When evaluating a real estate syndication, it’s essential to dig into the financial details to understand how the investment will perform. One effective method for this is a bottom-up analysis. This approach focuses on the day-to-day operations of a property, providing a clear and detailed view of its financial performance. Unlike a top-down analysis, which starts with broader economic and market conditions before looking at specifics, bottom-up analysis examines the property’s operations in depth to guide investment decisions.
In this blog, we’ll explore the bottom-up analysis process and its relevance to real estate syndications, emphasizing net income, cash flow, operating expenses, and more.
Why Net Operating Income and Cash Flow Matter in Real Estate Syndications
When it comes to performing a bottom up analysis on a passive real estate deal, two key numbers you need to understand are Net Operating Income (NOI) and cash flow. These figures help you see how well a property is performing and how much money it’s actually making.
Net Operating Income (NOI) is the income a property generates after covering its regular operating costs, like maintenance, property management fees, and utilities. It doesn’t take into account things like loan payments or big one-time expenses, such as replacing a roof. Here’s how you calculate it:
NOI=Total Income from the Property−Operating Costs
For example, if a property makes $200,000 in income and has $80,000 in operating costs, the NOI would be:
NOI = $200,000 − $80,000 = $120,000
Cash flow is the actual cash that’s left after you’ve paid all expenses, including your mortgage and any major repairs or upgrades. You calculate it like this:
Cash Flow = NOI − Debt Service − Capital Expenditures
Using the same example, if your mortgage payments are $50,000 and you spent $10,000 on a new roof, your cash flow would be:
Cash Flow = $120,000 − $50,000 − $10,000 = $60,000
So, in this example:
- NOI ($120,000) tells you how much money the property is making before you pay the mortgage and other big costs.
- Cash Flow ($60,000) tells you how much money is left in your pocket after everything is paid.
Understanding these numbers is important because they show you different aspects of the property’s performance. NOI helps you see how well the property is being managed, while cash flow shows how much real money you’ll actually make from the investment. This helps you figure out if the property will generate enough income to cover all costs and give you a good return on your investment.
Breaking Down the Operating Statement
To get a clear picture of a property’s financial performance, it’s important to understand the operating statement. This statement details the property’s revenue and expenses, helping you gauge its profitability. Here’s a breakdown of some key terms:
Gross Potential Rent (GPR)
Gross Potential Rent (GPR) is the total rental income a property could generate if it were fully leased at current asking rates. Calculating GPR involves multiplying the number of units by the asking rent for each unit. For instance, if a property has 10 units with an asking rent of $1,000 each, the GPR would be $10,000 per month.
Vacancy and Collection Loss
These are losses due to unoccupied units and unpaid rent. Vacancy loss is income lost from empty units, while collection loss accounts for unpaid rent. Estimating these losses helps determine the effective revenue the property can generate.
Loss to Lease and Concession Loss
Loss to Lease is the difference between asking rent and actual rent. For example, if the asking rent is $1,000 but a unit is rented for $950, there is a $50 Loss to Lease for that unit for that month. A concession is a rent discount given to stimulate leasing activity. For example, if a unit is rented for $1,000 per month but the resident is given two weeks of free rent in exchange for them signing a lease that day, the two weeks of free rent is a Concession Loss.
Other Income
Properties can generate additional income from sources like parking fees, pet fees, amenity fees, utility billbacks, or laundry facilities. This other income can significantly increase the property’s overall earnings.
Effective Gross Income (EGI)
Effective Gross Income (EGI) is calculated by subtracting vacancy and collection losses, loss to lease, and concession losses from the Gross Potential Rent and adding any other income. This figure provides a more accurate picture of the property’s income potential than the Gross Potential Rent alone. An easy way to think about this is GPR is where you would like to be, and EGI is where you actually are. GPR and EGI are never equal–there are always some losses to subtract from GPR.
Understanding Operating Expenses
Operating expenses are the costs associated with running and maintaining a property. Here’s a breakdown of common operating expenses:
Property Management
Property management fees compensate the property management company for overseeing the operations of the property. This fee ranges from 3% to 4% of EGI for large apartment complexes, to as much as 8% to 10% for small properties such as one-off duplex/quadplex and single-family homes.
Property Taxes
Property taxes are mandatory and vary based on location and property value. Estimating these taxes accurately is crucial for budgeting. Good operators research when taxes are due for reassessment and include this in their proforma. Additionally, contesting or abating property taxes can be a powerful strategy to reduce expenses and increase asset value.
Insurance
Insurance protects against risks like damage or liability. Costs for property, liability, and sometimes flood insurance have recently increased, impacting investment profitability. Many operators are now incorporating larger buffers in their proformas to account for these rising costs.
Repairs and Maintenance
These costs cover routine upkeep and unexpected repairs. Routine maintenance includes things such as carpet cleaning, minor painting, and replacing light bulbs, while repairs address issues like plumbing, electrical, and HVAC problems, among other things. Rising costs of materials and labor have made controlling these expenses challenging, so good operators are budgeting larger buffers to handle both routine and unexpected repairs. Unit turnover costs are sometimes included in this category, and are sometimes shown as a separate line-item.
General and Administrative
General and administrative (G&A) expenses include office supplies, uniforms, office internet and telephone charges, training expenses, tenant credit checks, legal fees, postage, and other overhead costs. Rising costs due to inflation and increased operational demands require careful monitoring and cost-control measures to maintain profitability.
Marketing
Marketing expenses are spent on attracting and keeping tenants. This can include costs for online ads, signs, promotional events, and other marketing activities. Effective marketing is key to filling vacancies and maintaining a steady rental income.
Contract Services
These involve hiring third-party companies for tasks like security patrol, alarm monitoring, landscape maintenance, pest control, and trash removal. Given the rising costs of labor and materials, it’s important for operators to review and negotiate contracts carefully and budget for potential increases.
Payroll
Payroll includes wages for employees such as building managers and maintenance staff. Increased labor costs can impact the budget, making it important to account for these expenses based on the property’s size and local wage rates.
Utilities
Utilities cover essential services like water and sewer, electricity, gas, and sometimes cable TV and internet service. Utility costs have risen recently, so it’s crucial to understand past usage and plan for potential increases. Utilities may be covered by the landlord or tenants, depending on the lease agreement.
Net Operating Income (NOI) and Its Effect on Property Value
Net Operating Income (NOI) is a key performance metric in real estate investing. It shows how much money a property makes after covering operating expenses but before accounting for taxes, interest, and depreciation.
To calculate NOI, subtract total operating expenses from Effective Gross Income (EGI). For instance, if your EGI is $100,000 and operating expenses are $40,000, your NOI would be $60,000.
NOI is important because it helps you assess a property’s income-generating ability and plays a significant role in determining its value. The higher the NOI, the more valuable the property is likely to be. Operators should focus on increasing NOI by enhancing rental income, reducing vacancies, or adding new revenue sources, all while keeping operating costs in check.
Multi-Year Forecasts vs. Proforma: Understanding Future Performance
Forecasting future performance is essential for understanding a property’s long-term potential. Multi-year forecasts project revenue, expenses, and net income over several years, providing a broader view of the property’s potential. They are based on historical data, market trends, and anticipated changes.
Creating a multi-year forecast involves making educated guesses about future performance using past data and current market conditions. For example, you might consider past performance and how economic trends or planned upgrades could affect future results.
Proformas offer a shorter-term view, typically projecting for one to five years. They provide a snapshot based on current assumptions and information but often don’t account for market changes or unexpected events. Both multi-year forecasts and proformas rely on assumptions and predictions, which means they are “always wrong” to some extent because they may not fully account for future uncertainties (like COVID-19, natural disasters, or runaway interest rates).
Cash Flow Analysis
Cash flow analysis looks at the actual cash a property generates after covering all expenses, including loan payments. This helps you understand if the property can produce positive cash flow and meet its financial obligations.
Key components affecting cash flow include:
- Replacement Reserves: Funds set aside for future repairs and replacements. Budgeting for these reserves is crucial to maintaining the property’s condition.
- Sponsor Asset Management Fees: Fees paid to the syndication sponsor for managing the investment. These should be clearly outlined in the syndication agreement.
- Debt Service: The cost of repaying loans or mortgages, including both principal and interest.
To determine the cash flow available to investors, subtract debt service and other expenses from the property’s net operating income. This amount shows the actual cash flow that investors can use.
When performing a bottom-up analysis of a real estate syndication, it’s crucial to be on the lookout for potential warning signs that could indicate problems with the investment. Here are some key red flags to be aware of:
- Unrealistic Projections: Be cautious if the projections seem overly optimistic. For example, if the syndication forecasts a 20% annual increase in rental income, but the local market has only seen a 5% increase in the past decade, this may be unrealistic. Compare these projections with industry benchmarks and historical performance to ensure they are reasonable.
- Inconsistencies Between Historical and Projected Performance: Look for significant differences between past performance and future projections. For instance, if a property has historically had a 5% vacancy rate but the projections anticipate a 2% vacancy rate going forward without clear justification, this discrepancy could signal unrealistic expectations or hidden risks.
- Overly Aggressive Assumptions: Be wary if the investment relies on overly optimistic assumptions. For example, if the syndication assumes that rent will increase by 15% annually while local market trends show an average increase of only 2% per year, these assumptions may not be supported by credible data.
- Lack of Transparency: If the syndication doesn’t provide clear and detailed information, it could be a warning sign. For example, if you receive a summary of projected returns but no detailed breakdown of income, expenses, fees, debt profile, or the sponsor’s detailed business plan, this lack of transparency could make it difficult to assess the investment’s viability.
- Inadequate Due Diligence: Watch for signs that the sponsor hasn’t conducted thorough due diligence. For example, if the property’s inspection reports are missing or incomplete, or if there is little to no market analysis provided, this could indicate that important aspects of the property or market have not been properly evaluated.
- High Leverage: Excessive use of debt increases risk. For instance, if a syndication uses 85% debt financing compared to 15% equity, it may be highly leveraged. In times of market downturns or financial stress, this high leverage could lead to significant losses or reduced returns for investors.
By being vigilant about these red flags, you can better evaluate the risks associated with a real estate syndication and make more informed investment decisions.
Final Thoughts
Bottom-up analysis is a valuable tool for evaluating real estate syndications. By examining net income, cash flow, operating expenses, and other financial details, you can make informed investment decisions and identify potential risks. Understanding these elements will help you determine if a syndication aligns with your investment goals and risk tolerance, equipping you to make sound choices and achieve success in real estate syndications.