Must Know Metrics When Evaluating an Investment

Welcome back to another episode of the Invest Like a Billionaire podcast. I'm your host, Ben Fraser. Have another top of mind episode for you. This is part 2 of how to review an underwriting file in 10 minutes or less. Last week I spent most of the time talking a little more conceptually, right? But not moving too fast away from that gut check. Smell test. Does this business plan seem achievable? Asking just the simple questions at a high level of do all the pieces seem to fit together with this, right? Is there, you know, proven upside in the market rents that they're wanting to achieve after the business plan? Does the time to achieve that seem reasonable? Right. Is there good local market data and knowledge of this specific area and submarket the property is in? Is there a good comp set? Is the capital structure supporting the overall business plan, right? Is there a mismatch between what the debt looks like and the timeframe needed to achieve the business plan? You know, looking at how much of my return is derived from cash flow versus, you know, value at the end of the day from appreciation of the property, you know, that increases risk. So there's not always one right answer to these things, but it's a combination of putting the pieces together and understanding where on the risk spectrum does this start to fit, right? If there's a misalignment of certain things, well, it starts to, you know, increase the risk. If there's, there's less confidence in hitting certain assumptions, well, it's increasing the riskiness, right? And so these are things that you really want to be just at a high level taking in because no one data point is going to give you everything that you need to know about the property, making an investment decision. Right. And so we're going to go a little bit more tactical today. And for those of you that aren't finance people or you don't necessarily like numbers or math, I apologize in advance. I'm going to go a little bit more into the weeds on some of the important ratios and things to look at. But with the caveat, I'm not going to overwhelm you. I'm just going to give a couple of ones that I think are really the most important metrics to look at when you're looking at the underwriting file, because I understand, you know, as some investors don't come from a background of underwriting, and when they see a file, an Excel spreadsheet that's 15 tabs and all these different assumptions, it's all like, yeah, like, it seems very overwhelming. Where do I look at? I mean, it looks like they have a lot of formulas in here. They probably know what they're doing. That seems good. Well, what I want to do is give you the kind of few quick ratios to look at to kind of add to that, that gut check, add that smell test. And then just to even provoke and ask more questions of the, the sponsor making the offering, the investment to get clarity if you don't know. But these are the things that I would look at. Okay. So the first thing we're going to talk about is cap rate, right? This is a very important metric. A lot of investors focus on this, but I want to put it in its right context, right, of where is it actually most important and where does it kind of fit in the overall understanding of evaluating the deal. First off, for those who don't know what cap rate is, it's a very simple formula and it's the net operating income, the income generated by a property divided by the value of a property. Right. And so this is the cap rate. It's a capitalization rate. And there's a few things we understand with this number. Right. So there's— it sounds like a simple formula, but there's actually a million different ways to calculate it. And that's where it gets confusing. So there is something called a going-in cap rate versus a reversion cap rate. So what that means is a going-in cap rate is what is the cap rate at purchase? And that is going to be generally the last 12 months of net operating income generated by the property as is divided by the purchase price. And that, that creates the, the cap rate that you're purchasing the property at right now. Now that's important to know, but I would actually argue it's actually not that helpful in evaluating the business plan. I'll get to that in a second. The reversion cap rate is what is the assumption that is being used in the underwriting on the cap rate upon the sale, right? Because the cap rate drives the value that the property is sold at once the business plan is achieved. I saw in going back to last episode on how much my return is from cash flow versus appreciation. If most of the return is derived from increased value of the property, a lot of that is going to be driven by that cap rate assumption. Right. And so you really want to understand what is the assumption for that. Now, there's some kind of rules of thumb. One rule of thumb is, you know, I want to increase the cap rate by 10 basis points or 0.1% every year that I hold the property and I'm increasing it from the going-in cap rate. That's a rule of thumb. I don't necessarily think it's very helpful because that situation doesn't apply in all scenarios. You also make the assumption that the going-in cap rate is actually the market cap rate, which a lot of times it isn't if it's a heavy value-add project. And so it's important to me to look at what is the assumption on the exit, disassociate it from the going-in cap rate. I want to look at what is the reversion cap rate, what's the exit cap rate that is part of the assumption, and does that kind of fit the current market scenario for that type of a deal, right? Because it's generally going to be a different range of cap rates for a value-add property versus a stabilized property. And those ranges kind of fluctuate over time, but they're usually not apples to apples. Because there's a different buyer pool for a stabilized property versus a value-add property. And generally, when you're looking at the exit cap rate, you want to understand a few things. And this is becoming more important now than probably it has been over the past several decades. But you have to look at an exit cap rate is what the next buyer is looking at from a value standpoint, a cash flow standpoint, given kind of the current market debt environment that they're going to be buying in, right? So obviously the expectation is things are going to change over the next few years, but especially right now where it's a very tight credit market, meaning it's very expensive to get debt. It's a lot of pressure on cap rates because buyers coming out of stabilized property, they can't go into what's called negative leverage situation. They can't go and purchase a property at a lower cash flow than the debt service to pay it, right? That's called negative leverage. One kind of quick thing to understand and look at is understanding. So, so cap rate is the total yield generated by the property without debt. If the total yield, that cap rate is lower than the current interest rate on debt for that type of property, that's negative leverage. That means it's actually the debt to purchase that cap rate is more expensive than the yield that it's generating. To purchase it. So it's very important to understand on that back end, do those numbers make sense, right? Is the cap rate going to be higher than the debt assumptions at that point? Because that's going to be important for the next buyer when they're looking at the property and want to make sure that they're going to be in a positive leverage scenario, which is when the cap rate is higher than the interest carry costs. And that's really important to understand that next buyer coming in. Right. So it's not just Does the cap rate increase by 10 basis points every year that I'm holding it from the purchase cap rate? That's not a very helpful rule of thumb right now. Some scenarios that can actually work. And the idea is they're trying to be more conservative on the cap rate than when you are purchasing it. But it's usually pretty incomplete analysis because especially right now when the credit markets have changed so dramatically, it's very, very difficult to have that match what's going to happen down the road. So that's an important thing to understand. So the next metric that I want to focus on is yield on cost. And this is a number that's similar to the cap rate, but it's really, really helpful for a deal that is a value-add deal or a development deal, right? Any, any type of investment where a lot of the return is going to be driven from increase in the operating income over time and creating value by, by increasing the income. And the way that this is a very simple formula, but it's simply the future stabilized net operating income divided by the total project costs. All right. So it's a little bit different than the going-in cap rate where it's, you know, the current net operating income divided by the purchase price. That won't account for what does it take to achieve the business plan, right? How much of the total project cost is my renovation budget, my CapEx? My fees and all the things that are wrapped in. So it's, it's a very simple metric, but it creates the ceiling of what is achievable to hit that current yield. So yield on cost is again similar to a cap rate, but now it's going to account for all the costs associated with achieving this business plan on a future stabilized basis. So, you know, you could have a going-in cap rate of, say, 6% on a multifamily property, but your, your yield on cost could be, say, 7.5%, maybe even 8%. At the end of the day, after spending all the budget for the renovation, for CapEx, taking all the fees, that property will now produce a 7.5% to 8% unlevered yield on those total costs. Now, why does this matter? Why is this important? Well, it's really important to understand what's called the development spread. And so this is really helpful on development projects where the value and the return is like 100% derived from appreciation because there is no cash flow along the way. But it's also very helpful in value-add deals where a lot of the return is derived from the property improving in value. And so you want to look at what's the difference or the delta between my yield on cost minus the exit cap rate. So what the market cap rate for that type of a property. And if that's a significant positive number, meaning, you know, 100 basis points, 200 basis points, what that does is create the margin for that value to be realized because we can generate a 7.5% yield on this business plan given the costs that we're going to put into this. But the market cap rate is, say, 6%. So that's 150 basis points, a 1.5% delta. That's the value that's being driven. That's the appreciation that can be forced in the property because obviously when cap rates go down, the values go up. And so you can generate 7.5% yield by the, the business plan that you're doing, but you can sell that at a 6% yield to the next buyer. And that's where a lot of the value is captured, right? So understanding that difference between yield on cost and exit cap rate is really, really important. Another kind of version of this, this is less relevant to equity investors, but it's really important for the lenders and understanding how the lenders look at it. It's debt yield. So it's, it's pretty simple, but it's, you know, future stabilized NOI, not divided by total project cost, but divided by the total principal balance of the debt. Right. So it's always going to be higher than yield on cost. And it's important to understand from a lender standpoint, how much risk are they taking if the project doesn't work out, they take it back. Is there enough yield for them to earn the return they need to return on, on their capital? So it's another form of it, but it's really designed for lenders, not as much for investors, though it can help with understanding the type of debt and leverage that is going to be brought into it. So I'm going to spend another top of my segment just on understanding debt terms because that's a whole other topic that's really, really important. But I'm going to go kind of the last section here on today's episode is really talk about what factors impact the underwriting the most, right? What are the kind of ways that a sponsor could potentially juice the returns a little bit by just changing a few little numbers? Having put together and evaluated hundreds and hundreds of models, they all come down to these few things that are are really going to be the biggest drivers of impact to the reality of the returns being hit. Here's the reality. I hate to say this, but you can make a pro forma say whatever you want to say. That's the reality, right? Most of the time investors assume that, hey, whatever the model spits out, that's what I'm going to put in the presentation for investors and say we're going to hit. Usually, you know, there's going to hopefully be like a range of potential outcomes that they can hit based on a variety of different factors. But by changing a few simple inputs, you can modulate and basically get to whatever number you want to get to by changing a few things. And that's what's really important to understand. Where are the most sensitive parts of an investment model, pro forma model, in, say, in this case, a value-add multifamily, but really in any asset class, any business plan, any pro forma? What are the most impactful numbers? I'll tell you right now, first one Said it earlier in the first segment, the market rent numbers establishing the case for how achievable is that upside in rents going to be, because again, that creates the ceiling, right? It's a real estate property is pretty simple. It's how much rent can you generate? What are the expenses you have to operate it? How much is left over? That's your operating income. At a very simplistic level, that's as complicated as it gets. There's a lot more work to that, right? But if you are setting the market rate numbers, this is what I think I can achieve at a top line that creates the ceiling for how much income you're going to be able to derive from that, right? And so understanding the market rent and how achievable is that is so, so important because if the assumptions are, say, 10% higher than market, even just 10%, that can have a massive impact on the return of the project, especially if it's a levered project, if it has any debt on it, which most real estate does, right? That has a significantly asymmetric impact to the equity investors and the debt investors. Even just a 10% difference from achieving those. So you want to understand how aggressive or conservative are those numbers because that creates the baseline and the kind of ceiling again that you can achieve. And so you want to understand how achievable is that, because that's really going to be one of the biggest factors of the overall business plan, because that's what you're shooting for. That's what the operators are trying to hit. You want to understand how achievable is that. The second one, and this one is a really simple little change, but it is so impactful and it's a really simple way for sponsors to juice the returns. It's an inflation assumption. This is really simple. It's usually in some kind of the assumptions tab or somewhere in the model that you know, what's the rent inflation annually going to be? Right. And it makes sense that you would expect over the course of time the average increase in rents is somewhere between 2 to 3%, depending on the market, depending on what metric you're looking at. But, you know, that's just a reasonable assumption. The problem is if you just change that like 3% number to a 4% number, it doesn't seem like a very big change, but it has a massive impact on the potential returns of that property just by one simple little change of 1% higher. So that's something you want to look at. And I would stress a lot about changing that number downwards to see what impact does that have on the returns if it goes from a 3% to a 2% or 2% to a 1%, right? It's pretty reasonable to expect there to be some rent inflation over time, but it might not be a linear path, right? I think in the short term, the next couple of years, it's going to be hard to achieve significant rent bumps. Rent inflation. But I think over 2 to 3 years from now, we're going to see that kind of tick back up again. So on the average, is that number makes sense? And then even the short term, how they're making assumptions over the next couple of years versus the next 5 years, that's important. Another little trick that I'll see some operators do, they'll increase their rent at, say, 3 or 4% per year, but they'll only increase their expenses at, say, 1 to 2% per year. Well, if you have a growing rent number over time that's higher than your growing expense number, that's going to have a pretty big impact on your net operating income over time. Right. So understand how much are they kind of being similar assumptions. They're expecting expenses to be lower than the rent. Usually that's not the case. Now, if it is the case, don't bake it into the projections, but let that kind of be part of the upside. But you don't want to see a difference there. In your rent versus your expenses. And the last thing, and we talked about this a lot already, but exit cap rate, this is the biggest driver on that sale value. What's the market going to do? The challenge with this again is if the returns are mostly derived from appreciation of the property, you're taking a big risk on the cap rate, right? Because that's not anything that the sponsors can control. but it has a very big impact on the total return and the timing of that return. And so you want to understand what impact does that have on the returns if the market is softer for the next couple of years or cap rates don't come back down to where they were before, or they actually go up, right? How much does that impact the returns? And so usually what I like to see, what we'll do, like in our deals, is put together a cap rate sensitivity table. It's pretty simple to do, but it's basically at different levels of cap rate assumptions, what does that do to the net returns to an investor given some of those changes over time? You can kind of see how sensitive is the return to that cap rate. Okay. A lot of information here. If you don't like numbers, sorry, but this is really helpful. I think, you know, these kind of 3 or 4 metrics will really give you a leg up in understanding, you know, how to look at an underwriting file. And for all of you that don't Give a rip. Sorry. This is really going to help investors ask the right questions, right? So it's something that I think is very important to just understand the basics of, to have a basic level of confidence when you're looking at an investment opportunity, just to level up on that a little bit, because this will give you a lot more when you're writing that check, a lot more confidence, ability to ask better questions, to understand what risks you're taking, right? Because within investing, we are taking risks all the time. Most of the time we don't understand what risks we're taking. So this is just another way to try to understand what risks am I taking? How much of a risk is that? What am I taking to earn those returns? What risk am I taking to earn those returns? So I'm going to do another section on debt because that's probably one of the biggest impacts on total capital structure and total deal performance of really any of these things. These are all kind of isolated things, kind of put it together, but if you have a bad capital structure on a project, it doesn't matter how good the deal is, it's doomed from the get-go. So I want to talk about that a little bit on the next episode, but we'll come back to debt because it is a very, very important topic and couldn't squeeze it in today. So hopefully this was helpful. Again, if you guys are enjoying this episode and our podcast, please leave a review. It really helps us continue to grow the podcast. And if you have suggestions for content you'd like to hear us talk about, always would love to hear that. You can go to thebillionairepodcast.com, hit Ask Anything. We see all of those responses and maybe have your topics or suggestions be part of the show. Thanks so much.