How to Review a Deal Proforma - Part 1 | Top of Mind Series

Welcome back to another episode of the Invest Like a Billionaire podcast. I'm your host, Ben Frazier, coming to you today with a top-of-mind episode all about how to review an underwriting file in 10 minutes or less. So if you're an investor that is trying to figure out, is this a deal I should invest in or not? And don't really know where to start to look at evaluating if this is a good deal or not, or how does it compare to another deal? I'm going to give you some real good tips in this episode and another episode, part 2 next week, on the key things that you need to be looking at to really understand if this is a good deal for you or not. So with these episodes, these are shorter episodes, uh, Top of Minds are either reacting to something going on in the economy, or we're going to start putting together more educational content. On things like this with just kind of basic 101 ways to help investors level up their investing skills and become better investors.

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So for today's episode, I'm going to be doing a part 1 of how to review an underwriting file in 10 minutes or less. And this is a really important topic because when we've done surveys in the past, I've talked with different investors. One of the biggest questions that we get and honestly concerns from investors is I don't have confidence that I'm able to make a good decision because I don't really know what I'm looking at, right? When I'm looking at an investment opportunity, how do I know that this is a good investment opportunity and how do I compare this one with maybe another one that I'm looking at? right? And it's a little bit hard to understand what are the kind of key things I should look at. So I want to take some time and talk through some of the kind of most important factors that are going to drive, in my opinion, the decision of making an investment or not into an opportunity. And for those of you that don't know, or maybe you are new to the podcast, my background is actually as an underwriter. So I used to underwrite commercial loans for different banks and actually lead the underwriting efforts as the Chief Investment Officer for our private equity firm, Aspen Funds, right now. I've probably seen over the course of the past 10 years, thousands, about multiple thousands of deals in more than just a cursory way. And I've reviewed lots and lots and lots of data. And so this is kind of my synopsis of what's important. What do I look at when I'm looking at a deal and reviewing an opportunity? What do I want to see to have confidence in moving forward with it? So with that, we're going to kind of dive right in. One of the kind of first points I want to make, and this is where I think a lot of investors miss the boat, is when you're looking at an investment opportunity, you're looking first at what's the rate of return, what's the IRR, right? And that is a very, very important metric. What generally happens is, you know, I like this deal and this is a nice IRR and it's higher than this other deal with a lower IRR. So I'm going to go with the higher one. But what you're not doing in that scenario is adjusting the returns based on the risk. And that's when you're looking at underwriting and kind of understand what is the risk that I'm taking in this deal to achieve a higher return, right? Because generally to achieve a higher return, you are taking more risk. Now, not all the time, but that's generally the correlation between risk and return. And so a 20% IRR on a ground-up development deal versus a, say, 13% IRR on a stabilized core asset is a very, very, very different set of risks that you're taking. So you need to understand what those are when you're looking at it. So that's what I really want to do is, is help you get past just the first IRR evaluation, actually get to the meat of what's really important in understanding if this is a good opportunity or not. So the first thing that I'll say when you're looking at an underwriting file, when you're looking at a presentation from a sponsor and reviewing a deal, and, and just for simplicity, I'm going to be focusing in this analysis and this kind of process I'm going to go through here for a value-add multifamily deal. And the reason is that's what most people have invested in over the past several years. It's still probably the most popular asset class. And a very popular strategy. Most investors are investing in value-add or development opportunities. These are retail investors, I mean, and they're generally going to have the higher returns, but there's a lot of things you want to look at when you're evaluating these. So with that in mind, the first thing I always do is just look at the overall deal, the big picture, look through the presentation, look through the business plan, and just ask myself the questions. Does this pass the smell test? Right. It's a very simple question. It's a very simple framework. But a lot of investors don't actually give enough credence to their own ability to have a good sniffer. I have a good ability to— does this make sense? Does this business plan seem achievable? And some of the things that I'm looking at when I'm looking at does the business plan make sense and pass the smell test, are how confident am I that this deal and this operator can achieve the rents that they are projecting to get right? So in my mind, I want to see some level of a proven upside. And a lot of times this wasn't as important, especially in the past few years, because when we were having, you know, in 2020, 2021, we're seeing rent inflation numbers of high single digits, if not double digits, that's historically an anomaly. And you could, you could just do a deal and just bank on higher rents the next year. That's great. But that has kind of— the times have changed, right? And so you can't just make the assumption that we can just achieve higher rates. You want to actually see the proven potential. And I think right now more than ever, this is why it's so important to do this because it's much harder to get the rent upside than it was in past years. And so what we want to see when I'm looking at a deal is how confident am I that they can hit these, these rent numbers? How conservative are they being? And I'll get to this later, but this is a very, very important question. This is probably the focal point of everything, right? Because the new market rent numbers the pro forma revenue that they're projecting in the underwriting creates the ceiling of all the income the property can earn, right? And now they'll assume there's an inflation, you know, that increases that over time, but it's going to be a small incremental number. You know, the kind of first big push on, say, a value-add deal in multifamily where you're renovating units and you're getting higher rents at the end of the renovation, lease them for hire. That delta, what you're able to achieve there is the biggest driver of value of anything else. And we'll get into that a little bit later in the second part of this content. So proven upside, we want to see how confident is that and really what are the ways to do that? One is the property already achieving these rent numbers that they are projecting. And one way that could be is some of the units are already renovated and are they achieving the numbers that they are projecting to hit for the rest of the units? So is there kind of a proven level? That's kind of the first— if that's happening already at the property level, then that's a pretty good indication that this is a pretty conservative, achievable business plan. The kind of next level would be you're looking at the comparable properties in the area at a short, you in a driving distance and understanding what are they already achieving for a similar level of renovation. Right. It's really important to dig into the market comps, the right comps of the property. Are they similar age of the property? Right. If this is a '70s or '80s, you know, vintage property, are the comparable properties that same vintage? Are the amenity packages the same? Right. Do they have a pool? Do they have a pickleball court? Do they have a gym? Do they have a leasing office, etc., etc.? All these different things you want to see as close to an apples-to-apples comparison for the rent comps that they're making the correlation to achieve. So that's kind of the first thing. And to me, that's probably the most important thing when I'm looking at is how achievable is that business plan? The other piece of this is what is the time to achieve that business plan, right? How long is it going to take to renovate all the units? Usually there's some kind of assumption that we can renovate 5 units a month or whatever the assumption is, but actually digging in a level further of how are they going to do that? Do they have other construction crews that they have at other properties they're going to reallocate? Is this all third party? Is they vertically integrated? Do they have the ability to renovate these in a quick way? Generally, if you're buying a value-add property, a lot of times you're not going to cash flow that kind of first part of the renovation period. So how are you going to fund that? Do you have enough cash reserves? The other kind of thing you want to look at is the local market knowledge and the data. So as we all know, right, real estate investing is very, very localized. We can make general comments about the real estate market in general, but that's really not very helpful because every market is, is so different in how it's performing based on supply and demand. And, you know, job growth, population growth. And there's always different factors that impact that. And then not to mention the submarkets within a broader MSA, you know, certain submarkets are having more people move there, certain submarkets are not as good to be in and they're on a decline. So you want to understand, so what's the localized market knowledge and the level of data that they have? Is that more just an MSA broad level or is it very localized within kind of a 5-mile radius? And does this operator have the experience and understand that market? Look through all the levels of comps, go onto the website and click through their comps. And does it seem to be a very similar property and are they achieving the levels of rent that this property's going to try to achieve? Another kind of thing going away from the property level, more at the investment level, is a few assumptions. One, how much of the return is derived from cash flow versus appreciation, right? So you can have an IRR, but IRR is purely what's the cash out and then the timing of when the cash comes back to me, right? And not all IRRs are created equal because if I have a property that is cash flowing at, say, 8 to 10% for 5 years and then we sell, we get a nice gain on sale, my IRR potentially could be lower if that gain on sale is not as large as a big value-add project, but it's actually a much safer return because more of my return is derived from cash flow, not appreciation. So you want to look at the kind of return of the pro forma, how much of the return of that IRR, how much distributions am I getting as an investor Throughout the whole period versus at the very end of the whole period, because if it's mostly at the back end, if most of your return is derived from the appreciation and the value of the property, you're taking more risk on several things. One, the business plan being achieved, but two, you're also taking a risk on the overall market at least staying the same. If they've had a similar cap rate on the exit than they have right now. Or in an improving market, right? So you want to understand that the other kind of thing too that some sponsors can do or some underwriting, you can improve the IRR by having a cash-out refinance earlier in the hold period. And while it's not necessarily a bad thing to show because you're sending cash back sooner in the hold period than at the end, it can actually improve and make the IRR look better by doing that. So you want to understand how much of the return is being derived Cash flow versus appreciation. If it's from cash flow, less risky, right? Because you're getting cash flow along the way. One, you're covering the debt service, and two, you have enough cash flow to pay out profits to the owners. And if it's appreciation, that's not a bad thing. It just increases the risk. And am I confident in the level of risk associated with achieving that business plan to hit those numbers? So that's a really, really important thing to understand. The other is understanding the debt structure. And I'm going to get into this more in the next segment, understand the underwriting file, but understanding the, the debt. This is to me probably the second most important piece of everything, right? As you look at the property level business plan, is that achievable, right? Does the market support this business plan? But the other side of this is, is the capital structure fit the business plan? Right. And that's where a lot of sponsors that are maybe less sophisticated might put on not great debt on their project that is actually a good project, but they're either overleveraging the debt, they're taking additional risks with floating rate debt or shorter terms. And so understanding the debt structure is really, really important to see if it actually supports the business plan in the whole period. Right. Is there alignment between the overall hold period and the business plan being achieved and the debt structure. So a lot of times when you're in a renovation period, a value-add business plan, again, you're renovating units. Most lenders will offer 1 to 2 years of interest-only payments before it starts to amortize, which means you're not paying interest and principal, which is a higher payment. And that allows the property and the business plan to have less cash being taken out of it in the short term while you're in the middle of this renovation period. But if the renovation period is going to take 3 years and you only have 1 year of interest only, you have to look and understand what's the impact going to be on cash flow from that year 2 and year 3 when you actually have a higher debt payment. So do they have cash reserves, right? So understanding the debt structure is very, very important to make sure it matches the business plan. But then also, have they accounted for all the risks with that and have they supplemented it with enough cash reserves Have they bought an interest rate cap to limit the interest rate risk exposure, etc., etc.? So these are kind of more conceptual things, but I wanted to start there because it's really important for investors not to just move past the quick sniff test. I look at the numbers and sometimes it's hard to know what to focus on. And so for me, it's always important to take a step back and ask the simple questions. Does it pass the smell test? Does the business plan seem achievable? Have they hit the rents of the property that they're looking to get for the rest of the units already? If not, are there a good comp set of properties in the short distance around it, similar age, similar vintage, similar amenities, that they're already achieving those higher rents on renovated units? Does the capital structure fit the overall business plan as well? We'll get more into that in the next segment. But with that, hopefully this is provoking some good thoughts for you, and I'm going to get a lot more tactical, get very specific on specific ratios and things you want to look at. In the next segment. So be sure to tune in next week when I go into how to review an underwriting file in under 10 minutes, part 2. All right. Thanks so much.