I often joke that ‘pro forma’ is Latin for “fiction”. This is especially true when you are analyzing the financials in an offering memorandum on a multifamily deal.
Let’s talk about how to evaluate the financials of a deal you want to buy. I will tell you how to know if the numbers presented to you are real or not and some rules you should keep in mind when analyzing the numbers.
An offering memorandum (often referred to as “OM”) is a marketing document created by a listing broker to tell buyers in a market about the asset they are representing. Note the word I just said is “marketing”. It typically contains photos, projected financials and sometimes a history of the property, to give a buyer some insight on the property’s condition and financial performance. Because it is marketing, it is meant to entice buyers into taking a closer look at the deal and possibly submit their highest offer. It is rarely based on real financials and often based on assumptions.
So you are at your desk when an email comes in from a broker. It’s a new deal in a decent part of town. The price seems to be higher than what the market is at, but the broker says the cap rate is in line with the area, implying that the valuation is correct. Then, you dive into the pro forma financials and determine their level of accuracy.
Here are 3 things to look at in a pro forma:
First, look if the numbers end in zeros. For example, if the NOI says exactly $900,000 – and the income and expense line items also end in zeros- chances are the rest of the numbers are made up. When was the last time you went out to dinner and the bill was exactly $100? The same thing goes for a multifamily property. There are many tenants, vendors, expenses and income items. I have yet to see the actual financials of a property where every single item ends in all zeros.
Second, look at the cost per door. If you are active in your market, you generally know what the average rent is for a given area or for a given class of property. If the going rate for a C-class area in Pittsburgh is $47,000 per door for the $650 rent level, I know that I should not pay $75,000 per door. It will not support my cash-on-cash targets for me or my investors. It doesn’t mean I won’t look at the deal. It just means I need to take a look at the upside to see if that asking price makes sense.
Third, look at the expense ratio. The general rule of thumb is that expenses are 50% of gross income. In general, in apartment buildings where tenants are paying for electricity and heat and the landlord pays for water and sewage, I expect expenses to hover between 53% to 59%. Anything more could mean an opportunity to get expenses under control. When you see an expense ratio sitting in somewhere around 30% to 40%, it is probably not accurate. On well-run, large complexes where the tenant is covering all their expenses you may see an expense ratio sitting somewhere in the 40% range.
Those are just a few of the things I look at when reviewing the financials in a proforma. I do look at other things, such as taxes, insurance, and utilities. When real estate is hot, cities and municipalities turn up the tax bill to capitalize on the real estate transactions. On several occasions, I found that the taxes on the proforma were not actually paid current by the owner or it was the same as it was when they purchased it a long time ago, not reflecting what it will be today. Make sure the taxes are paid current and they match up to what is in the offering memorandum. Your title company should make sure the taxes are paid before the property transfers. You want to make sure the property generates enough revenue to pay for all expenses. If they are skipping taxes, it will impact net revenue. As a side note, keep in mind that taxes will likely go up if you purchase the deal. You need to account for that in your underwriting.
As far as insurance, I have a great relationship with my broker and I typically get good rates as I am able to put the asset under my umbrella policy. I always base my underwriting analysis on the financials in the offering memorandum or given to me by the broker to decide if I want to move forward. If I don’t, I call the broker and let them know I am not interested and why. Regardless, you will want to verify the numbers and anticipate all expenses in your underwriting.
Anyway, what do you look at when you get an OM emailed to you? More importantly, how soon do you contact the brokers with questions? Let me know in the comments.