Ep. 38 | 10 Financial Metrics Every Syndicator Must Master

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On this episode of The Mobile Home Park Lawyer, Ferd talks about the top 10 formulas you need to know to be a real estate investor or syndicator. These 10 formulas will help you secure a bank loan if you’re considering syndication.

HIGHLIGHTS:

0:00 – Intro
1:50 – What are the top 10 formulas you need to know to be a real estate investor or syndicator?
4:24 – Net operating income – Amount by which operating revenue exceeds operating expenses
5:03 – Debt service – the payment of principal interest due on the existing debt
6:08 – Cash flow – The difference in the cash available from the start of a period to the end of a period
6:34 – Preferred return – A profit distribution preference where one class of investor gets paid before another
7:17 – The waterfall/GPLP split – how much gets split between the GP and LP, all of which is negotiable
10:08 – Cash on Cash ROI – the percentage of return derived from dividing cash flow from the initial cash outlet
11:12 – Reversion – Estimated value of the asset when sold
12:23 – Cap rate – percentage at which a future flow of income changes to a present value figure
12:36 – NOI – irrespective of any debt service
15:29 – IRR – the average annual rate of return earned through the life of the investment as Ferd offers an example of a farm
19:16 – Single-family homes typically go up, but won’t go up as much as Ferd’s farm example
19:50 – Ferd offers a third example of how to make money off IRR
24:20 – Ferd sometimes chooses to syndicate, sometimes not. It’s based on how much cash he’s sitting on
26:55 – Equity multiple – the ratio of equity to total net profit
27:58 – If you’re going to be an LP, know who your operator is

FULL TRANSCRIPTION:

Welcome back mobile home park nation. Here again today with another great episode for you. Today we’re going to talk about math. I know everybody loves math. I’m a little bit of a spreadsheet dork. I have to admit. Nack in 2008, I was getting my MBA at Rockers University here in Kansas City. And I was also working at Jackson County as a financial analyst on tax incentive projects, commercial real estate projects. And I really got into the spreadsheets, really kind of dorked out on them and still work on spreadsheets today. But what I find the problem sometimes is with spreadsheets, as you see these ratios and these percentages and these, you know, big words like reversion value and like, what the heck is that? And I felt like there was a lot of misinformation out there on the internet back, what has been 12 years ago when I learned this stuff. So, I feel like there’s still a lot of misinformation or maybe rudimentary explanations for some of these complex terms. So, I figured might as well go through them today here and teach you guys to fish. As far as financial underwriting, financial modeling. I’ll have some other podcasts and zooms on actually going through some spreadsheets.
But today I want to just cover kind of 30,000-foot view. What are the top 10 formulas or financial terms and ratios that you need to know if you’re going to be a real estate investor, especially if you are going to be a real estate syndicator. Some of these to provisions in terms are just purely for the investment side, but if you’re going to start syndicating, you really got to get a good grasp of this. You need your spreadsheets to be accurate and you need your contracts to be accurate. You need your private placement memorandum to be accurate and you need to be able to articulate how the deal works, if you ever think you’re going to get loan approval. And a lot of times, you know, there’s some bankers out there that are really sharp, but there’s also a lot of bankers out there that are very rudimentary. And this is kind of outside their lane, especially some smaller banks. So, you got to be able to articulate it with precision and confidence. And of course, accuracy in order to win the deal.
I’ve been in front of a lot of loan committees and loan officers. And sometimes they tell you no, and some of them tell you no, not because you don’t get it, but because they don’t get it. And that’s tough. But I mean, I think there’s an old saying, like, if you can’t explain it to an eight-year-old, you don’t know it well enough. So today I’m going to try to explain this well, and if I can’t do it and you’re still, you know, confused as mud then well, sorry, sorry not sorry. I’m trying here.
All right. Let me jump into the 10-key metrics. We’ve got net operating income, and I’m going to provide on the show notes, these definitions and these names. You don’t have to write all this down. Just listen and learn. Number two, debt service, which also kind of to be debt service coverage ratio. DSCR, debt coverage ratio, DCR. Number three, cash flow. Everybody cares about that one, right? Number four, preferred return. Your investors care about that one. Number five, cash on cash return on investment. Number six is the waterfall or the general partner slash limited partner split. Number seven is the internal rate of return. I feel like this is like the mystical fantasy formula that everybody knows how to do and Excel, but nobody really understands not nobody, but a lot of people. I didn’t understand. Nobody taught me how, I had to teach myself and I just had to see it and watch it, learn it in real life.
Number eight, reversion which is basically your sale price. At the end of year 10, which we’ll get into.
Number nine, capitalization rate or cap rate, and number 10 equity multiple. So, I am going to rattle off some definitions here and I’m going to, and the ones that are more complicated, I’m going to dive into and explain a little bit more.
So first off, out of the gate net operating income, I think everybody knows what this one is, right? It’s the amount by which operating revenue exceeds operating expenses without taking debt service into account. And the reason properties trade or sell on an NOI is because we all get different financing terms. I may, if we’re both buying a million-dollar property, I may buy it for a million cash. You may buy it for zero down and a million-dollar loan. Well, our cash on cash returns will be different. But our net operating income is the same. If we operate the same way, the same number, we’ve got one-unit times 200 bucks, times 12 months at 2,400. If our expense ratio 50%, that’s $1,200. We got $1,200 net operating income.
Debt service, this is obvious to the payment of principal and interest due on the existing debt. The debt service coverage ratio, that’s your NOI divided by your total debt service and lenders care about this. You can put it in your spreadsheet for your own edification and feel warm and fuzzy that you got some DCR that’s 2.0 or something, but typically banks want a minimum of 1.2, a ratio of 1.2 over one for net operating income over total debt service. So, I’m looking, I’ve got a spreadsheet right here. I’ll just tell you real quick. This is a small deal I’ve got in Iowa, NOI is 44,000 in year one, debt service is 30,000 and change. So, the DCR is 1.46. So, the next year it goes 1.56, 1.67, 1.78. Okay, that is bankable. Because the asset covers the note and then some, and the ratios banks want are anywhere from 1.2 to 1.5. Some banks will do a stress test, which is basically manipulating your assumptions in a negative manner to see if you can still maintain that 1.2 DCR.
Number three, cash flow. This is the difference in the amount of cash available at the beginning of a period and the amount at the end of the period. Basically, this is NOI, minus debts service equals cashflow from operations. There’s other cash flow that is not from operations, you know, interest and things like that. We’ll get into perhaps another episode. But I’m not going to get it too much in the minutia here today.
Number four, preferred return. This is, you’ve probably seen this like an eight pref is a common term. And what that basically means is that’s a profit distribution preference where one class of equity gets paid before another. So like on this deal, I’m looking at, if I’m going to promote this, I’m going to say, okay, my investors get an eight pref and they get the first eight, if the investors put a hundred thousand dollars in, the bank gets paid first. So preferred return to preferred equities is junior to bank debt. But if the deal makes a hundred thousand dollars, then class B shareholders of my private place memorandum who are my limited partner equity providers, they get an 8% preferred return, $8,000 before I get a penny.
Then we get into the number, I’m saying, number six, I’m skipping one here, the waterfall, the GPLP split. And if I’m the GP, let’s say it’s 30/70, which means I get 30%. And then the investor gets 70 there’s 8,000 go to them. There’s 92,000 left. If for district distribution times 0.3, that’s 27,600 that come to me, the Delta 64,400, that goes to the LPs. Basically, that’s what it is. It’s a waterfall. And you can have different, hurdle is a better term. You can have different hurdles. You could say, okay, it’s 30/70 until the IRR or some other metric gets to 15%. And then it goes 50/50 or something like that. This is all negotiable. People always ask me. And I was asking people and I went around, I did, my first syndication was asking anybody that would listen, you know hey, how are you guys doing this? What’s the industry standards. And it’s really, it depends. If you got a hundred-million-dollar project, it’s probably closer to, you know, 20/80. If you got a, you know, a small deal like this is what I’m looking at here. If I was to syndicate this it maybe 70 for me, 30 for the investor, or you could even put in a cap. I’ve started putting some caps in my syndications, to be honest, because I had a couple where, my share was supposed to be like a million. And we over-performed. Did the project in half the time and twice as good, not twice as good, but 25% better and half the time. So, the IRR is through the roof and now my investors are getting like an 80, which is great. They love me, but dang, I left a half million dollars on the table for myself. So now I’m starting to put caps in which investors don’t probably care for, but if a cap is 30, they don’t get that much hair on it because they’re like, dude, nobody else would give me a 30. So, I could say hey, 8%, pref, 30 for me, 70 for you. But once you hit a 30 IRR, the rest is mine, which really ends up making it more like 40/60, 60/40 in some instances as high as 90/10. But hey, you going to 30 IRR, you know, when you’re bringing up partners, I had a friend and mentor who he turned a company from zero 6 billion in revenue and he’s worth a ton of money. And he told me there’s two types of partners. There’s the type of partner that cares how much money’s in their own pocket. And there’s a type of partner that cares how much money is in your pocket.
And the ideal partner or limited partner investors. The guy that says, I don’t care how much money you make. I hope you make a gazillion dollars, but I just want to make sure that I’m getting what I deserve and what I think what I negotiate for, and that can all be structured in your PPM. So anyway, that’s just kind of some sidebar on choosing investors. Okay. Back to number five, we’re going in the wrong order here, but I’m kind of in charge. So, deal with it, I guess.
Number five, cash on cash ROI. This is the percentage return derived from dividing cashflow by the initial cash outlay. Okay. That’s pretty obvious. I gave the example of okay. 64,400 plus the investors got 8,000. So, their total cashflow is 72,400. If it took a million dollars to invest in this deal, you divide that by a million, that’s 7.2%. Now I combine the cash on cash, full return on investment, which included the pref return and the distribution for the LP in the waterfall. You could do numerous sub metrics like the cash on cash ROI from operations, cash on cash global, which is the cash against global is kind of, it gets into the next one internal rate return. And this is one of the more confusing ones.
The definition is the average annual rate of return earned through the life of an investment. This takes into account overall cash flows; debt pay down and the reversion value. So, I’m going to jump to number eight to reversion value. And then come back. When you’re trying to compare an Apple to an Apple, you need to have similar time horizons. So, the IRR calculation and through a process it’s called the discounted cashflow analysis. What it really does is it tries to bring things to normality and make them uniform. And it does that by having a forced sale or a reversion on your 10 and typically the rear 10 reversion. It’s basically, it’s the estimated value of the asset when sold at the end of the 10 years. And it could be any investment holding period, but typically it’s 10 years for a spreadsheet. Even for the kind of guys like I never sell; my kids are going to own this. My grandkids, I get it. I used to have a lot clients, they literally have never sold them like three generations. And they are just massive land barons. I got it guys, but you need to compare it to other like kind of business, so you can make a better decision.
So, it’s the value of an asset when it’s sold, it’s derived or calculated by dividing the future estimated NOI by the market cap rate. This is where most people mess up. They do a ten-year proforma and they used a year 10 NOI, which is generally leaving some, you know, leaving some money on the table. Because you’re supposed to calculate that 11-year NOI. And you take that NOI divided by the market cap rate. That is your reversion value. That’s your sale. Okay. And what is the cap rate? The cap rate, it’s the percentage at which a future flow of income changes to a present value figure.
A cap rate shows how quickly an investment pays for itself based on operations. So back to the NOI, the NOI was kind of irrespective of any debt service and the cap rates are similar. So, there is an easy way to calculate value is, it’s just triangle formula. You know, “IRV” is what I was taught when I was doing appraisal work. Income divided by reversion value, NOI over price equals cap rate. And then the inverse is NOI over cap rate equals value. So quick math here, a hundred thousand dollars NOI divided by the cap rate, 10%. So, divided by 0.1 equals a million dollars. NOI divided by cap rate equals value or price. And then NOI, hundred thousand divided by price, a million dollars, what’s it going to be? A 10 cap, 10% capitalization rate. So how do we come up with our cap rate? That’s how you do it mathematically, but if you’re looking to purchase a property or in this case, we’re looking to estimate our reversion value in your 10. Well, you have to, pull out your crystal ball and say, what are cap rates going to be at this timeframe? And then in today’s world, you look at market forces, like what are other properties that are similar to this trading force? Like an MHP world, I typically start with an eight. If the property is more than 50 lots, I drop it a hundred basis points. It’s more than a hundred lots, I drop a hundred basis points. I’m down to 6. If they got private utilities like a water sewer, that you are responsible, that’s bad, right. Up a 100 or 200 basis points. If it’s got a lot of park-owned homes, or RVs I up it even more. If it’s a lower quality property, gravel roads, or, you know, just rough area, tertiary market, you got up that cap rate.
If it’s 500 lots in downtown Denver, and it’s senior living only, and they’re all brand new double wides. That’s probably going to be like 40. If it’s a hundred dollars below market rent, it might even be a three and a half cap. Okay, so the cap rate is supposed to reflect risk. So, you look at market forces into the future that it’s kind of a crystal ball time and to some degree cap rates and to a large degree cap rates float with interest rates that the federal reserve sets. So generally, cap rates are, you know, a few basis points higher than the interest rates. And now in our current, I say current last several years environment, it’s like, there are no interest rates, you know, from the federal reserve. So, what’s the bank producing. If a bank can give you a loan at 4%, which is kind of current rates, you can buy at a seven cap and make a 20% cash on cash return, inclusive of debt pay down. So really an IRR. Some people say cash on cash, but it relates an IRR if you get into the formula there.
So, to each their own, as far as their yield requirement. Yield meaning return on investment or yield being the, I usually focus the yield is on the IRR. But that’s how cap rates work. So back to the IRR. This is kind of the Holy grail of financial metrics in my opinion. Again, the definition is the average annual rate of return earned through the life of the investment.
Okay, when I started looking at this, I said, what does this really mean? Most people know how do it in Microsoft Excel. It’s equals IRR open parent and then you drag all the cash outlays and inlays. But what IRR does is, it takes into account the time value of money, money and the amounts of money. So, for example, I used to teach my appraisers this, I’ll see if I can remember my example. When I used to be County assessor, I had 35 appraisers under me and only a handful of zero to one, understood it. So, we had to teach them, especially the commercial guys. The residential folks didn’t need to know as much, but the commercial folks said, okay, here’s three different investments. I said, if I was to buy farm ground out on the edge of town for a million dollars and my cash from the farm ground was, you know, 2000 a month. It was 2000, times 12 months, it’s 24,000 into a million. Those are realistic numbers by the way, they were at the time. That’s a 2.4% return. I must be a fool. So, let’s say I put $200,000 down on that, $200,000 down on a million dollars. That’s 24,000 into 200,000. My cash on cash is 12%. That’s not too bad. But it’s because they got leverage.
Let’s go back to if there is no leverage. I’m making 2.4%. Why am I doing it? Like me personally, I don’t really want to do that for 12%. And I really don’t want to just do it. But what happens if in year 10, when we’re going to sell, what happens if the city, here in Kansas City it expands and now it comes out to the farm ground. Well, now some residential developer or commercial developers going to call you and say hey, your ship just came in. I’m going to buy your farm ground. Well, now I might buy that farm ground for, I may sell that ground, excuse me, for $3 million. So, my regular cash was low. If I paid cash for it, million dollars, I have no debt pay down. I have no leverage. I’m making a 2.4% return. But at the end of the movie, I have a $2 million gain. So, my appreciation on my reversion value is high. So that could be a very good investment, even though I had almost no cash flow and no principal paydown. So that’s one of, you can see where only one of the three metrics was really used and It impacts your internal return.
Another example would be like single family housing. Single family housing, I probably more likely I get a loan for it. By the way, on the farm, it’s harder to get loan because it’s not going to pencil well financially, you got to have more down payment typically or stronger net worth. It’s not a pure cash flowing investment, banks are going to typically be tougher on you. I’m like, let’s say I buy 10 single family houses and I buy them for a million dollars. I put $200,000 down. Typically houses like that, million dollars, they have a 1% rent. That’s 10,000 per month to 120,000. So basically, homes like that can cashflow in the 10% to 20% range. But I have a 30-year amortization on my loan. So, my principle paid on that loan is very, very slow. Like diminimous almost, I think it’s like 17. I haven’t looked at it in decade, but I think it’s like 17% of your first payment’s principal and the rest is interest. Shooting a little principal paydown okay, but you’re getting good cashflow on a monthly basis. But what’s your appreciation going to look like? Well, those homes are probably not going to go up that much. Single family homes do tend to go up historically, but they’re not going to go up like my farm example. So really my appreciation is a combination in there, but it’s not as big. The cashflow is the King on the single-family residential world. So again, I have three metrics. Principal paydown, cashflow and reversion value appreciation to come up with my IRR.
The third one in this example is a little bit, in the second one the cashflow was a lot, that principal paydown is almost a minimum. That could be a wise investment, just like the farm was a wise investment. But because of different metrics within the return. Here is a third one. Here in Kansas City, there’s a lot of government jobs, federal jobs. So, there’s this place called two Persian place and one Persian place, and the IRS is right there. IRS has massive facility. I don’t know how big it is. I want to say like 2 million square feet, it is one of the biggest facilities in the country and they have thousands upon thousands of employees that work there. And it’s federal government tenants. So, the group that built that, I think it was DST, it is a company, a big company here in Kansas built that. They have a really safe tenant, but because it’s so safe, I don’t know the terms of their lease. But it’s likely that that lease on the cashflow perspective. I’m going to go to lane two. It’s likely that it’s not spitting out huge cash. It’s probably like 4% return cash on cash, not that good. And then as far as the third component appreciation, it really does have much. Those kinds of buildings, you’d value them using the cost approach, probably there’s three approaches to value income, sales, and cost. And if the trades mid lease, it’s going to be income approach most likely. But at the end of the movie, that’s a 10-year lease, at the end of 10 years, the IRS does not renew that building may be functionally obsolete for the next user. This is really common like on auditoriums or like sports arenas and things like that. Or even like an old Walmart building, the list of valuable Walmart building when Walmart leaves, it’s just warehouse, you know, not that much. And it doesn’t matter what the income what Walmart was producing, or even the rent rate that Walmart was paying. So, in this IRS building example, the third billing appreciation is probably not going to go out much. It’s probably going to be less than the cost of build it, frankly. It’s going to be, you know, cost less depreciation is what that building’s going to be worth at the end of 10 years.
So why would you DST or this big, sophisticated company, why would they invest it this? Well, let’s look at lane number one, principal pay down. If they got a 10%, if they’ve got a 10-year amortizing loan, they pay the building off in 10 years. Well, that facility probably cost a hundred million dollars. Instead of a hundred million dollars of equity paid down by the IRS. And most likely because the commercial property, they had a longer loan, and they paid a 20-year amortization. Pretend 10 years, they had a hundred-million-dollar building. They’ve paid that building down considerably. I am just making some off the top of my head. I don’t know the number, but call it, they’ve paid it down to 150,000, 150, I just mean from a hundred million, they paid the note down to 75 million. That means they now have $25 million of equity. It could be, the shorter the amortization, the faster the payments, the more equity you build, the worse your cash flow is. Because your debt service is up right. But that could be a really good investment for capital preservation and, or just debt pay down to have, you know, more liquid or less highly leveraged assets.
So hopefully that was clear, but that’s really my way of trying to explain to you the three ways you can make money in return. So, the back on the spreadsheet, you know, this one here, equity investment minus 250 in the first year, that’s the cash that this deal’s going to take. In annual cash flow, you go year one, it’s going to be negative, but you’ve got a big cash outlay. Year two, Ooh, cashflow, positive, which is to the cashflow on this is, it’s a combination of prep return payment, which is, prep return payment is 250 times 8% is 20,000 a year. And then any additional cashflow from operations, sale of mobile homes, gets you your global annual cashflow to the investor, net of fees goes down the line, 29,000 and change 32. Then we’ve got 71, we’ve got to refinance year four. And then the debt service goes up with a refinance of the cashflow actually goes down, 13, 17, 21, 26, 28. At the end of the movie, we have 560K of net sales proceeds, which are the sales price. You asked me to reversion value at the estimated capitalization rate, less the promoter GP fees and then you get a return of a hundred percent of the principle. Once you pay back the principal of the investors, the preferred equity is what’s really called. Then you have to continue to pay the preferred return until the preferred equity is refunded back to the investors. And this example here on a 10-year hold and the four-year-old, it gets a lot better, which is a game on this actually. But I do a four-year proforma and I do a ten-year proforma and the payback to 250. So, the net proceeds in investor is 550,000, which gives him a 20.77% return.
So, what are the metrics you need? In this case, I think I could fund this deal, if I wanted to syndicate this and I run it both ways, sometimes I syndicate them, sometimes I don’t, frankly. It depends on, not my mood. It depends on how much cash I’m sitting on. What I got coming down the pipeline, how big the deal is, what the yield is. Whether it’s too small to even worth messing around with some investors. So, this case I’m going to pay an eight pref. I’m going to have cash on cash of 10.56, 11.8, 13.13, 28.7 in the first four years. So double digit cash on cash and an 8 pref, meaning I don’t get a penny until the investors get at least the rate. I could probably syndicated this. This is with me taking a 50% of the GP split on the sale of mobile homes. And this is when we take an 80% of the waterfall split at the sale refi. So, if I train it, so I’m going to go down row here. And I may just use this one as my next podcast, as I’m already kind of getting into some of these numbers look like, I’ll show you guys just on zoom. But at the end of the movie, I get 20.77, that’s because I am taking an 80% on the exit. Which is pretty high to be honest? But I got a heck of a lot of guys on the pipeline. The one invests relative to, you know, I got five deals under contract, but I could probably fund 20. So, I’m not, I don’t want to leave a half million dollars on the table. Like I did last time to be honest.
So, if I change that split to 50, only on the exit, well now the investors get 26.37. I think that’s too rich, frankly, you know, because this is a really down the middle of straightforward deal. If I do 30, promote 30/30 on these, you know, now the investors and I’m only taking 30, which is pretty standard. They’re making 31% and getting a pref and my assumptions are very conservative. And I’m not even counting by the way in this deal that it comes with 12 acres of development ground. This is going to be, I’m going to try to, I’m going to re-split it and I’m going to make it a single family. I’m getting title for single family and McMansions. Cause it’s really a fluent area of Iowa. And then I’m going to sell it off. So that’s all cherry on top, but I don’t know if I can get it pulled off. So, I’m not going to like to put my reputation on the line with my investors. Because realistically with the 30% cap, I’ll hit that cap for them, and I’ll get that extra. I’ll get most of the extra money if I over-deliver. So that’s what I’m setting them up nowadays.
So anyway, back to our regularly scheduled programming. Number 10, equity, multiple. What does the equity multiple? Well, in this example, the equity multiple is, you know, this example it’s 5.08 that’s because I just passed back over my own numbers. So, I go back to 50% on the Park owned homes and 80% split on the sale refi, the equity multiple to my investors is 3.31 on this transaction. What does that mean in English? Okay, It’s the ratio of equity to total net profits plus the total equity invested, divided by the total equity invested. Basically it’s, how much money they put in, plus their profit divided by how much money they put in and just tells them over the life cycle of this investment. In this example of this 10-year hold, they’re going to put their money in. It’s going to net of all my fees. It’s going to grow 3.3 times. So, some investors care about equity multiple. Some banks care more about the DCR. Everybody seems to care about the IRR. LPs should certainly care about both the preferred turn and the waterfall. But last point for today, this is all spreads. If you’re going to be an LP, really what’s most important is know who your operator is and know who you’re going to bed with.
I put some money in with some guys that I really trust before as an LP. And it worked out well. I’ve been co-GP or LP on other deals. I’m an LP on five mobile home parks. I sold one them and I’m still in five of them as an LP. Cause like requirement of the sale and the promoters are a nightmare. They’re breaking Sec, regs, they are breaking IRS regs, they are breaking loan Covenants, or breaking, operating agreement. I don’t see a financial report ever. They’re mismanaging the properties. And in that case, I didn’t really choose them. It was kind of like I threw in some of the cash at my sale, because it was requirement. It was all like quote, extra cash because I thought they were overpaying me. So, I was willing to do it. And I thought, how badly can these guys screw this up? Well, they’re screwing it up badly. So, it’s a matter of time to like to come around and get a minute, dig into that operating agreement in PPM, which I didn’t even do properly, frankly. And you know, I squeeze in and say hey, Merry Christmas guys. I’m here to take over your deal. But that could happen by the way, if you’re a promoter and you’re not following your operating with PPM, you could get pushed off your own ship. So you got to be careful who you’re getting in bed with, but understanding these metrics is going to be crucial for you, as an LP in understanding what’s going on with your money, but as a GP and understanding how to cut the best deal for you, but also a fair deal for your investors and be able to articulate it as hopefully I have done today so that you can get loan approval. Till next time, God bless.