Step 5: Initiate the Underwriting Process

Welcome. This is the Insider's Edge to Real Estate Investing with James Nelson, the principal and head of Avis and Young's Tri State Investment Sales Group. In this program you'll learn game changing strategies to outperform the market. James will teach you how to source, execute and capitalize on the best real estate opportunities in New York and around the world. Now here's your host.

Welcome to episode number 120 of the Insider's Edge to Real Estate Investing. This is your host, James Nelson. I am principal and head of Tri State Investment Sales for Avis and Young. Thank you as always for joining for subscribing for your ratings. That's what helps others find the show and it means so much, much to me as well. So if you are joining for the first time, we are in the midst of a 10 part series, well, actually 12 if you include my introduction, which is my story, and then the preface, which is why Real Estate so today is step five on initiating the underwriting process, which is quite possibly one of the most important parts of a successful real estate investment is how to calculate what you're going to pay for a property. I can't remember who came up with the saying that there's only one thing that you can't change about a real estate investment and that is what you paid for it. So very much true. And so part of this is, yes, how you will go about underwriting, what are the basic components? But again, we're not going to be able to teach you on one show how to actually go through and do this underwriting. There's some great programs out there, whether it's in ventures, in real life, real estate investing, whether it's Doug Marshall's series. You can hear him in one of my first couple episodes on the podcast. You can find his program@james nelson.com if you want to sign up for it. Or there's a lot of great master's programs out there and you don't have to necessarily go and get your whole master's degree. You can just sign up for a course or two. Maybe it's at nyu, maybe it's at Fordham, but you are going to need to learn how to underwrite. I think it's important for you all to understand the basic principles, how you go about valuing. And even if you aspire to one day have a full time analyst who's going to run numbers for you or certainly like everything else these days, you can outsource it, there are analysts who will help you come in and underwrite But I think it is important again that you understand the basic fundamentals, how you approach a property, what are the different ways to go about it, whether it's underwriting it for an investment approach, whether it's looking at comparable sales as you get more sophisticated, whether it's conversion development potential. So we're going to really be diving in today talking about how you approach this. What type of return should you be looking for based on what type of property it is? What type of risk profile? Is it core? Is it value add, where you're going to be changing the property, improving the property? And so these are some of the things that we're going to be going over today. And so we're going to have a brief word from our sponsor and then we're going to get into this discussion on initiating the underwriting process. And as always, thank you for connecting with me at James Nelson NYC. Whether it's LinkedIn, Twitter or Instagram, feel free to send your questions or what you think of this podcast. I'm always happy to connect. So thank you again. A brief word from our sponsor and we'll be right back.

A different approach to putting our clients first Avis and Young's Tri State Investment Sales Group sells multi family, office, retail development and specialty sales throughout the New York metro area. As experienced thought leaders in our industry, our 35 member group is available to help you make informed investment decisions by advising you on your current holdings or identifying new opportunities in the marketplace. Our one unified team is built on an industry unique platform which promotes unparalleled collaboration and and teamwork. We share core values of hard work, integrity and expertise. We put our clients first, providing tailor made strategies to achieve superior results. Please Visit us at aytristateinvestmentsales.com and follow us on Twitter, LinkedIn and Instagram amesnelsonnyc to learn more. Welcome back everybody. This is James Nelson. I'm here with my writing partner Rachel Hartman. We've been cranking away hard at work on this new book that's going to be coming out, the Insider's Edge to Real Estate Investing that yes, that is the title of the book, which is also now the new title of our podcast. So we're having a lot of fun. And Rachel, in case people are just tuning in for the first time or maybe they missed a couple of our last episodes, I know they can go to james nelson.com and they can get the, they can subscribe to the video and they can kind of see some short excerpts. But maybe you could also tell Them kind of what we've discussed up until.

Now, certainly, James, I'm happy to. We've had great discussions. You know, when we were starting off this series, we jumped right in with looking at the benefits that can come from real estate investments. And certainly there's so many different areas you can invest in. There's not necessarily a one size fits all for anyone. And yet we talked about some of the unique aspects that real estate investments bring, including how you can actually take advantage of certain things in the marketplace. You know, it's opaque, it's not always clear, it's not always efficient like other things, such as the stock market. And that can really come to your advantage. You can really gain value by jumping in in that area. After we talked about some of the advantages, we went through different property types. That's a great starting point. If you're thinking about investing, we need to start somewhere. So we talked about different asset classes. Asset classes, including where you might want to start. We talked about the importance of building your team. This is not something that you on your own from the start. From day one until as long as you do it, you'll be working with people. And it's so important to know who you want to work with, how to build that team, and how to make those connections to really drive value. We went over different ways to spot great opportunities. Certainly shopping for real estate, especially commercial real estate, is a very different game than residential shopping. So it's important to understand those differences. It's also important to know what to look for, what questions to ask, what to watch out for. All of those can make a big difference when you start looking at what kind of return you get at the end. Last time we connected, we went through what I thought was a really fun one, the walkthrough. We got to hear all sorts of great stories from James, who has walked through many, many properties all over New York. So do listen to that one for sure if you haven't. And we talked not only about what to look for, but what to imagine as you're looking at a place, how to look at it with a new set of eyes, and not only you, but who to bring in to help you reimagine that space. So I think those steps have all actually been leading up to what we're going to talk about today, which is determining real value. So how do you go about knowing what a property is worth? What do those numbers mean? And how do you come up with the right number for you? So with that in mind, the first question I have for you, James, is actually why is it important? Why should we be talking about determining real value? I think when we are shopping for a place we think, well sure, what's it worth? But why is it important when we say that phrase, real value?

Awesome, Rachel, thanks as always and really appreciate that intro and summary and you hit on all the high points and hopefully if people are just tuning in that they're going to go back and listen to those episodes. And you know, I'm sure the excitement is building on the book because as much as we can talk about here in the podcast, you know, I know and looking at some of the chapters that we've, we've put together so far, it's just could not be more excited about this. So, yeah, Rachel, you know, you know the title of this chapter is Determining Real Value. And again, it might seem obvious. Why do you need to determine the appropriate price to pay for an asset? I can't even remember who said it, but I've heard this many times throughout my career that the only thing that you cannot change about an investment is where you bought it. So yes, I mean a lot of things once you've bought the property, whether you know, how you reposition it, the construction choices, what happens with the market with rents up, down. But one thing you know that you cannot change throughout the life of the investment is what your basis is. Basis is just where that original acquisition prices, you know, you're all in cost, what, what it, what it took to acquire that. And you know, the beauty about investing in real estate. And we talked a little bit about this in our first discussion ever, the introduction of why real estate? The advantages of why real estate over maybe the stock market is, you know, on one hand, no, you can't go and look up the value of a property, you know, at any, you know, split second. Right. There's no, you know, index that you can read in the Wall Street Journal. Every property is unique. And look, I know you know, Zillow has this incredible algorithm to determine residential home prices, but I've yet to see anything to try to tackle commercial values because they're so specific. You can have two buildings right next door to each other and they can be worth one could only be worth half the cost. And that might be because it's encumbered by a below market rent or it needs a ton of work. But it's just until you have the information, it can be really difficult to understand what is the value that you should, should pay. So I'm really excited to have this conversation with you today because I want to help our audience, as always, get that insider's edge, that ability of what to look for. You know, when do you know that you have a great opportunity right in front of you. And so, you know, what are some of the. What is the approach on how to go about in valuing?

Exactly. You know, and when we talk about this step and we talk about these different questions I'm going to be asking with you at James, I just keep thinking, what better person to ask than the insider himself? You've seen so many transactions go through, you've been in on so many deals. I feel like you really have great insight into how this process works and what's all involved with it. So I'm curious if you could share with us your approach. You know, what do you do? What's the process that you see when you're valuing property?

Great question. And I think it's also important to kind of set the stage because there's different types of valuations and it really depends your role in the transaction. So first of all, with my broker's hat on, and to remind those of you, if you haven't heard, so I lead a team of three dozen professionals, we do investment sales in New York City. We sell all different types of properties. Part of our job, when we first meet an owner and they're considering working with us, retaining us to sell their property, is to tell them what we think their property is worth, what it will bring, what is its market valuation. We call that a broker's opinion of value. Okay. Now a broker's opinion of value is separate from an appraisal. Okay. So an appraisal, you know, whole different process. Where you have a licensed appraiser, you oftentimes see them involved. Whether a bank is looking to make a loan, whether it's an estate looking to pay tax, they are a third party. They're not really looking at, kind of forward looking, right? So as the broker, I need to see, you know, look in the past, look at comparable sales, understand the market, but also think about, okay, we're going to put this property out in the market. So what, what is, what's the value that we are looking to achieve? Whereas that, that appraisal is going to use certain defined standards. In the case of an estate, it might be on a certain date where they can only use, you know, information from before as opposed to really looking at current market activity. When I'm valuing a property, I'm as interested in what is actually closed. But more importantly, I'm very interested in what's in contract. Right. Because deals that haven't even closed yet, that's more real time information or even properties that I'm currently marketing and getting offers on. So an appraiser wouldn't be able to take information to say, hey, here's a deal in the market and these are the high bids. Because is that going to happen or not? There's no guarantee. But I think we're really trying to predict the future, if you will. I think it's hugely helpful. And I think as the investor, you have to think the same way as well. You know, sometimes a great buying opportunity is because the market is moving on this great upwards trajectory and, you know, maybe you're dealing directly with the owner or maybe you're dealing with a broker who's using old information and maybe they're relying on, you know, sales that took place six months ago, a year ago, and you have live information knowing that values are picking up. So again, as far as my brokerage team, we are valuing over 500 properties per year. I mean, think about that. That's over 10 valuations per week. And so just that information alone, if we are valuing that many properties, think about how many rent rolls we're seeing. Think about, you know, we have the leasing comps, the information. You know, we have a sense just by seeing the information that owners have provided. Because remember, Rachel, a lot of this information is not public record. You can't just easily pull up and say, okay, I'm trying to compare this property to the one across the street. It's not as easy as just saying, okay, well what's, what's the property's total rent roll across the street? What's his net operating income? I mean, that's not publicly available. That's information that, you know, you need to have either as the broker or, you know, but by, you know, checking around and, you know, having other sources. So we put together a broker's opinion of value. You know, typically we are looking from an investor standpoint, so we're looking at what the property's current income, what we would project the expenses, the net operating income. We're taking that net operating income. We're typically dividing that by a cap rate. That's the rate of return that an investor is looking for before debt service. And then we're factoring a value. We're then going to be looking at comparable sales or other properties that have sold similarly and looking on not just a price per square foot, but we're looking at what kind of cap rates that those properties traded for. Sometimes there's conversion potential, sometimes there's development potential. And so there's different ways. And we're trying to put those options on the table. And then we're going to reconcile a value and say, this is what we think that we can bring in the market with a competitive bidding process. And then we're going to establish an asking price, okay, which is aspirational, above and beyond, okay? So compared to if you're underwriting this for yourself and you're looking, you know, what makes for a good purchase, you know, you're looking for a certain kind of return, I might, as the broker, say, I think this property can bring, you know, a four and a half cap in this market. And you're saying, you know, that's too tight for me. You know, my investors are looking for a higher return. I'm solving for a five and a half percent return. So a property that I think, you know, I can bring $10 million on the open market, you might only pay 8 million for. So that 8 million is, you know, that, that's your investment analysis, and that's how it works for you and for your investors, not necessarily what it'll bring in the open market. That being said, it's good to know that, because if you're buying in at 8 million and the market clearing price is 10, you already know that you're going in at a much better basis. And so when you're making that investor model and you're looking at the comps, it's always a great story to tell potential investors, because a lot of the reason why you're putting this model together, especially if you're going to go out and raise capital, is to show other potential investors, okay, this is what I'm underwriting. These are the type of returns we can look for. And by the way, here's some other comparable sales. Here's some other, you know, market intel. What I'm hearing, we're going in a really good basis. And that's, that's what investors like to hear. They like to hear, hey, I am buying some buying in at a below market price, okay? And sometimes that can also mean below replacement costs. So sometimes I get that question. Well, what would it cost to build a new building? Well, it'd be four or five hundred dollars a foot. Well, hey, this building needs renovation, but I'm only buying it for 200 a foot, and I think I can renovate it for another 50, $75 a foot. I'm below replacement cost. So, Rachel, I know I just threw out a lot of terms, but I wanted to kind of set the stage because I think it's important for investors and our listeners out there to kind of understand the different approaches in getting to value.

Oh, this is all great, James. This is a perfect overview. And yes, definitely the expert. And we've talked in other episodes about the important role that a broker can play in all of this. And I think what you just mentioned speaks to that as well. You know, they can help you see these aspects that you just mentioned. So let's start with some of those terms you brought up. I know we hear cap rate quite a bit, especially when we're talking from an investing standpoint. Can you tell us what that means and why it's important?

So it really is a tool of comparison. Right, so. And it is a way when we look at different investments. Right. So again, simply put, the cap rate is the rate of return that the property yields before debt service. Okay, so just kind of taking you through the analysis. So top line is really your revenue. That's all the revenue that the property brings in. That could be if you have apartments, you have rents from your apartments. If you have retail income, laundry income, maybe there's a cell phone tower. I mean, that all goes on the revenue side. Then you have expenses, which are the properties, operating expenses. The biggest one is typically real estate taxes. Right. And then utilities. And especially in these turbulent times, heat is a very big line item. And it's something, you know, if you're talking about oil or gas prices, you know, you better not just be relying on the broker's setup. I mean, brokers, if they're doing their job, should be putting, you know, the best information possible there. But it might be old information. It might be what the owner gave from last year. So you want to update, make sure that you've got the right numbers, you know, for heat. And you also want to confirm, and this is one of the questions, if we didn't cover in the walkthrough, who's paying for what? You know, if you go into a renovated or a new apartment building, you might see package units on the wall where the tenants are paying for their heat and ac because they have that, that package unit. If you go into an old pre war apartment building in New York City, almost all of them, landlord is going to be providing the heat and they'll have a boiler down in the basement and they'll be burning oil or gas and they're going to be providing that heat and hot water. Right. But then you're going to see is the property separately metered? Are the tenants responsible for any of their utilities? They might have to pay for cooking, gas or the electricity in the apartment. Typically water and sewer is typically paid by the landlord. Also repairs, that's a line item that you need to go in and figure out what is market. And a great way to get these expenses is to go speak to a managing agent to kind of understand what is typical. Especially they run other properties in the area. And then of course you'll need a management fee which is based on the revenue. It could be anywhere on the size of the deal from 3 to 6% of that revenue. Right. So you've got revenue up top, you've got the properties, operating expenses that you're going to subtract out of that. Okay. Offsetting that is any pass through. So sometimes if you have a retail tenant, they're going to pay a certain portion of the taxes over, you know, a certain base year, a certain percentage. They might, you know, if you have a laundromat, you better hope that you've got it sub, the water and sewer sub metered and they're paying for their own water and sewer. So you might have some reimbursements, right, to offset that. But what you're then solving for is that net operating income. Okay, so if I take that net operating income, let's say it's $100,000 just to make, you know the math, very easy. And you're solving for a 5% return, you're looking to buy at a 5 cap. Okay, you take that 100,000 divided by a 5 cap and that means you would pay $2 million for the property. So another way, if you buy the property for $2 million, you'll make a 5% return again before debt service. Because what's going to happen is we're then going to try to go out and finance and it could be 60, 65%, typically where you're going to be borrowing from the bank, usually five year money. And look, Rachel, this is something where you got to be working. We talked about the team be working with that mortgage broker to watch what rates are going to, you know, before you could borrow five year money in the low 3% range, it might be up around 4% now. Right. But if I'm buying at a 5% return and I'm borrowing money from the bank at 4%, okay, what we're still getting positive leverage. Okay. So when you do the math, so you take that net operating Income, you subtract that debt service to pay pay that loan. What you're left with is your cash flow. We're still not factoring in taxes. This is still before income tax, right. But you're going to take that cash flow, okay. And you're going to divide that by your equity in the deal. So you're going to finance a portion of it. Equity is the cash you put in, okay. And that, that is your, what they call cash on cash return. Okay? So if you're buying it at a 5 cap, but you're borrowing money at 4%, your cash on cash return might go up to 7, 8%. I mean that's the power of leverage. So again, a little hard to demonstrate and talk people through this on the podcast. I think last time I mentioned there's two great sources because I really believe if you're looking to invest, you need to know how to underwrite. Okay? You can't just expect and look, maybe you work for a huge shop and you have a dedicated full time analyst. Then you know, this might be elementary for you in the first place, but I think if you're looking to do your invest your own investments, you need to know how to underwrite and you need to have a good investment model. Okay? I've heard great things about Adventures in Real Estate. That's a course that you can take. They give you models that show you, okay, gross rents, insert here. Operating expenses, insert here. This is your net operating income. Put in the loan information. This is the cash flow. Also my friend Doug Marshall, who wrote the book Mastering the Art of Commercial Real Estate Investing, I know that if you go to his website, he also has models that you can use to build on your own. So again, please don't let this, I mean, this is a really good conversation so people can understand the methodology behind this. But, but this is not to substitute, you know, how to underwrite a property. I mean, I think to do that, short of going and getting a master's degree or taking continuing ed, which I always advise people here in New York, even if you're not going to go for a full blown master's course, go and take a couple of courses at nyu, go to Fordham, you know, they have courses on underwriting. And you know, again, I'd love to say that we could teach you the whole premises of how to underwrite a property in an hour long discussion. But you know, these are classes that, you know because each asset class is different as well. How you underwrite a multifamily is different than an Office building is different from retail, so. But this should hopefully give you a sense of where to start and how to go about this.

Exactly. Great points. And yes, this is certainly an extensive topic. So I feel like it's so beneficial to talk to you because you can help us think about those key things to be looking for key terms, what's important to ask about and find about during the process. You mentioned looking at different expenses, writing down the expenses, you know, looking, including that in the model. I feel like the figures that go in make such a difference because ultimately we're coming out with the return that we want T. Have you found that there tend to be quote, unquote hidden costs or costs that might not easily come up even in one of those models where you're plugging in numbers that we should be aware of?

Yeah, great question. And the answer is yes. And again, you need to understand, I mean, a broker is set up and it's not because we're trying to hide information. I mean, look, if you added every little expense for a property, I mean, I don't know, I've never seen an exterminator fee on a rent roll or very rarely. I mean, maybe if you're down in the southeast and you got a big, you know, bug problem, you know, maybe that's a big line item. But I mean, here it is something, you know, it would probably go into the miscellaneous kind of catch all. You know, if you're for our broker setup purposes, we might put in a 1% miscellaneous. But I mean, let's face it, brokers want to put a property in its best light, right? So, and oftentimes, and look in that broker setup, under expenses, they might say estimated or they might say actual. If they say actual, they should probably refer to what year it is. Especially when you see that real estate taxes line. Remember, the taxes are. That's usually the biggest line item. Real estate taxes could be as much as 20 to 30% of the top line revenue. Right? So when you look at the taxes and you need to make sure, okay, what year is this tax estimate from? Is this last year? Has the property already been reassessed? Are we, you know, expecting an uptick? And it really, this is really specific to the, the city, the state, the municipality on where these taxes are going. And you know, it should be in New York, for example, if you're investing and you see the taxes are only at 10% of the revenue, okay, that should be a red flag where you should be looking at this saying, okay, maybe what happened was, I'M buying it from someone who just doubled the rent, spent a ton of money on it. And the way it works in New York is you file rpa, real property income and expense statements. So I need to send into the assessor's office, you know, what is my, my rents, what are my expenses, what are my net operating income. It might take them a couple of years to catch up for the property to be reassessed. So, you know, taxes again, being the biggest line item for expenses, you want to make sure that you're not going to get clobbered with the reassessment. Right. In other places, I think in Florida, they reassess based on when you purchase the property. And so look, you might be buying from an owner who's owned that property for 20, 30 years and their basis is very low because they've also, their taxes are very low because they've kept the rents very low. Right. But you're going to go in and completely renovate the place, double the revenue, your expenses, I mean your taxes could double too. So, you know, having good transactional counsel and most of these firms even have a specialist, a tax or CRA whose job is to really go in and look at the taxes. You know, where are they in relationship to where they should be? Are they expected to grow? In many cases, you know, our most sophisticated clients, they're challenging real estate taxes every single year. They're trying to, you know, and you should do that if, certainly if you think your property is overtaxed, you should be going in looking for reduction. So that, that's really important. But again, we talked about fuel costs, which is very volatile. You know, there are ways to buy out energy for a season. You know, again that, that, that's, we're not here to talk about commodity pricing, but you know, that's where if you have a good managing agent who's buying for a lot of different clients, that, that can be a good reason why to use a third party management. Because if you're just buying, you know, all of you know, from these vendors and you're just a small owner, you're not going to get the power of pricing that maybe a managing agent is going to be able to get. Same holds true with the superintendent. You might be looking for someone to clean the building, do repairs and finding someone who, you know, does great work in the area and you know, maybe you're one of 10 buildings. Hopefully you're getting the benefit more or less of having a full time super, but only paying one tenth of the price. So Again, I think having, you know, the right managing agent who can help you contain expenses, you know, but also get, get kind of best pricing and also the best people labor to work on your property.

That's such a great point. I completely agree. So you've mentioned some of the people who are involved in this process. I'm curious if there are any other main players we should know about when we talk about determining real value. We talked about brokers, certainly the managing agent and several others you mentioned. Just want to see if there's any others we should have on the lookout.

Sure. So this goes back to building the right team. And right now I'm probably scaring everybody as far as these runaway expenses. Say, James? What? You know, I thought investing in real estate's exciting and can make all this money and all you're telling me is how your expenses can, you know, run out of control. Well, you know, look, I think the point is to contain that, right? But why are we investing real estate? Where's the opportunity? It's all top line, right. So if you don't think that you can grow your top line revenue, and that's by the way, you know, there's a lot of fear. You know, some of these states in New York is having conversations now. We have rent regulation for about a million out of our 3 million units. But there's conversations out there now about maybe having universal rent control. Right. Capping rents, that, that already exists in California, Oregon. So you know, again, if you have expenses that can continue to grow, but you're limited on where you can grow revenue, that's something you really have to think about. But let's go with the premise here that you're in a state where you have the ability to collect a market rent. And that's the exciting part, right? That is the value add. That's why even if you buy a property and you're buying near the top of the market and then the market dips, as long as you have that upside in the rents. Right. And again, we're looking for that long term owner who hasn't maximized value. Maybe they're content to just have the same tenants there who pay the rent, don't bother them, but the apartments are dated. They might even be renting the apartments themselves. They're not really working with, you know, a broker to maximize the rent. So what I would say is really to project that top line again is speaking to that residential rental broker. So, you know, can I charge more for these apartments? Should we be splitting these apartments? I've got an oversized one bedroom, you know, should I turn it and do a two bedroom, right, for the retail? Okay. I've got this old diner that's been in the ground floor for a long time, but their lease comes up in a year or two. Can you go in and increase? I'm an owner in four buildings in Brooklyn right now. And I'm going through that process right now, looking at our portfolio, saying, okay, we've had a huge run up in residential rents. Where can we make improvements? I'm looking at the retail that was probably signed a couple of years ago. And you know, throughout, you know, Covid and everything was probably happy just to have a tenant, but now things are, are actually picking up. Okay, where can I make improvements? And so I'm in the business, right? You would think that I would know where retail rents are, but it's very specialized, you know, I don't know because I'm not leasing space, retail space in Brooklyn. So I'll call, I'll call my, my friend over, you know, James Famulero over at Meridian to give him a shout out and I'll say, hey, James, you know, where do you see rents in this area? Right? And that intel, especially when you're underwriting, is so important, right? Because your pro forma is going to say, okay, unless if you're just buying something that's got one tenant leased out for 10 years, that's your CVS, your Walgreens, we call that a core investment. Remember we talked about the different types of investments then. I'm just, you know, that's a coupon clipper. But I'm going with the assumption here that everyone's listening, is really interested in the value add, you know, raising the rents, you know, driving more value. And I think that's why it's crucial that you understand how you can go about improving that top line.

Exactly. And that I think is where some of the excitement comes, you know, having those conversations with people who will give you great insight and show you where you can add that value and get a great return. I wanted to ask how when we talk about the return, we talk about the value, might the return be different for some investors? Might they have different motivations going into a property? Can you walk us through how, you know, some of the reasons why one person's return might be different than someone else's?

Right. So you know, when we talk about the different type of investor profiles, right, so it really depends what your objective is. And I said, I just set an example that, look, if you're just buying a property that's got one tenant credit, long term lease. Look for someone who does not want to actively manage a property, that could be a great alternative. You don't want to have to go in and renovate apartments and deal with mom and pop tenants. But those type of investments that are, you know, delivered on a silver platter, those typically only generate lower returns, right? You're getting a higher credit of tenant. Usually there's less risk. Less risk should generate a lower return, right? If you're taking more risk where you're going in, you're renovating, you're doing this and that, yes, you should be compensated and you should get a higher return because if you don't, why are you even doing that? You might as well just, you know, go buy that cvs, right? The riskiest proposition is when you are building ground up, right? Because then you're taking development type risk. And I really, you go back and listen to one our earlier conversations, I think it was the second one we had on what to buy. I typically tell, you know, certainly first time investors to stay away from ground up development. But again, that risk in the type of asset, the business plan should also determine the type of return. And I think again go back and listen to that episode we did on what to buy because we also said different asset classes have different types of risk as well. So multifamily is the safest kind of investment, right? Because everybody needs a place to live. And if you go and buy a 20 unit apartment building and one tenant vacates, you can generally rent that right back up. But even if you don't, you still have 19/20 of your rent roll still intact. Whereas if you have, if you're just buying retail from some 99 cent store, that's not even, that's just a franchise in the middle of nowhere and that tenant blows out, you might be left with just four concrete walls where you say, well when I bought this it sounded really attractive because it was an 8 or 9% return. But then you find out there's no tenants in the market to replace that tenant tenant. And now your investment is basically worth nothing. So cap rate, you know, to go back to that principle is really so many factors go into determine that cap rate, right? And risk is one of them. You know, is, is, you know, what is the type of credit that, that of the tenant you're dealing with? What is the type of asset? How about the location, you know, and that's why, you know, you go back to the old Adage location, location, location. Why? Because if you lose a tenant, there's going to be demand, right. There's going to be more tenants who will step in and take over that space. Whereas if you're in a tertiary location, you might be sitting with a vacant property for four years. So there's a lot that goes into this. And when I'm valuing property, if I'm dealing with mixed use, I might assign a cap rate for the residential portion and a different cap rate for the retail. And I might say, okay, well 80% of the income is coming from the residential. And I think because you know this residential solid has upside, I'm going to put that at a 4% return. But the retail is a little risky and I think it's the rent's almost over market, you know, that's going to need to be a six and a half or seven percent return for just that 20% of the income. And then I'll blend the cap rate together to show what, what, what type of return that we believe an investor is going to look for.

Excellent, that's so helpful. We talked about cap rate. That's such an important term to know. I'm curious about cash on cash return and then the return on investment. If you could dive just a little bit more into those terms and talk about why they're important, especially from that beginner investor point of view.

Right. So as the broker, when I put together a broker's opinion of value for an income producing property, you're going to see a cap rate for May. You're also going to see a price per square foot. That, that's something that I can show especially when I'm looking at other comparable sales. You know, you compare them based on the size and that that's kind of the gut check. Okay. Well we're looking at other multifamily assets in the area, what type of cap rate they traded for, but also what's the price per square foot to just make sure we're in range. Sometimes price per unit is a great metric. Right. How much did you pay per apartment? Right. And some of the old school investors use gross rent multiple the grm. Okay. Which is just how many times the gross rent. So these are ways that a broker would probably approach this. But as an investor, and again, I don't, when I'm selling as the broker, I'm just trying to figure out what's the most someone will pay for this. As an investor, again, you need to solve for the return that works for you and for your Investor. So to go back and talk about that cash on cash analysis, right? Which is how much equity you have in the deal. Excuse me, the cash flow divided by the amount of equity that you have in the deal. That is your cash on cash return. And if that, you know, you do your business plan and you're getting to an 8, 9% return, the question then, Rachel, is, well, how much are you paying your investors? Right? So investors, and I know we're going to have a conversation with my, with our friend Derek Aiken at some point where we're going to talk about that capital stack, how to structure these transactions. Because typically if you're raising money, you're going to tell your investors, okay, I'm going to give you a preferred return, okay? They call it a preface of depending on the risk and the type of return, it could be 6 to 8%, could be even less. So one thing you don't want to do is if the cash on cash of the deal is only 5 or 6% and you're paying your investors in 8% pref. Okay, you're basically subsidizing them, right? So what that tells me is, okay, you want to be in a position where you've got some cushion, right? Where if you're getting that 8% cash on cash return and you're paying your investors 6%, because then what you're going to do, Rachel, is you're going to take your promote above that 6% return. And it might be, I'm going to take 25% of the overage of that additional cash flow or typically the way these things work out is on sale, then you pay back everyone's preferred return. And then out of the sales proceeds, you're going to keep your promote. So again, that cash on cash is important because you want to know, you know, after you finance this, what is, what are your dollars actually making you? Okay, now the return on investment, okay, that, that's a slightly different metric to figure out what you're solving for in a moment in time. So that return on investment is okay, if we're buying a property that we know we're going to have to renovate, right? You are looking at your all in costs, your total project cost, right? And then you are dividing that by your, your, your, your future noi. Okay, so what you're building to, I'm going to do all these renovations, I'm going to mark to market these rents. This is the, I'm going to improve this net operating income. I'm going to take that future net Operating income. I'm going to divide that by my total project cost. And that's my roi, my return on investment. So I might be buying in at a 4 cap, right? Cause that for that cap rate is just a snapshot of what I'm buying today. But unless this is that long term core investment, this is just you're buying that forecap, I would presume, because you believe you can grow the rents by 50% or whatever the business plan is. Now you're going to have to put some money in to do that. Construction, brokerage costs, downtime, free rent, all that. To get to that point, you're going to add that all up. That's part of your total investment, Right? But you're going to try to get that 4% up to a 6 or 7% return on cost. Think of that, Rachel, as your future cap rate. That's the cap rate that you're eventually going to build to. So there's one other term that, you know, we might as well throw in there while we're at it. And again, I'd be interested to hear what our audience has to say about this. But this is the internal rate of return, the irr. Okay, so that is what is your investment doing over the term of that investment? So then the question becomes, well, hey, what's your business plan? What's the timeframe? Most funds, for example, they like to get in and out of an investment in three to four years, right? It takes them a year or two to reposition, get the property in its best place, to capitalize that, they're going to go out and sell it, typically in that three, four year period. Most funds run five to seven years, maybe 10 at the longest. But the point is, on an IRR, you're actually looking at what is the aggregate cash flows that you are accruing throughout the life of the investment. And then you are predicting what you're going to sell this property for 5, 7, 10 years down the road. And using that terminal cap rate, what is the cap rate that I'm going to sell for in the future? And then I'm looking at the aggregate of all those returns and I'm discounting it back to today, the net present value of that future stream of cash flow. Right? And for a lot of these value add deals, that stream of cash flow is going to look like a hockey stick. You're going to start off, in some cases you might be, if you're vacating the building to renovate, you're going to be losing money the first year or two right before you can build back up, get some cash flow going, and then you're going to sell it. And a lot of times that's where all the value is driven down the line. A lot of investors will say if you're institutional, you live and die by IRRs, because if you ask them, hey, what are you looking to buy? Oh, we're core plus, we're this, we're that, we're solving for mid to high teens. What does that mean? They're looking for a 16, 18% IRR over the course of the investment. Right. But if you talk to a high net worth, they might just say, look, irrs, I have no idea what, where the market's going to be in a year, let alone seven, eight years from now. I just know where I'm buying it. That return on investment, that roi, is really what you're looking for. And I would tend to agree. I think really understanding where you're going to stabilize your return, that's what you should be focused on as opposed to, you know, trying to factor, you know, what cap rates are going to be, you know, five, seven, 10 years down the line.

Perfect. These are such solid explanations. And I think we talked about how this topic can be complex. You know, there's different layers to it. Obviously you're going to be working with the team players we've talked about, and there's other resources, there's models, there's courses you can take. I'm curious for the sake of this discussion, if there are general do's and don'ts that you give to investors as they determine real value. Anything, you know, as we kind of look at this from maybe a high level or just from your experience, do's and don'ts to be aware of.

Yeah, I mean, look, you can have the best model in the world, you can have it perfected. But I mean, I can get a model to change in value by 20 to 50% just by tweaking something as small as that terminal cap rate or construction costs. I mean, I can get a model to say anything you want on what to pay, but if it's not rooted in what is happening today, like, these are not static models. Right. These are not like fixed costs. And so that's why it's so important going back to that team, understanding what are the real numbers today. And look, everyone wants to be optimistic, everyone's hoping that the market's going to continue to go up, rents continue to go up. But when I'm looking to invest in a project, I like to see a base case, a best case and different sensitivities. Because what is my base case? If rents just stay the same and interest rates go up, which means cap rates go up, which means I'm not going to get. I might be buying at a 4 cap, but I'm only going to be able to sell at a five and a half going out, like, hey, if I don't grow my bottom line substantially, I'm going to lose money. Right. So a lot of the times you can get these models again to talk you into doing things, but you really have to be realistic what's going on and really understanding the expense piece, but also where these expenses could go and also being realistic about not only the rents, but what is it going to cost to get there. So, you know, if you're going to take a one bedroom that's renting for 2,500 and get it to 4,000, you're probably going to have to spend, you know, 50 to $75,000 renovating that apartment. Right. And so you need to make sure, you know, talking to the gc, is that possible? How long is it going to take? Right. People don't take into consideration when you take a unit offline to renovate, that's three to six months of downtime, right. That you're losing. So I think it's really important to, you know, account for the real cost, the time it's going to take. And again, if it's really, if your base case is not looking so great, you're probably, you probably have to come in at a lower price. And I think it can be really challenging to be disciplined about what to buy and whatnot. I think of one of the investors that routinely makes offers on our properties, and sometimes we'll be like 2, 3 or percent apart on price. And I'll say, hey, Jesse, why can't you stretch? We're so close. Can't you just give me another 100 or 200,000 and very disciplined and because, look, if the numbers do not work, if you're not in that comfortable range, you need to go out and find more opportunities. So really important you vet this information. I mean, again, brokers who just put together unrealistic projections, they're not long for this business. I mean, they should be doing their job, trying to be realistic. But you have to vet it. And that includes the owner expenses as well. Trust but verify, Right? So, okay, you're telling me these are the expenses, but let's look at some of the bills again, you might not get that until later in the due diligence process. But it is important that you really vet these.

Yeah, this is also helpful. So one of my last questions I wanted to ask was regarding you mentioned that it can vary from property type to property type. So it's maybe a little bit. I'm not saying we have to go in depth here, but I'm curious if there's anything we should know about how determining value varies based on asset class that we haven't covered yet.

Sure. So multifamily again I think is pretty straightforward. I mean that's kind of what we've been speaking to. Typically you're not going to see the type of pass throughs that we're talking about. Although it is important to understand what do tenants pay for? Right? What part of the expenses they pay for? What, what does the landlord pay for? Once you get into a retail component, it is important to understand what is the retail tenant in addition to the rent responsible for? Right. Are they paying a portion of the taxes? Are the paying some of the expenses? And not only are they supposed to, but are they actually doing this? Right. And I think it is important and I'll apply this to all asset classes to find out are there any arrears, you know, and again that goes part of the, you know, the due diligence. But just because you see a rent roll, you know, are the tenants actually current and paying that? Right. And so, you know, and if they're not, okay. And a lot of post Covid, a lot of these retailers would, you know, landlords to help them out would cut deals with them and say, okay, I'm only going to charge you half rent, I'm going to forgive some of this back rent. So you need to understand, okay, what is the tenant currently paying? Are they in good standing? Are there arrears? If they do owe back rent, you know, what happens when I buy this? Are you going to collect this or does that become, you know, my, you know, obligation? If you have a tenant who is a holdover tenant, meaning that they're in arrears, they're not paying, there's a proceeding. Okay, well what's it going to take to get this back? Because one thing we haven't even talked about is kind of legal, you know, landlord, tenant, if you have a tenant who holds over, of course they're going to stop paying rent, you're going to have to pay legal and you're going to have to vacate them. And so that's why, you know, it's really important to Kind of understand, you know, the location of where you buy, you know, what, what type of tenancy issues you might have. You know, and I forgot one key thing up top is that vacancy and credit loss. So, you know, if you're in an area where you're going to see a lot of turnover, a lot of tenants who might, you know, give you, you know, a challenge, you know, that vacancy and credit loss might be 5 or 10% off the top line because it might take you, you know, sometimes, you know, tenants aren't going to pay rent. You're going to have to evict them. You know, is. And then is there a legal cost? So that's retail. There's one. And sorry to keep saying, I keep thinking of things going back. But on multifamily, it's also important, those residential rents to understand, were there any concessions given in renting that apartment? So you went in, Rachel, you were renting an apartment for, you know, they gave you a 14 month lease, right? But they gave you two months free going in. Right. So you're, you know, the tenant's thinking, all right, well, I'm looking at what I'm paying and I'm dividing that by 14, and that's really what I'm paying per month. You know, question is, you know, what's going to happen in the future? Are rents going to continue to go up or you'll just continue to renew and not get the benefit of that free rent moving forward? So kind of understanding, you know, were there concessions baked into that rent to push it up? Right. What are they actually paying? At the end of the day, it's good to know, but it is market driven. And talking to that rental broker, well, hey, you know, when I bring in a new tenant, do I have to give them any concessions? They want a free month's rent. Also, who pays your commission? You know, do you, you know, does the tenant pay? Do I pay? Those are market driven. Okay, so now going over to office. Office is, you know, the most sophisticated, you know, type of investment because in addition to the leases that these tenants sign, you need to know what are the concession packages? And those concessions could be free rent, right? But it could also be ti. That stands for tenant improvement. Right. So I might be delivering a beautiful space, that white box and ready to build out. And the tenant says, great, I'll take it. I'll sign a 10 year lease, but I want a year free rent while you go and do the work at your expense. And I want a work letter, right? I want you to Spend, you know, however much it is per foot, 25, 50, a hundred dollars a foot in, you know, some of these trophy buildings where that landlord has to pay. And so as a result, sometimes it could take a year or two or more for the landlord to actually start getting rent because they've, they've, you know, had to pay all this upfront. So that's why it's so important to know that you have a credit worthy tenant. Did they have the right security to make sure that once you do all this work, they're going to come through. Now because of the way those cash flows work, that's probably an office deal where you do need to rely on that irr because you know, your stabilized yield on costs, you might not even get to that till year three or four. It might take that long to get all these tenants, you know, paying rent. And especially if they're all in different schedules and what we call that as the walt, the weighted average lease term. So I might have 10 tenants in a building and it's a great situation then when they each, you know, renew once every, you know, their leases expire, you know, maybe every year you have another tenant who expires. So they don't all. Unless if you're looking to gut the whole building and you want it vacant at the whole time. But if you're looking to maintain cash flow, you might not want half of your building to come vacant at one point. So that might be spread out. So again, looking at what it's going to take to re tenant the building and then looking that over the life of the investment, you know, what is that internal rate of return. So, but that's why I said, and again, go back and listen to that episode we did on what to buy. Because office is a very capital intensive business. You need deep pockets, you need, you know, to take that longer term view, you know, as opposed to residential, you know, renovate an apartment, you know, it's a couple months, it could be pretty easy to get someone in. You know, you're not going to have to sit there, you know, for years waiting for the rent to come in. And look, development is a whole nother proposition. You know, we could do a whole nother discussion on how to analyze that. But in short, you know, when you're doing a development model, you're looking at what the finished value is that you're going to be constructing and then you're subtracting the hard cost, the soft costs, hard cost being the bricks and mortar soft costs. Those are kind of your Professional fees, less the debt service, the carrying costs, and then the developer's profit. If you subtract that all out of what the finished product is worth, that is your residual land value. So I'm going to pay you this amount of money for the land. And if you're a developer, you're looking at that very important line, the developer's profit, and that's why you're. You're doing it. So that should give our listeners a pretty good overview on the approaches to, you know, these different kind of assets.

This is excellent. I think all this whole discussion we're showing, you know, preparation is key. Knowing this in advance is so helpful going into these. So my last question. You've done so many podcasts, you have so many access to so many great resources. Do you have an example that helps highlight what we've talked about today on determining real value?

Yeah. I would go back to some of those earliest episodes I did where I interviewed Doug Marshall, who wrote that book, Mastering the Art of Commercial Real Estate Investing, how to successfully build wealth and grow passive income from your rental properties. And he really goes through step by step. And we talk a lot about these terms and how he looks at risk. And in some of those early episodes that I did, I brought in some experts. My old colleague Ash Wenig, he talked about how do you underwrite based on a tenant's credit? There's a lot of great discussions on some of those early podcasts that I did. So this is really about getting the fundamentals. And again, if you get anything out of this episode, it is so important that you understand the mechanics of how to underwrite. Because when you go in, and we're going to talk about this next, when you go out and look to raise capital, you better be able to show your model and have it be defendable, because that's what investors are looking for. Okay, well, they're going to look at your model and say, okay, have you done your research? Is this credible? Do we really believe that you can substantiate the rents, the pro forma that you're doing, where you're going to turn around and sell this, and you're really trying to justify to the investor why it's a great deal. Why, why are you getting in at a great price? Why is there value? You know, show someone that that path and you're going to show in that investor deck, you know, what everyone's getting out of this. And, you know, Derek will talk to us about sources and uses. But yeah, where, you know, where's that promote going how much? What is that return? And I'll give one last term for people to think about on the way out, which is that equity multiple. And that, that is when, when you get, you know, ask well, what's, what's the return on equity? So again, that doesn't factor in how many years it's going to take to get there. That's your IRR. But if I put in $100,000 and this is a home run investment and I get $400,000 back, that's a 4X, you know, and so developers like to think that way. If I'm going to go in, I'm going to put my name on the line, I'm going to go and invest, I better be getting a four or five times my equity. Right? So that's, you know, that's the big picture. And Rachel, it is awesome to be able to have these conversations with you. I'm just hoping that our listeners are getting a lot out of this because we want to prepare them to go out there and be as successful as possible.

Yes, thank you, James. This has been a wonderful discussion and join us next time we'll be talking about raising capital as the next step.

Wonderful. So thank you again, Rachel. This is your host, James Nelson of the Insider's Edge to Real Estate Investing. Yes, we have a new title. We are no longer Real Estate Investing Live from New York, but that's what we're here to do. And so thank you as always for joining. If you have not connected with me already, please do so at James Nelson NYC. You can find me on Instagram, LinkedIn or Twitter. Also, if you have not already, please check out my new website, james nelson.com I built this for you. You can find a lot of the key terms that we discussed today in on that website if you need to go back and review. So thank you as always for tuning in and sharing this with your friends. Until next week, this is James Nelson and Rachel Hartman signing off. Thank you.

Thank you for listening to the Insider's Edge to Real Estate Investing. We approach appreciate your subscribing and sharing with your friends. If you haven't already, please connect with James at James Nelson NYC on LinkedIn, Instagram and Twitter. Please also visit jamesnelson.com where you can find the show notes and other episodes along with an exclusive video series and other helpful resources so you can gain the Insider's Edge to real estate investing. Until next week.