Cody Davis Explains Analytics and Underwriting: Episode 3 of the live sessions

Get to your seats. All right, we've run about 7 versions of this event over the years, so usually in the offseason. This is the first summer one, uh, because it makes zero financial sense to shut down your resort in the middle of summer peak, uh, season. That being said, I wanted to do the heat here. But we did 7 versions practicing for this multi-day event. The one thing that I learned is that the best part of these events by far is lunch and the breaks. Everyone's favorite part is like, we got to hang out. We got to, you get the best questions answered. So I tried to break this into a lot of, like a lot of, like a little bit less speaking, a lot more hanging out. So I hope that you guys are enjoying that because that is a very intentional thing. Uh, the next one is going to be Cody again. He's going to go over math. I also had a limited number of already downloaded pictures of Cody. So this is the— you guys see Cody and his awesome bicep? That was one of 3 photos that I had of him available already in the system. Cody is going to talk about math. Cody and I will often trade off in the mentorship talking about math.

Maybe.

And I get about almost a perfect 50/50 of people like, oh my gosh, you explained it and it clicked for me in a way that it never did. And then I'll have the other half of you be like, oh my gosh, Cody came on and did a guest presentation and it clicked for me in a way that it never did. Cody and I process math correctly in totally different ways. Since most of you have seen me talk about math a ton, I very intentionally gave this one to Cody. Also, Cody always has— I always have a little giant Post-it note for Cody to do the math on. So if you're far away and you can't see, Sure. there's some seating. You guys can move your seats and creep on up. Otherwise, I'm gonna go bring the little whiteboard here for Cody, and Cody's gonna talk math. His tenants occasionally spell math with an E. That's meth. It's a drug joke. I'm funny. But Cody's gonna talk about math, the analytics, and what actually makes a deal a deal. There you are, sir.

Deal. Do I even have a marker? Heck yeah, you got 2.

And I upgraded you to Sharpie. We got name brands now because we're a real company. Uh, can anyone see this past the post? What is the best spot for this?

Uh, should I move this over? This over, and then that goes here?

Yes, that's probably smart, assuming that you're going to want to use this.

I'll try.

There we go. Sharpie there?

Sharpie there. Okay. Before we jump into numbers and everybody's eyes gloss over, I would like to share the reason that all this works is because when we got started, we would do a drill. And I never told Christian, but the reason I made us do this drill is because my memory was terrible. However, it did help us go really far. Number one, whenever you go into an encounter, you go into a meeting, you have an intention. So I have a goal from this encounter. I've been asking a few people I've been chatting with already, what is your goal from this weekend? If everything worked out exactly how you hoped, what would you take away from the weekend? What is your objective. And then after a meeting, I would always ask Christian, because I would forget what we talked about, I would say, what was your takeaway from this meeting? And I tried to propose it as, hey, this is me trying to be intentional, make sure that you're learning. It was just me trying to recap what we did. So going into every meeting, we would have an objective. It would be, I want to learn how this person built this development portfolio, or how did this person get financing to do this? How did they own half of the town? This is a super generic name, so I can share it. But one time we met up with an owner and asked, how did you build the Great Wall of Gary? There's a guy named Gary who owns a strip through the middle of the state that goes all the way through central Washington, and he bought a railroad track. So we asked how he did that. You look up his name and it just pops up for miles and miles across. across the state. It's incredible. We would have an intention going in and a takeaway coming out. So going into this, the way I'm going to structure it— I've done this again and again where I've gone through math at these presentations, but I want you to think about what you'd like to take away from this. And after I'm done sharing for probably 20 to 30 minutes— might go faster, we'll see how it goes— ask your questions, get your takeaways. Don't leave the session with unanswered questions would be my request. All that to be said, I'm going to go through a few things, and if anybody has any questions at any time, please stop me. Also, if I confuse you, please let me know. First thing we're going to talk about is NOI. Is anybody here familiar with NOI? Is anybody here confident enough to tell me what it is?

Net Operating Income.

What does that mean?

That is your final income minus all of your expenses minus your, your debt.

Almost. So NOI, net operating income, is your income less your expenses. What does that mean even simpler put? It's our cash flow with no debt. That is all it is. So if you're thinking about NOI, It's your cash flow before your debt. Why does that matter? The reason it matters is because we're going to use debt. So that is the maximum number we have to service whatever loan we're going to negotiate. So if you're ever doing underwriting, and you're thinking, how much could I afford to pay? Make it less than that number, and you are set. And if you want more cash flow, you make your payment a bigger gap from that number. But this is the thing people get confused. They talk about cap rates and NOI and rate factors, and a lot of people on the internet don't even understand what they represent. All it is is your cash flow with no debt. Now that that's out of the way, let's jump into cap rates. I'm gonna write that up here. All right, so now we have a cap rate, cap percentage. What does this represent?

What you're paying for in that unit as a percentage of profit.

Can you make it simpler? And the reason I'm asking these questions is because majority of us are in the program, right? So these are things we've seen. If no one had seen this before, I wouldn't want to bring it up like this.

Cash return if you had no debt.

Exactly.

Which means it's your cash-on-cash return if you pay cash. That's exactly it. The reason this matters is this is going to show you your dividend expressed as a percentage. When doing purchases in real estate, it should be really important to you to make it as simple as possible, apples-to-apples comparison. There's different asset classes, there's different debt products, but at the end of the day, when you're looking at something you want to buy, we want to make it as simple as we can. And this number is going to tell you, expressed as a percentage, what's the actual income that I'm going to get relative to what I'm paying? How much disposable income will I have in relationship to my purchase price? It's also how people value deals. But we're going to leave it at that for now and jump into the next thing. So I don't think I've ever met a mortgage broker who knows what this is, which is ridiculous because that has everything to do with debt. Yet people don't even know what it is. Your cap rate is your dividend. That's your net income expressed as a percentage of a purchase price. Your rate factor is your realized cost of capital expressed as a percentage. If we're just spitballing here and we don't even know, which one would you want to be bigger, your dividend or your cost?

Dividend.

Dividend. Why? I don't like costs. I don't like costs, yeah. There was an owner we met with and they just don't pay bills, so their properties go down and their profits go up. That's not a good business model. When you're underwriting deals, you want your income to be higher than your debt cost. And the nice thing is we make it really simple. People online have asked questions, well, what about property taxes? There's people that buy in Texas where taxes are Double what they are here. What about your insurance bill? What about utility costs? That's all factored into NOI because your NOI is your cash flow if you have no debt. Take it one step further. Your NOI divided by your purchase price shows you your dividend expressed as a percentage. That's the equation: NOI divided by price. That's going to give you your dividend. Now we just have to make sure our debt costs Is less than that expressed as a percentage. We want apples-to-apples comparison. For those who are writing notes, the equation, super simple. I'm going to use letters. You don't have to use letters. It's your principal and interest times 12— 12 months in a year— divided by your loan amount. If you can remember this, you will be smarter than 99% of mortgage brokers. So, again, the equation. It's one thing to know how to calculate something. It's your principal and interest. It's just your monthly payment times 12 divided by the loan amount. A lot of people know how to calculate stuff. You bring up cap rate online, people say NOI divided by price. Right? Or NOI divided by value, but they don't actually understand what it means. And my objective here is everybody at least comes with their questions and can get an understanding why it matters, why it works the way it does. Because if you can do that, people— there's a saying I have come to find true: math doesn't lie, but people do. Seems consistent. And if you know how to do the math, people can't lie to you. They can try, but you're going to be able to, even if it takes you a few minutes to work it out, you can find when people lie. And majority of everybody's going to lie at some point. It's just important to know what they're going to lie about and to what extent. This helps you fact-check people that are trying to steal. On this deal right here, when we bought it, one reason that we had a good learning lesson, we didn't know what we didn't know. Talk about the box drill, right? For anybody who knows that, that was in the bottom right corner. We did not know. Well, we didn't know because they had 2 bank accounts. We didn't know everything. We didn't see everything. And so, you know, that threw off our numbers. If we knew how to really calculate and met with other owners that owned these types of deals, we probably could have fact-checked them on some stuff. But we didn't know how to work it out. We didn't know how to check things. And so my encouragement, really get to understand this. And how they work together. Does anybody have any questions on this as of right now?

Can you give an example with maybe one of your properties on how it's math-maths?

Absolutely. I'm going to use my first deal. I bought a 12-plex in Quincy, Washington. Does anybody know where that is?

Yes.

I didn't know either, so I brought it up to my very first mentor. It was actually Christian and my boss at the time, and he said, what the heck is a Quincy? Nobody knew, but I ended up buying the deal for $1.125 million. I'm going to use round numbers. I'm going to take off the 25. $1.1 million. It's about $100 grand down. It was 10% down. And so I owed about $1 million. Anybody can check this math. It's going to be true 100% of the time on a 30-year AM at 6% interest. If anybody wants to throw it into a mortgage calculator, The payment on a million-dollar loan is about $72,000 a year.

Okay.

Based on this formula, which is the formula— it's also called a rate factor, it's a mortgage constant if you ever want to look it up— if we have a $72,000 annual principal and interest payment on a million-dollar loan, what is our true cost of capital?

7.2-ish?

Yep, 7.2. Whoever said that, amazing job. So we took the $72,000, my actual payment, my principal and interest, we divide it by the loan amount, and that's going to give what's called a rate factor. And now it doesn't matter if you borrow $100 or $100 million, that rate factor for that interest rate and that amortization will always be the same. It's just a math formula. It's not going to change on you. So once you start to see trends and you've done it a few times, it's going to be consistent. So if my cost of capital on that deal is 7.2%, we took the actual annual payment divided by the loan amount. What's my cap rate have to be to break even?

Above 7.2.

Okay, what's it have to be to break even?

7.2.

Okay. So let's say the cap rate is 7.2%. What's that mean?

You're struggling with maintenance, so you're going to struggle.

Well, okay, so here's the thing.

You're not making money.

Well, this is where I really want to dig into questions today. If your cap rate and your cost of capital are exactly the same, you make no money and you lose no money on the debt. You would only earn a spread on your down payment. Because you're paying cash for a portion of the deal. If I put $100,000 down on that deal, I'm going to earn the cap rate on my investment, $100,000. So I'm going to earn 7.2% cash-on-cash return. That is how every investment calculator calculates stuff. Whatever you put down, you're going to earn the cap rate on the investment. The question of if the cap— the cash-on-cash return goes up or down Depends if your cap rate's higher than your factor rate. Do I make money on the debt or do I lose money on the debt? That's it. So you can make a spread on other people's money. You can also pay a spread on other people's money. The thing you got to understand, you're always going to earn the cap rate on your investment. But if you are making money on the loan, if your cap rate, your dividend's higher than your cost of capital, Then your cash-on-cash return is going to explode above the cap rate. And if you are negative margin here, if I bought below a 7.2% cap rate, my return would go down.

Because you're paying more for the investment.

Exactly. The investment's not producing a high enough dividend to service the debt that I took on. Practical application: markets like California. Seattle, New York, cap rates are pretty low. People are borrowing at the same interest rate in California as they are in Kentucky. So what do those markets make you do? Put more money down, right? Borrow less money, right? So maybe instead of putting 20% down in a market like Quincy or Kentucky or Indiana, They're going to make you put 35% to 50% down because you're actually losing money on the loan. So they say, oh, if you're going to lose money on the loan, borrow less money. That's how people make their deals work. So that's a practical application, real-world situation.

That's awesome.

Anybody have any other questions before I move on? All right. Last year I used the whole sheet, so I'm going to save a few pages for Christian this time. I want to work through an actual deal. Is anybody willing to find a deal really quick on CREXi or Zillow? Phil?

Yeah, purchase price, NOI, expenses, what do you need? Yes. I just went under contract for it, like, an hour ago. So $420,000. $425.

Okay, that's the price? Yep. All right.

11 units, $425.

Hold on. And we're gonna put this right here so I don't forget. All right.

Expenses?

Okay.

$21,000.

Should we start with the income?

Oh, income? Uh, $5,750 a month.

Okay. Can someone annualize that? Because we will always want to underwrite on an annual basis.

$60-something thousand.

We can use a calculator.

Up there.

I mean, I don't have one.

$69,000.

All right.

There you go.

All right.

Okay, so that is our income. Now what's our expenses?

$21,000.

Okay, so does that include vacancy?

No.

Okay, and then for vacancy, can we put like $3,500?

5%, yeah.

Okay, and then we're gonna subtract all this out. $3,500, sorry, I know I broke the trend of K. What is that total? What's our NOI?

Uh, about $70,000.

You have a calculator?

About 74,500. How do we go up? Sorry, sorry, I'm adding everything.

Okay, 44,500. I'm gonna quote you on that. All right, and that is our NOI. I'm sorry if you can't see it in the back, that is the the numbers. So let's just work through our last page. What is our cap rate? How would we do that? That's our cash-on-cash return when we— that is our cash-on-cash return when we pay cash. What would be our cap rate? What's the formula?

NOI divided by purchase price.

Divided by what?

Purchase price.

Alright, so if we take $44,500 divided by $50,000, 10.5. That's pretty high. You buying in the ghetto? Nope.

Oh, okay.

Nope.

All right.

Yeah, it's a block from my 12-unit. It's a 7 cap area.

Well, this is really important. If the cap rate in a market is 7 and you're getting a 10.5, is that good or bad? That's great.

Why?

Because you're making money.

Well, you're making money, but what does it represent? What's your cap rate? It's your cash-on-cash return when you pay cash.

So when you refi, it's going to increase your price by a lot, increase your total value.

It increases the value, but this is what I want you to understand. If a market return is 7%, which is what he said, and he's getting 10.5%, He's doing better than the market. He's doing better than an average deal. It doesn't mean this is valued on a 10.5 cap. It just means that's what he's buying it at. So if we wanted to figure out the actual value of the property, knowing it's a 7 cap market, what's this thing worth? Anybody can answer.

4.

When I did the math, I'm like, okay, it's $470,000.

So if we take $44,500 divided by 0.07, which means he has $210,000 or about 35% equity at close. Doesn't suck. So now what's your debt?

6.1% for 5 years amortized over 20.

Okay, so we got a 20-year amortization at 6.1% interest. What's your payment?

Well, yeah, I mean, I haven't gone through it yet. I need you to do the 20-year amortized math in your head. Yeah, I know.

Right now.

Okay, so my first part was $430,000, and It was almost exact same terms. It was like $3,500-something.

Can someone plug it into a calculator? Because I want to use actual math. Because we're either going to poo-poo your deal or accept it. All right, 20-year AM.

Bit late now. How much money?

Yeah, 20% down. So he put 20% down, 6.1% interest. On a 20-year AM. What's 20% of $80,000? Monthly payment is $2,455. All right. So based on what Matt Wang said, it's $2,455 a month. What's the annual payment?

$2,455 times 12, $29,460.

$29,460.

Can we talk to the weather guy about this wind? Yeah.

I'm going to save you paper this year though.

All right.

So I just want to remind you it's 6.1% interest for the loan, but it's a shorter amortization. What would be our rate factor? And this math, by the way, if you ever wonder how I do stuff in my head, somehow I just remember to do step by step by step by step. And you can do it with a calculator. You do not need a fancy calculator online. If—

what is our rate factor?

Remember, it's our annual debt payments divided by how much we borrow.

8.66.

Okay, so our rate factor of 8.66.

Which is bigger than the cost of the place.

No, no, no. No, it's 10. Yeah.

So this is the beautiful thing about math. If you use the right formula, it will work 100% of the time. Unfortunately, we didn't use the right formula when we bought this place, hence the shirt. We effed around and we found out. This is the fun part though. Your true cost of capital is 8.66%. He's earning 10.5%. If we take the return and we subtract this cost of capital, that is going to show us our margin. In this case, he has positive spread, which means that every dollar he borrows, he's going to make money. If he paid cash for this deal, he would earn a 10.5% cash-on-cash return. I have a suspicion your cash-on-cash return is going to be significantly higher because you have a margin here.

Yeah.

If you wanted to actually walk through exactly what he is going to earn, what we would do, we'd figure out the difference between your dividend and your cost. We'd multiply that by how much we borrow. You divide that by your initial investment and you add it to 10.5. So if we want to do that— Say that again, Cody. So yeah, let me, uh, let's do it. All right, can you write down this?

The—

I need someone to write it down.

So 1.86 is the spread.

All right, you make 1.86% spread. That's just the difference between your— sorry, 1.84. All right, write that down. So what we're going to do, this is how every calculator works. If you can just remember this, and this is recorded.

Yep.

Perfect. I don't expect anybody to remember this on the first try. 1.84? Yeah.

Okay.

What's our loan amount?

Uh, 20% minus—

$340,000. $340,000?

Okay.

$340,000 and our spread's 1.84%. So if we multiply the loan times the spread, what do we get?

$625,600.

$6,266? $6,256.

All right.

What is that divided by your initial investment?

Because this—

what this represents, everybody, this is important to understand, and I would encourage you to rewatch it. And we'll go into questions. This— I did not get this right away. This is how much money you are cash flowing because you signed a promissory note. You are getting paid to be in debt. That's all we do. We go into debt.

And we get paid to be in debt.

and we buy something that pays us more. This is the actual math. So this divided by your down payment is what? How much did you put down?

20%.

What's the number?

7.36%.

Okay, so if we take this and we divide it into our down payment, it's 7.36%. What's our down payment?

$85,000.

Okay.

Okay.

7.36%. Our cap rate's 10.5%. You add those together, that's your actual cash-on-cash return. What that means is you buy this deal, you're earning about 18% cash-on-cash. That's the actual math. Take the spread as a percentage, add the cap rate, that's your cash-on-cash return on any deal. All this complicated roundabout way to do the math that you never have to do again in your head Is to illustrate that you're either making money on someone else's money or you're losing it. You never have to do this in person. You have a spreadsheet. But if you understand why things work the way they do, why a return could go up or why it could go down, the only thing that's going to determine it is if you have positive margin.

Good job.

Technical difficulties.

It wasn't me.

It works. You have to make sure your cost of capital is less than your cap rate. If you can do that with these equations, you're going to go far in real estate. That's also why I've been able to structure the current portfolio. Ash and I just added it up. It's about $37 million for us, and we have less than $100 grand invested. That's without doing a bunch of crazy syndications. We own Over 50% of every single deal that we have. So majority of the portfolio is just us. But this is why you don't have to be able to rattle through the numbers like that. That's not what's important. Understanding why things work the way they do is important. And if you can make money by borrowing money, by making sure your dividends above your cost, You can buy unlimited amounts of real estate. That is the solution that Christian and I were looking for when we asked how could we buy everything. Yeah.

This might be for later, but Phil, with that $21K annual expenses on that deal, what did you factor into that? And it's okay if you want to talk about it later, but I'm curious.

Oh no. Well, that— so that's— I don't know yet.

Okay.

Because the owner doesn't have profit and loss, doesn't have anything. That's just the number he said, that's his expenses.

Oh, okay.

So I just got this under contract like literally an hour ago, so I'm still due diligence, haven't gone through it all yet, so I don't have all the answers.

Okay.

But my—

You don't just believe what they tell you?

Well, so I've actually factored because I own a 12-unit literally across the street. I kind of know what the numbers should be. And it lines up roughly close. I'm like, all right, well, there's so much— I paid $850,000 for my 12-unit. This is half that. Yeah, for 11. So I'm like, all right, there's plenty of meat on the bone on this. Even if he's off by 10 or 20%, I don't care because now you made it work on the 12. Yeah, exactly.

And based on the math, you're going to get about an 18% cash-on-cash return. If you plug these numbers into the calculator, you would come up with the same thing. Well, that should not be the end goal for folks. What's really cool about this opportunity is you're getting it at a 10.5 cap in a 7 cap market, which really means you have your 30+% equity position to go back to the bank, pull your down payment back out, and now you have an infinite return. That's where the real money is in real estate. So congrats.

Thank you.

1% rule that people like to go by for, uh, if an opportunity is going to cash flow. Yeah. And we haven't even jumped into debt coverage ratio yet, but a 1% rule, you buy something for a million, 10 grand a month income, that's gonna mean very different things in Washington versus Texas versus California. There's variable expenses. So just looking at a gross income as a percentage of a purchase price is a bad idea. You've gotta look at the actual NOI. The income after those expenses. Now, as part of the presentation, we, we can go into debt coverage ratio, but I want to go back to what I mentioned in the beginning— having a goal going in, getting actual takeaways coming out. Who here has questions they're willing to share about math and really just understanding how it all works? I heard 2 accounts, 2 banking accounts.

You were looking at state Right. Something tells me they had to know that, and if they didn't disclose that—

What our attorney told us was it's a buyer beware state, and we dropped it at that.

No, no, but here's what I'm— The thinking is to— You just taught all of us how to do what you get away with, which isn't good, but anyways, it teaches us what to look for. And the point is, what were they putting on the other account? Just any major expenses, putting modest expenses?

We didn't see it.

And hiding the other. Is that what they were doing?

Didn't see it. So we don't know. But the point of it is, if you look at every deal in your market, you're going to start to see trends, you will see averages. And then when you see something that stands out, if it's too good to be true, it probably is. From an operational perspective, you're not going to operate a deal at 30% if everyone else is at 50%. We did not meet with owners that owned stuff like this. And so there was no way we could have projected that because we didn't do the proper due diligence before we bought it. There, there's just steps you gotta do. And so underwriting every deal in your market, meeting with people who have owned the type of assets you want to buy, those are all steps that will help you not make the mistake like we did on this asset. Curtis, you're talking to the brokers or the owners.

Are you going over this math saying, hey, this is why the numbers need to be what they are?

Yeah. So I negotiated a debt product for a building we bought years ago. I don't own it anymore. 12-plex in Efreda. And the broker, funny enough, it was Eric. He's going to be speaking later. He brought us terms and it was 5.5% interest, 25-year AM. I walked through this math and the cap rate was below the factor rate. So what we ended up doing is I said, we can't do 5.5%, we can do 4.5%, and it can't be amortized over 25 years, it has to be interest only. Something worth noting, if your cost of capital is only interest, it's an interest-only loan, the formula principal and interest times 12, well, There's no principal, so it's just the interest rate. So our true cost of capital was only 4.5% interest in that situation. You do the calculation, 5.5% interest, 25-year ARM, it's a heck of a lot higher than 4.5%. So what we actually did in that negotiation, I told Eric, can't do it. This is why. I don't want to earn 6% and pay whatever it was, 7%. I don't want to be paying the seller to borrow their money. I want to get paid to borrow their money. And we got it accepted. But it's very simple once you go through it again and again, because I've been going through this for 5 years now, right? Like, I don't expect anybody to just be able to gloss through it like that. But if you practice it over and over, you understand, okay, cost has to be less than dividend. How do we calculate it again? And you just keep doing the reps and practice these deals. You can negotiate the debt terms down with owners. And that could be an intro period. We've bought deals and I bought one about a year and a half ago where we had an intro period at a lower interest rate, allowed us to cash flow. I just own it with my wife. We bought it day one and we made the interest rate at a point where it would cash flow day one with time for us to get the income up so we could pay them what they really wanted later. Just had to show a path of how we could grow together, like I was talking about with the owner meeting, show a path where we can grow to where they want to be.

So another way to look at this, you could either adjust your interest rate or you could adjust your purchase price, right?

You could. So there's a few ways that you can increase your cash flow, right? Does anybody know them? Talked about them on the platform a lot. There's— well, there's only 4 ways, right? And so if we remember there's only 4 ways, it makes it very simple. Okay, we could raise revenue.

Income, expenses, debt service, lower expenses.

Okay, so we could increase revenue, we could lower expenses. Talked about debt. What about debt?

Reduce total cost.

Okay, so we can reduce the cost of the debt or That reduces the cost of the debt.

Oh, okay.

Or we could borrow less money. Those are our only options. There's only 4 categories. So if you're struggling to make a deal work like this, I mean, you got a great buy based on this math. However, there's only 4 ways to improve it. There's 4 categories. You could increase revenue, you could decrease expenses, which maybe you can't do on this one. You have to look at it deal-by-deal basis. That's what the seller of this place was saying. You can decrease expenses, not even showing us all the expenses. So, you know, obviously that was wrong. It was a bad assumption. You could borrow cheaper money, lower the interest rate, or you could lengthen out the amortization. That falls in that category. Or you could borrow less money, which means put more down. My pockets are empty. I can't do that. So That would mean a lower price.

If you put more down and you don't have that down payment, you're still paying for that debt.

It's just—

Exactly. Yeah. And that's the thing you have to be aware of, right? You have these 4 categories. Doing one may not work for this deal. You may have to operate in the other ones. You may not be able to increase the revenue. It may be a Class A deal, top of market. We bought a Class A project and it's our biggest asset today.

It—

when we're all said and done, that asset will be worth about $18 million. We can't raise the rent. It's brand new. It was already occupied. There's nothing to do. So we have to decrease the cost of capital. That was the only solution on that one. Decrease the cost of capital, seller finance to a point where we have margin, and then hold it for a long time. That's all we could do, but it's going to fall in these categories and it makes it very simple because that's all you can really do.

Yeah.

So like we were talking about over there, there's certain markets that don't have a spread built in.

You're right. So this is part of our strategy, why we started building in Washington. We buy based on cash flow. For equity growth. We're not buying for just one or the other. We're buying based on the cash flow, but we're buying for appreciation because appreciation, like Christian mentioned, is how you really build up a big balance sheet. It's how you can become exceedingly wealthy. The problem is people build for that, but they don't have the cash flow. They're not basing their assumptions off of positive income. So if you're buying in a low cap rate market, you're in California, maybe the cap rate's 4%. What does that mean for your cost of capital? Has to be less than 4. That's hard to do, but it's not impossible to do. What that really means is you're going to be on an interest-only loan, and maybe you have 2 to 3 years at 2.5%, and then you have 2 to 3 years at 3.5%. Gives you time to get the net income up so your cap rate actually goes up, right? You can move the net income up over time, but it doesn't happen overnight. So if you're in a really expensive market— I'm still buying in an expensive market. We bought some assets for $235 a door. That is not free, but we made sure that the cost of capital was less than the dividend it produced.

So commercial banks are going to not have that same flexibility.

You're saying You're right, they're not. Or you get a blended rate. An example of something that we're working on, you have the seller— and we've already done this, we did this on an 8-unit, done it on a couple other assets that we haven't even shared online— but where the seller will finance a second mortgage at 0% interest, 10%, 20%, 30% of the purchase. If your cap rate is 5 and your cost of capital from the bank is 6, but you have, you know, a third of the deal at zero, what's your total cost of capital? It, it could be actually lower than 5. So there's ways to make the numbers work even in an expensive market. It doesn't have to be black and white, seller finance first mortgage. You can do seller finance second mortgage. You could have 2 seller finance mortgages. You could do a second and a third with different terms. Behind the bank. There's a lot of ways to play the game, but you have to know the premise is one number has to be higher than the other, otherwise we lose money on the debt.

Now, if you're in a market where you just can't get a seller willing to do that, but you see an upside another way, like an occupancy problem, you know, it's a bad management company, you would still skip that if you can't get a 2-year spread?

Well, you asked about if there's just a market where you can't find sellers to do that. There are going to be people who will do this in every market. If you're talking like SoCal or, you know, LA, there's people that will do that in every market, but they're probably not lining up just to talk to you. You find their phone number, you pick up the phone and you go meet with them. A lot of the relationships, a lot of the deals that I'm doing today, I've been working on for 5 years, 7 years. I would say longer, but I was in high school longer ago than that, so I can't. Can't lie. But you get what I'm saying, right?

Yeah.

It takes time. And so that's where broker relationships can come in handy, because you can get a deal done pretty quickly with a broker in the meantime. But while you're buying deals through brokers and letting them know what you're looking for, build the relationships on the side, cultivate owner relationships along the way, because 5 years are going to pass whether you like it or not.

Thank you.

So all the math that you just did, that's in our calculator, right?

Correct. So this math is all on your calculator. It's very handy. You don't have to ever do it again. But if you understand, again, how the calculator works, you will be able to more intelligently talk about this stuff with owners, with brokers. Mortgage brokers don't even know what a mortgage constant is. It's crazy. They don't know how to use it. Mortgage constant, again, is another word for rate factor.

One thing I want to make sure we go over— debt service coverage ratio is the other big thing that's really important to understand going in. Can you give a quick rundown of DSCR?

I'm in. All right.

I know what that is.

Yes, sir.

If I handed somebody a portfolio today that cash flowed $20,000 a month and it was zero down, who would take that deal? Are there any important questions you'd want to ask?

Yes.

Let's assume it's fixed-rate debt and— oh, the clip. Let's assume that it's fixed-rate debt, 30 years, you're cash flowing $20,000 a month. After your expenses, your standard stuff.

How much did I buy it for?

Nope, doesn't— price doesn't matter if it's fixed rate, it's going to amortize, whatever. You got $20,000 a month. What is an important question?

How big is the total loan? If it's $50 million, if it's only cash flowing $20,000 on a $50 million loan, you don't want that.

Maybe more so than the total amount of debt, what is the total monthly debt payment? $20,000 a month cash flow. With no debt doesn't suck. $20,000 a month cash flow when you have a $20,000 a month mortgage payment. You know, that's pretty good. You're— well, no, it's after the debt, right? So if I'm cash flowing $20 grand after making a $20,000 payment, I'm chilling, right? Every month I save another mortgage payment. How scary do you want to go? What if it's $40,000 a month you're paying, you're still cash flowing $20,000? What if you're paying $100 grand a month and you're only cash flowing $20,000? What if you're paying $200 grand a month, you're cash flowing $20,000? There's a metric for this and it's called debt coverage ratio. It's how tight are you on making your actual payments? If your payment is $20,000 a month, then after you make that mortgage payment, you have $20,000 left over. That's a pretty safe place. Every single month you make a payment, you save a payment. That is called a 2 debt coverage ratio.

That's 2.0.

2.0. And the way that a debt coverage ratio works, it is something to 1, right? So it could be 2 to 1, it could be 1 to 1. One of the ones, I'm going to write it out for you, is your actual mortgage. So, 1x debt coverage ratio, DSCR.

1.

That means you got $10,000 a month in NOI coming in, $10,000 a month going out. You have no cash flow at 1. If you ever heard of a DSCR loan, maybe they say, I want to be at a 1.2x. What does that mean?

That's 1.20, 20% more.

Exactly. So lenders say you need to have a 1.2 debt coverage ratio. A lot of investors don't even know what that means.

Christian says 1.25 and 1.5.

Okay, yeah, 1.25. Let's use that math.

Oh, I studied that.

I love it.

Every time he talks, I'm listening.

1% is basically break even.

So 1x, you're breaking even. 1.25, which is a bit more conservative than 1, it's about 25% more conservative. All that means is If we're trying to get to 2, right? It's going to take you 4 months to save a mortgage payment. If your mortgage payment's $1,000, you're going to save 25% of that mortgage payment, which means you're cash flowing $250. If you are at a 1.5 and your mortgage payment is $1,000, 1.5 debt coverage ratio means you cash flow—

$500. $500.

This is a measure of your risk, right? It's one way to measure risk. If you are at a 1, which a lot of people are right now, which is crazy, your net operating income is exactly what your debt payment is.

Mm-hmm.

That sucks. I had a YouTube Live with someone that talked about being at a 1 debt coverage ratio, which means it works as long as nothing goes wrong.

If your roof breaks down, you're out of luck.

Yeah, if anything happens outside of standard operating expenses at a 1, you will lose money. Nothing ever happens. Right? Nothing happens.

Everything's perfect! There's no way your roof is going to blow off, right? There's no way my roof is going to end up in my front yard.

It's not going to happen. So again, the 1, if you're— yeah, the 1 is break-even. If you have anything after the 1, that is your margin. If you're at 1.5, every time you make a mortgage payment, you save half a mortgage payment. So it takes you 2 months to build a reserve of 1 mortgage payment. It's all about risk. So I mentioned the whole thing about cash flowing $20,000 a month. It could be great. It could also be a curse, right? There are going to be sellers who are like, I will hand you this portfolio. There's a seller in Grant County right now. I would call him an owner, but he's a desperate seller. He is willing to hand me a portfolio that will cash flow $15,000 a month.

Sweet.

The question you got to ask, how much is the payment? A 1.1 debt coverage ratio is kind of scary for $15,000 a month. That's why I wanted to ask the question that way. There's always another question. You got it. You got to turn the rock over. You actually have to underwrite it. The amount of NOI— we can go over the equation. It's your NOI over your debt cost. How much is my net operating income above and beyond my actual cost of capital? So NOI over annual debt service, principal and interest times 12. That's your formula. But this is what it represents. You're looking at risk. You want to make sure you have enough disposable free free cash flow to service when things go wrong, because they do.

So do you typically, uh, how do I word this, like, get— borrow money in addition to the purchase price as a reserve?

I have, yeah. But again, you know, on this, you need to underwrite all your debts. You could get a first loan. So an example, I bought an RV park with Christian. It's over there. I sold it to Christian. Christian sold it to Matt. Matt might sell it to one of you.

We'll see.

We'll keep it in the family.

Take the offers.

So bought it for $373,000. That was the purchase price. We got a loan at close For $525,000. There are people out there that are just going to look at what's my debt payment on the purchase price. If you borrow more money than your purchase price, you have to look at the total cost of capital. That could be with a first mortgage, it could be with a second mortgage, but you have to actually underwrite all of it. What's your actual annual debt payments? There are people that don't count their HELOC. I've got a buddy who always forgets he has a HELOC on the property. Like, it is debt. It's not your first mortgage, but you still have the payment. So you have to look at the actual total cash out on your mortgage payments to do this calculation right. Otherwise, you're going to put yourself in a position to be surprised. And later, we ended up actually getting a loan mod to $650,000 on that deal. So we had to now calculate the new $125,000 in debt that we had. So, After you've done a few deals now, do you kind of— what's your DSCR that you like to see on deals? And what's your range of like, if I had this, this is like a home run? Yeah, I like to get to 1.5 within 18 months. So a lot of my mortgages right now, I'll give you an example. That one guy that I owe $10 million to, My payment— yeah, I'm gonna round down. It's $52,000 a month, but let's put it at $50,000, right? To hit a 1.5 debt coverage ratio, what would be my cash flow?

1.5?

If I'm a 1.5 debt coverage ratio and my mortgage payment's $50,000, the NOI would have to be $75,000, which would mean the cash flow is $25,000. It would take 2 months at a 1.5 debt coverage ratio To save another mortgage payment. That would be ideal.

Yeah. Same with you, Christian?

Yep, that's the same target. We would like to see within 18 months a DSCR of 1.5 and above. And when I do a cash-out refinance, I don't like to bring it beyond like 1.5, maybe down to 1.4, but I try not to max. I really want to hold my portfolio at 1.5 long-term. That is a great place to do it. I have a few deals that are above 2. I have a few that are working their way up. On an average, globally, I like to try to hold 1.5.

And something worth doing for those who are starting to build their portfolio up, I would look at your— it's called a schedule of assets. You've got your total assets listed out. List out your NOI. List out your debt service. You can actually come up with a deal-by-deal Debt coverage ratio, and you can have a blended ratio for your whole portfolio. And so something that we built out for our portfolio is we look at everything as a whole. Each one, like, if there's a red flag and it's a little bit light, like, we need to go spend some time and attention on that deal and fix it. But we like to look at the whole portfolio as a whole, try and keep it above 1.5. You will probably not be there. In the first year. But if you can get there within 2 years, you're doing pretty good. We all good? Nobody has any unanswered questions? Have you run into— have you run into banks calculating DSCR a little bit differently than how you're underwriting it? Absolutely. Yeah. And I found brokers that will calculate it a lot different than they should, too. Basically get the broker underwriting and throw it in the trash can, right? Like, everybody's going to do it a little different, but whoever has the money makes the rules, right? That's— that rule has been around for a long time. So you need to figure out how the lenders are going to play that game and then underwrite to that. You still have to do proper underwriting. Some lenders don't know what they're talking about.

Yeah.

That is just a fact, right? And some lenders aren't going to be the right lender for that type of deal, so they're going to be Extra aggressive or conservative, but make sure you're doing your good underwriting. And if they played a little different, negotiate harder with the seller. Just say, "Hey, the bank's underwriting it here. There's got to be something that I'm missing. How do we fix this?" And then you get a better price or a better rate, right? So, do you have a question?

Okay. How do we get this calculator?

Oh, it should be in the platform, but however, the formulas itself are pretty simple. Do you have something to write it down? Because I can go through all these really quickly. I took some pictures.

Oh, okay.

We will also send out the recording of this when we're done. My editing team will package this and I'll send that out to everyone. I also We also have the calculator and a bunch of other free resources that we will send out as well. So you will have access to all of this in a super easy format. I have thought through that part.

Question, are we going to do another one?

How much time we got?

Uh, we have a couple minutes before lunch, but lunch is long.

We can go over.

It's fine.

Well, I'm not going to hold everybody from food because then I'll be the least favorite person of the day.

But we did math before lunch this time. That was something we learned from the last field trip.

Yeah, you're not sleepy.

So you had something you want to go over really quick?

Yeah, I, I'm looking at, I'm looking at a property.

Okay.

Killeen, Texas.

Killeen, Texas.

Yeah, I, I know, I know the area very well because I spent a good portion of my life, uh, near— I would never call it Fort Cavazos, it's Fort Hood, Texas.

Okay.

They're asking for $1.5 million.

All right.

My offer is $1.2 million. I've already talked to the broker about that.

So we're buying how many units for $1.2 million?

32 units.

32 units.

For $1.2 million.

Million 2.

The NOI that they say on here is $114,182.

What did you underwrite? I want to use your underwriting for this one.

I haven't completed it.

Okay, so $114,000. Okay, so we're going to go through this, and I want somebody here to walk me through what we're doing. 32 units, 1.2, and then 114 NOI. So what's our cap rate?

Uh, the cap rate is, uh, 7.61.

Well, not at 1.2. We're doing your purchase. So $114,000, 9.5 cap. Yeah, always got to underwrite to your deal, right? Because as soon as you adjust this price, your percentages are going to change. We got to make sure we're using accurate percentages. So it's 9 point—

9.5.

Okay. So 9.5% cap rate, that's 9.5% cash-on-cash return if we pay cash. That's before our debt. That's all that means. What's next? How much money are we putting down?

35%.

Okay, which is how much money? 35% times $1.2 million.

Uh-huh.

$420,000. $420,000? All right. So, on the $420,000, just off of this, what's our cash-on-cash return so far before we look at the debt?

You've got a positive 39.99.

Well, what's our cash-on-cash return as a percentage? It's 9.5%. Right? Because we paid cash for that portion of the deal. $39,900.

Okay.

So you're making about $40,000 in cash flow just off your down payment before we get to the debt. That's the important thing you got to remember. You're earning the cap rate on your down payment. So what are your debt assumptions? What's your interest rate amortization? What's your month—

6.5% interest rate.

6.5% interest. On a 30-year fixed.

Okay.

So what's your payment?

Probably going to be— your payment is probably going to be— annual debt service is going to be about $54,231.

Okay. So our annual debt service is $54,000. So if we want to go through the whole complicated— basically go through— become a calculator, right? We take the debt service divided by the loan amount. That's going to give us our rate factor. If we want to figure out what our actual— like if we wanted just a little shortcut, we could— wow, union's popping. Way to go, Phil. See ya. So, if you want a shortcut on this for what the calculator's also doing, because this is equally important to understand, you take your NOI, you subtract your debt cost, that's going to give you your cash flow. There's just a little hack I've learned along the way. So if we have $54,000 in debt payments, $114,000 NOI, what would our cash flow be on the deal? $60,000, right? And if we want to figure out a cash-on-cash return, again, we just took this minus your annual debt payments. You have $60,000 a year in cash flow.

Divide by 12.

Well, we could take that, we could divide it into our investment. $60,000 into $420,000 is what?

14.4.

14.4? Is that what you said? 14.3? So that means we have positive margin, right? We ended up making an additional 4.8% cash on cash just because of the debt.

So it's 14.28%.

Yeah.

Cash-on-cash return. But that's only because your cost of capital was less than your cap rate. So in that situation, if you're good earning 14.3% cash-on-cash to own this deal, then you'd proceed.

It's a good deal.

Well, if it works for you. But 14.3% may not be good enough for Christian. I'm not saying it's not. Maybe he wants 30.

What's the market cap rate?

Market cap rate was 7.6.

Okay, market cap rate?

Like, uh, 6.89 for clean. 6.89 for clean in that area.

So if we have $114,000 NOI and a 6.9% cap rate, what's our value? NOI divided by the cap rate is?

$1,650,000.

So it's worth $1,650,000 the day you buy it if those assumptions are correct, which means you would have doubled your money because you've got $450,000 in upside on a $420,000 investment. You turned $420,000 into $870,000, and you're getting paid 14.3% on your money while you wait. So that's how all the math can work. Your calculator will give you the exact same result if, you know, if you put in the same assumptions. Anybody— they call it pencil whipping. You can make any deal look great on paper. If your assumptions are wrong, so will your returns.

So basically, Basically, you get the T-12, your rent roll, and the rest of the information that shows the actual financials on it, your expenses and everything, and determine if they're actually making that $114,000 NOI for the year.

Exactly.

Yeah, the quality of your inputs determines the quality of your outputs. If you're using bad information, you will get bad results, and you will be surprised when you lose the property.

So example of that, uh, I got an AOI sent to me and, uh, the guy is putting, uh, $150 in there as an expense for amortization. He's putting depreciation in there.

Those aren't actual realized expenses. The question of amortized debt paydown and depreciation, that's not a legitimate OpEx here. That is for tax purposes, writing stuff off and paying down your debt.

But interest on the note is figured in the NOI also.

So here's just a little thing. I know we got to wrap, we got to go eat. If sellers are adding in a bunch of unnecessary expenses, it drives their NOI down. If it drives their NOI down, it pushes their value down. I'm not going to correct them. Let them be wrong and then walk into it. You don't have those expenses and all of a sudden you have day 1 equity and more cash flow. You do not need to be right with these people. Let them be right.

I think what he's trying to do is he's doing it more for tax purposes.

That's great. But if you can buy it off of that, you have extra NOI in your deal. So now you're just worth more money.

Yeah.

Optimize on your own.

All right.

All right. I'll take the little mic. Lapel mic me.

That was a good question.

All right.

Thank you, Cody.

Did the thing. Everyone, that's the basis of the math.

Now, a couple quick pieces and then we'll wrap for lunch. When you are doing these deals, you are not going to know everything At the time that you write an offer and go under contract. You're going to be reasonably certain that your numbers are correct. Due diligence is for that. Your refundable money is to— when you look at a deal and you're like, hey, I believe that this math makes sense, this lines up with the inputs that I have, you write an offer, you go under contract. Huge mistake people make. They try to get every single number before they go under contract. And it is the most painful thing for me when you guys bring a deal to the mentorship call. Or someone emails me a deal and then 3 weeks later they bring it up again. And then 2 weeks later they bring it up again. I'm like, it has been over a month that we are still underwriting the same deal. Your timeline from— assuming, let's assume that we had a basic P&L, we had basic financials on the property. I've had a conversation with the broker and we've got one round of questions answered where there's a couple of items like the one that you just brought up where you're like, hey, I noticed there's a couple of extra expenses in here. We got some clarity. If we are reasonably certain that this deal is going to work based on the numbers that we have, make sure that it is your deal to lose. That is the point where you write a contract. Due diligence is where you prove the assumptions were true. So you do not have to know everything to go under contract for a property. One of the biggest differences between people who analyze deals and people who buy deals is that one piece. You actually do have to write an offer. At some point, you will also not know everything when you write an offer. We went under contract for those 2 deals that I've been talking about in the long view. We have P&Ls. We've looked at a lot of financials. We will 100% discover new things when we're in due diligence that we don't know upfront. We've done our best to factor for them. Hopefully we'll do our due diligence. The numbers are going to be a little bit better and we were extra conservative. Most likely outcome. We could get into a bunch of the units and figure out, oh my gosh, there's a major problem. You don't need to know everything to go under contract. That is why we have that due diligence period. There's a point where you're going to prove the math is true. Also, hopefully really encouraging. While we'll send out the calculator and you have all these, notice that there was no equations that go above Algebra 1. The most complicated that we got was a times b equals c. That's the NOI cap rate. Same equation for debt service coverage ratio. Basic, basic, basic algebra, which I love about real estate. Once you get the terms down, and again, we'll give you guys a copy of this presentation, you guys have the calculator. But once you know what the terms are, the actual math is not complicated math. It is very, very, very simple algebra, which makes real estate really doable. If you guys are wondering what I like to see day 1 on a deal, Ideal universe, if it's a relatively simple deal, I need to see positive cash flow. I would like to see it around 8% or higher. Sometimes it's way higher, but it has to be really good on the upside for me to want to go significantly below 8% day one on cash-on-cash return. Most important metric to look at when determining where— how is a bank going to look at this? If I'm negotiating everything at par, that 1.25 debt service coverage ratio is If you are buying there, it is almost a guarantee that the bank will like the deal. That's a really good starting point going into a deal. 1.25. The first thing I personally look at when you guys send me something to look at is always, where are we at day 1? How far off 1.25 are we? And then everything comes after that. A cool thing happens with debt service coverage ratio. If you get to the point that Cody just referenced, one seller, he has $52,000 a month of mortgages. So when you're talking like, hey, I'm trying to get to a 0.5 debt service coverage ratio, if you're paying a ludicrous amount of money in mortgage and half of that is what you're paying yourself, that's freaking awesome. That's a lot of good margin. It's one thing that I really like about the real estate is keeping that margin between what I owe and what I have to pay myself and pay my investors is, in my opinion, the most true cash flow metric that you can follow. It is the first thing I will look at. Loan factor rate, Cody covered quite a bit. I want it to be positive or near breakeven day 1. If you have an operating plan where that gets positive really quickly, it's the least important of the 3 upfront. As long as we have positive cash flow day 1, we have a decent debt service coverage spread. I'm okay if the loan factor rate is like, oh, we're losing a 1 1 point on every dollar we're borrowing, but we're making way more on the money that we had invested. As long as we are positive, you can get paid to buy the real estate. When you look at where are we at at the end of the project, you should be very positive on loan factor rate. All of them should be green lights all the way through. Day 1 loan factor rate, you should know where it's at. It doesn't have to be a positive spread on the loan factor rate for every deal as long as you have day 1 cash flow, long-term fixed rate debt, And you get it into a position where the spread on the debt is positive in a relatively short period of time. Guys, that's it for math. Oh, right. There's sandwiches in the back. There's also chips. I know I get a lot of complaints about too many carbs at these events, but you know what? It is what it is. If you guys want any other food, there's awesome restaurants around. Again, you guys can drive over to Dos. You guys can walk down to the Alderbrook. We have a reasonably lengthy lunch. I try to leave these to socialize. So you guys have a blast, and we'll resume soon.

Thank you.