Reviewing Historical Financials During Due Diligence

First, relying on the current owners’ historical financials for an expectation of your operating expense is fraught with risk.  Essentially, you are making the assumption that you can and will operate the property  in very much the same way the seller is.  This assumption can prove incorrect for a wide range of reasons.  The risk averse investor must bring a clear understanding of their expenses to the closing table and be guided heavily  by this understanding.

This earlier point stated, historical financials provide much needed hints about a given property’s costs for some key areas including: 1) utilities, 2) key  maintenance issues such as appliances and air conditioning, and 3) landscaping.

Your costs for labor and management, cost of supplies, and cost of contractors are brought to the  property by your mode of operating.

The last factor determining your cost is the combination of your physical inspection of the property, the property condition report, your market study, and your operations and management plan.

Each of these items should be combined to create your financial projections.

Blake Ratcliff

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Financial Statements Supporting a Residential Investment

Investors are often out of their depth producing required documents for lenders and investors. They feel inadequate or poorly prepared to accomplish this end. However, preparing the documents is really mainly a function of knowing what the documents are and how they interrelate.

The key documents for a rental investment whether it is a single family home, a duplex, a four plex or an apartment complex of several hundred are:

1. The residential rental property information including age of construction, number and type of units, amenities, acreage, number of buildings, features per unit (appliances, flooring, carpet, heating, air conditioning, bathrooms, bedrooms, etc.), and address;
2. Debt information including term, amortization, rate, interest only or not, and amount plus broker and lender information fees and origination costs;
3. Capitalization table with investor information including name, address, email, phone, fax number, amount invested, price per unit, number of units purchase, total equity invested, and management interest;
4. Sources and uses showing debt (from the debt information), equity (from capitalization table), fees, improvement reserve, operating reserve, purchase price with sources equal to uses;
5. Balance sheet showing assets consisting of operating reserve, improvement reserve, buildings, land, and other, liabilities showing all debts, and owner equity. Assets will equal liability plus owners equity. Buildings and land will include the capitalized costs of the purchase price and fees;
6. Pro Forma financials showing revenue, expenses, debt service, improvement costs, net cash flow and operating reserve;
7. Occupancy assumptions per month over the life of the project. Most banks will want to see a minimum of three years and up to seven years. Normally five is a number of years that works for all;
8. Key metric calculation for Net Operating Income, estimated value based on assumed capitalization rates, loan to value ratios, and debt service coverage ratios; and
9. Return calculations including Internal Rate of Return (IRR), cash on cash performance, and return on investment as a ratio of cash flow annually to cash invested.

(The following examples are generated by our financial statement tool.)

With these defined, investors can easily pull the information together, ask there accountant to pull the tables together, or use a service or tools to complete these documents. In fact, we have prepared a package of tables that allow simply filling in the blank to produce all the tables automatically. As an investor, the onus is limited to knowing your expected debt terms, investments by investor, property information, planned improvement costs, and expected income and expense. The worksheet then automatically produces the entire set for you.

Keep in mind as you consider this information, that regardless of how you produce these statements, you should examine the documents to assure that they make sense at each level. When completing this you should be checking balancing amounts on the balance sheets, verifying expense totals, verifying revenue totals, verifying income, verifying cash flow, and so on.

by Blake Ratcliff

Cap Rates Rising During 2010

Property and Portfolio Research projects average CAP rates to rise to between 8% and 8.5% during 2010 as the treasury rate rises and some inflationary pressure gathers.

This is very consistent with our own expectation and does not consider REO and foreclosure sales.

Blake Ratcliff

Investors’ Pro Forma and Financial Workbooks

I am preparing a financial workbook and pro forma for investor.  This items will include:

1. Property description factors including address, acreage, unit mix, key  unit descriptions, amenities, acres, and buildings,
2. Expense table to be input  by the investor,
3. Income table to be input by the investor,
4. Occupancy table to be input by the investor,
5. Economic assumptions to be input by the investor,
6. A debt table to be drawn from the lender’s offer or the input from investor assumptions and will include debt tranche / draw inputs,
7. Key metric calculations including Debt Service Coverage, Loan to Value, and Value based on 6%, 7%, 8%, and 9% capitalization rates annually and annualized for the last 90 days of each year,
8. capitalization table including investor information for investor communication,
9. Sources and Uses of equity and debt for the project,
10. Return  tables stated  as IRR and cash on cash results over 3 year, 5 year, and buy and hold annual return on invested cash.
11. 5 year improvement cost table to be input by the investor
12. 5 year proforma financials including Net Operating Income projections, Cash flow projections.
13. Appraisal inputs for building and land value.

The document will include a legend of investor inputs (cells highlighted to indicate investor input), calculated values, and which tables require investor input.

Non-Investor input cells will be locked (this will include descriptions and calculated fields).

All documents will be set up to print cleanly in portrait or landscape format.

This complete set of documents will allow investors & principals to quickly produce all required financial tables for their supporting investors or lenders.  While no pre-prepared tables can meet every scenario, I believe this tool can satisfy most investors needs.

Unfortunately, because of the complexity of this document and likely required refinements in the future, this cannot be offered for free.  The anticipated cost is under $50.00.

I am very interested in investors input on any additions or changes they would propose to this material.

Return On Investment

Most of us don’t normally consider return on investment (ROI) to be a a part of the multifamily due diligence process.  Nevertheless, we should consider it to be a part.  This is true because:

• We gain much information specifically from due diligence that directly impacts revenue and profit.
• During due diligence is the best time to measure the likelihood of success and to recalibrate our ROI expectations.  As a result, we may or may not choose certain tactics with a new investment.

These consideration can determine final capital requirements and ultimate investment goals.

2010 Due Diligence Consideration

There is a great deal of speculation regarding whether we will experience serious inflation or not.  Additionally, the consensus is that that interest rates are definitely headed upward.  Because of this, investors should make expected loan to value accounting for rising (inflation driven) expenses and potentially significant and sustained interest pressure.

The Multifamily Interest Rate Environment and Due Diligence

Given the recent debt binge by the U.S. government, investors should be on their guard regarding interest rate risk.  The effective business plan and due diligence must consider the interest rate and financing risk projects may face over the next 5 to 7 years.

This is a tough assignment as most due diligence experts do not have the financing skills to offer much in this area.  Investors will need to seek sources with strong banking and general investment research skills to offerthe support neede for this.