
of cover your underwriting as well. Because if somebody is a
stickler for those definitions, they may call you on it. And I
fortunately haven't been yet, but I could be. So what are we
doing when we are doing financial analysis? There's two
phases to this. So the first oops, the first phase is we are
taking a snapshot in time. As of now, what does that property
look like? So what are its characteristics? So if we looked
at all the things as let's put it this way, if we look at all
of the things that go into the bucket of the financial
analysis, we've got the most important thing for the the now
analysis is fact. We're trying to say these are the facts about
the property right now. Now we're gonna go into those in a
little bit more detail. But that's the the main thing that
we're trying to do today. And then much smaller than that,
that impacts how we look at that. And that changes this
picture that we're taking with this camera is our assumptions.
Right, it's small because it's just, they're 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
performer which I really considered 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 cam And so we're trying to say what is it
going to be in the future? Now, oops. Cloud Backup, when we're
looking to the future of what this looks like, the facts that
we have, aren't very become much less important. Because time
erodes all those things, leases start expiring, and maybe
they'll renew and maybe they weren't, taxes may go up, or
they may come down, they don't really go down, but they taxes
may go up, or they may go up a lot. And it's our assumptions
that start ruling the debt. And I'm gonna run out of room
assumption start ruling the day. So we go from big fact to little
fact and little assumption to big assumptions. And these are
what's changes. Now, the further you go out, the bigger this
effect is, because, you know, you're going to have to make
more and more assumptions. And the more and more things change,
the more and more those assumptions that you made, in
the very beginning, will do it. And so 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 the either the proof, certainly the performance that
you get from other people, but even the performance that you
get from yourself, that you're doing yourself for your own
investments, there's there's two ways of looking at, at that pro
forma, and how and how you're going to use those assumptions.
You have a a way that is I would call it let's call it optimistic
and then we'll call it I don't really want to use pessimistic
I'll say conservative. So they're either optimistic or
conservative. So because that's generally the terms that we use
in the industry, we don't generally say pessimist, so 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, they're not the most necessarily the most likely
to happen. Because when you're predicting the future, I mean,
there's obviously a huge range between, you know, from
something like, you know, very unlikely to happy happen to
unlikely to happen. And they probably go on some sort of bell
curve and to how they actually play out. And so if this is our
bell curve, our optimistic is probably at this end of the
spectrum. And our, our conservative is probably at the
center of the spectrum. So they're just they are like,
they're within that bounds of like, but not, they're not,
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 know, you're going to 10x or 10x the 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 in some world just not very likely
hours. So let's go through kind of how this range happens
between fact and assumption and amateurs this he is and we start
with the facts on this side. We start with the assumptions on
this because that's really what they come out they come out of
each other
facts for the for any property, somebody want to name a fact go
for it. What's what's a fact Size. 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
get what else? Fry price I think a lot size. I think well, yeah,
certainly lot sizes. I don't think price is a is a is a I
don't think price is a is a 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. Sar sure stands
for floor area ratio. So there's sighs I'm gonna put location
here because it's kind of a big topic, right? So we have
existing tenants, right? They they exist, they're in your
building. And that it'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 whether Well, let's start with what the
rental amount. So we don't know what their their rent, let's say
you don't necessarily know what their rent is going to be rent
next year, if they are on CPI. And oops, if so, and we'll talk
about that more, probably not in this call, but another comp. But
if their rental increases are, 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 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
the on their lease or not? Or if they're what kind of credit risk
they are. They 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 to guess that you're gonna make. So other
facts that you know demographics demographics at the given time,
is, is absolutely there. But you don't know in the next 10 years?
If you know, is it growing? Is it 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, you're gonna make, you're gonna make some guesses.
And those all have an impact on ultimately, your your market.
And maybe it's gonna be your it might be how your 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 the 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 we
in California, we have a more set set system, but we're very
much in the minority in the way we do things most of the country
has, has what the assessed value is going to be and then it can
that assessed value can change it can go up or it can go down.
And similar in California, you know there's there is still
ambiguity here prop 13 could go away. Whereas was on the last
election was to move prop 13 To eliminate prop 13 Four 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, 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 I mean, if
you're doing it yourself, you don't know whether 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 your management fee
or not. Utilities is a huge one. So, so I'm going to put these
together actually, utilities, contract labor. And by this, I
mean things like your garden, Port Portage, pest control, etc,
etc, 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 nother
category of your market leasing.
And your market leasing is something is a fact that what
does exist is your, your market and historical terms your market
and historical rents the how long it takes to to turn it. And
commission mounts, 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 Commission's if those greedy brokers are
going to start demanding more Commission's or not. And, 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 it. And it's we're looking
at at all of this through the lens of really the whole
investment itself, not just you know, your pocket, obviously,
but But building out projections for your investors. So each one
of these things put as has an impact. And then capital
expenses, obviously. Who knows, right? Who knows what's going to
happen on that a track 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 Proform. So again, the reason that we're
talking about it here and in this context is because all of
these things are part of your that snapshot that you're taking
right now. But to build that a pro forma. Those are all
assumptions that become the overriding thing. To that drive,
your your number at the end of the day. They're very 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. revenue. And it's really up to you to decide, you
know, it's a terrible drawing, it's up for 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, you know, a
sophisticated read doesn't just won't 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. Does they want they've got their own
assumptions that they've decided are, are what they're going to
base everything off. And it would also be who viewed to act
in a similar manner, start figuring out what your
assumptions are going to be about what things you do, I
mean, likelihood of renewal is how we'll see 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, you know, 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, 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 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
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, your
inspectors, your property managers, you know, 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
you'll 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 was this this 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? Was it a good pace? Anthony tech. Yeah. Okay. Good
luck. Yeah. Okay. Perfect. All right. So. 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 B. It all kind of builds on
itself. So this is the way that I see.
This, see, 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, 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, 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, we've got a series of gears that are all
kind of going to get now this gears turning around this is
your this can be thought of as your income to nice big gear.
They go in opposite directions because their gears this gear is
your expenses. Actually, I would let's just call it expenses,
because I don't want to get to compete. And then out of that
comes your and we'll have a go all the way out, that comes out
your cash flow. Or in this case, let's actually that will be a
little bit like. So let's say that this is your so this will
be operating expenses just because we're going to call this
their outcomes your noi. So now automatically in our machine,
we've got everything we need in order to calculate our, you
know, where 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 the NOI over your cost is your, you
know, 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 of how this thing
works. So as things change over time, you know, as it as income
goes up. So hopefully expenses come down. Your NOI is going up.
And then for that same cost, your cap rates going up.
Now if it costs you more obviously then it's going to be
be degraded. So I put it in that context just to set the frame
for how 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 by putting together a real estate fund or a
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estate need extra capital were the people to call