Recently, I was conducting the last class in my course on real estate investment analysis that I teach in Columbia’s MSRED program. I had assigned my 55 students a series of case studies (much like those in my book, Mastering Real Estate Investment) and told them to build financial pro forms and discuss the reasoning behind their analyses. After reading and commenting on all those analyses, I felt there was one overarching theme on which I wanted to focus my final remarks to the troops: The theme was “clarity.”
Trying to reduce a course to a single word might seem unrealistic (because it is), but I really had more than one angle on the notion of clarity in mind. Even combined, those notions would not replace the real content of a course in investment analysis, but they might express some essential principles that are sine qua non — “without which, nothing” — for investors.
Be Clear About Your Objectives
Before you fire up your spreadsheet program or sharpen your pencil, you need to be very clear about your objective (or objectives) in analyzing the property. For example:
- Are you a potential buyer, trying to establish a reasonable offer on a particular property?
- Are you seller or broker trying to justify your asking price?
- Are you a buyer or broker, trying to demonstrate to a seller that his or her price and terms would not be acceptable to a reasonable and prudent investor?
- Are you seeking financing, or refinancing and need to demonstrate to a lender that this loan will meet their underwriting expectations?
- Are you assembling a partnership and trying to show potential equity investors that this deal will make economic sense to them?
You are not trying to create alternate realities, but you might be harboring more than one objective in a given situation. For example, for your private use you might want to look at a range of possible offers by creating best-case, worst-case and in-between scenarios; but in making a presentation to the seller, you would surely not begin by volunteering what you believe to be the highest price at which the investment might have a chance of success.
In making a presentation to a lender, your focus must be to ensure that your presentation includes items like debt coverage ratio, allowance for possible vacancy, and projected cash flows — items that will have an immediate impact on an underwriting decision. For equity partners, you want to be sure that you can demonstrate not only that the property itself makes sense, but that the particular investor, considering allocations and preferred return, can expect an acceptable rate of return on cash invested.
You are typically trying either to make a personal decision about a property or to “sell” your point of view to a third party. Being clear in your own mind about the purpose of your pro forma allows you to focus on how you analyze the property and what information is of greatest importance to your intended audience.
Be Clear About Your Use of Terminology
Real estate, like most businesses and professions, has its own language – terms that carry very specific meaning. The misuse of real estate investment terminology can have several possible consequences, all of them bad.
- You can substantially skew the results of an analysis by not being clear in your understanding of important terms. Some of the more egregious examples I have seen include:
- Not understanding the real-estate-specific definitions of terms like “operating expense” and “Net Operating Income.” I have often seen investors try to include mortgage payments, capital improvements, or reserves for replacement as operating expenses. This mistake can drastically affect your estimate of a property’s worth.
- Not understanding an important term like “capitalization rate.” I have seen investors try to estimate value by applying a cap rate to the property’s cash flow instead of its Net Operating Income. Big mistake.
- You can bring a dialog or negotiation to a grinding halt by being unclear and offhand in your use of what should be unambiguous terms. Yes, “price” is a legitimate English word. But if you use it as part of an analysis or presentation, you will leave your reader stumped. Do you mean the seller’s asking price, the buyer’s offered price, the actual closed selling price? You can tell me that a building has 20,000 square feet, but do you mean usable square feet or rentable square feet? It makes a difference.
- You can establish your identity as a rank amateur. Nothing will earn you a sandwich board with the word “newbie” on it quicker than misusing terms or lapsing into incomprehensibly vague language. Credibility matters — just ask your lender or your equity partners. Be clear. Be precise.
Be Clear When You Build Your Pro Forma or Presentation
If you insist on being a do-it-yourselfer, and you plan to give your pro forma or presentation to a third party, keep in mind that nothing will unsell your argument faster than a jumbled pile of numbers. Your information should flow and be segmented in a logical order (e.g., don’t show someone the income after the expenses, or the debt service after the cash flows). The reader should be able to apprehend the key metrics with a quick scan of the page, then go back and fill in the details. If your report turns into a scavenger hunt for vital information, then you will fail to deliver your message. No loan, no partner, no deal.
Your success as a real estate investor requires serious number crunching, but it doesn’t stop there. You must be able to convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience. Clarity is what you need.
Get some clarity, as well as accurate calculations and industry-standard reports. Use RealData’s Real Estate Investment Analysis, a market leader for almost 30 years, to run your numbers and create your presentations.