The Skinny:
Having a mindset around redundancies and incorporating them into your valuation process is the best way to eliminate major mistakes from investment decisions.
What Are Redundancies?
In the traditional sense, which I typically associate with engineering and quality control, redundancy is the incorporation of components that are not required but are included anyways to ensure the reliable execution of a task. If the “first line” component fails, there is another that is there to fill in and take it to the finish line. It could be something simple like a backup battery in a power strip (which many of us have at our desks) or a multi-layered steering system to ensure a commercial airliner can always land.
Redundancy in the context of real estate underwriting (and calculations in general) means approaching a problem from more than one direction to check that a result makes sense. If you use 2-3 distinct methods and they are not in the same ballpark, something is probably wrong.
This might sound like a no-brainer, but after 10+ years in the business, I am still surprised to see how many newbies and veterans alike do not take an interest in double-checking. A healthy dose of skepticism of face value results is a must in my opinion.
The Importance of Redundancy in Underwriting:
When I was working in the institutional real estate world, a co-worker told me about the person I replaced. This individual (Associate level) was fired for so egregiously mis-underwriting a large property that the company massively overpaid for it and ended up selling at a loss a short time later. It turns out that while the Investment Memo and model input showed a 3% rent growth for 7 years, it was hardcoded to be 5%. That effectively caused an overvaluation (all-else equal) of about 15%.
I could not believe there were no controls in place to prevent this from happening. I personally felt the firing was unjustified because large deals should not weigh solely on a junior level employees’ numbers. Models are “incorrectly specified” all the time. Garbage in, garbage out is a notorious shortfall in the finance world.
That being said, this would not have happened if some basic redundancies were included in the underwriting process.
Redundancy #1 – BOE Valuation:
This is the first and most important checkpoint for underwriting that took me way too long to fully appreciate. Before you break out any fancy model, you must first run the numbers in a very simple way. After you distill the rent roll and T12, you will make some pro forma assumptions (based on your research or direct experience in the market) to arrive at a stabilized NOI and a “finished” market value. Then you subtract your costs and profit margin to arrive at today’s valuation. You can refresh on how to do that in this article.
This value is your baseline, no heavy calculations necessary. No rent growth forecasts, debt assumptions, or other inherent guesswork. Just the finished value today less your costs and profit margin. You could literally do this on an envelope if you wanted to. Any subsequent calculations should be made with reference to this starting point.
Redundancy #2 – Main Model:
Everyone should have their own underwriting model that they built from scratch themselves. It should be checked, re-checked, and upgraded at least once a year. Building your own model is important because it forces you to know what every cell does and how everything works. Adopting someone else’s model leaves you susceptible to not understanding everything properly and you might also adopt their mistakes. Always build your own.
Drop in the same set of operating assumptions that you used in your BOE Valuation and populate the non-BOE assumptions such as rent growth, debt, and exit cap. Review each input and ensure you have a very firm reasoning behind each of them. Always assume you will be grilled on them by someone.
Where does your main model valuation shake out based on your desired IRR? How does it compare to your BOE Valuation? If the two values are worlds apart, why could that be? It does not necessarily mean something is wrong. For example, if you are confident that there will be outsized rent growth and cap rate compression on the exit, then your main model valuation should be higher than your BOE, which does not factor in such things.
However, if there are no special assumptions that could cause a divergence, then differing values (say by more than 5%) is probably a cause for concern. Follow the money in the model and see if anything looks off. Sometimes it is simple as forgetting to remove a source of income from a prior deal that is not relevant in this one.
Redundancy #3 – Checking Model:
This redundancy is for when the deal really picks up and you are going to make a bid. Your BOE and main model valuations are within a reasonable range of one another, but you just want to make doubly sure that everything is copacetic.
This is where the “checking model” comes in. A checking model is an underwriting model (or several) that was built by some other talented person in the field. Perhaps it was a free download from a reputable website, or a trusted friend at another shop sent you theirs. The key is that it must be (i) something you had no part in making (ii) vetted so that you know it does not have major mistakes.
You will take this model and re-input the same assumptions as your main model and gauge the results. How do the year-by-year cash flows look when stacked up side by side? What do the exit values look like?
Real estate is not rocket science and most underwriting models should put you in the same place. Once again, if there is a divergence in values, there must be an explainable reason for it. Follow the money month-by-month, and determine why there are differences. Perhaps you might find that you were too aggressive or conservative in your own approach.
If you are diligent, the checking model will be right in line with your own main model, but it is always good to have this layer in your process because it will not take up much time and it will give you a lot of confidence that your numbers are solid.
Redundancy #4 – Peer Review:
The purpose of the peer review is two-fold, to verify inputs and to check the outputs. As primarily an acquisitions guy, I always like to enlist one of the asset managers to check both of these. They are especially helpful with inputs because they work with live operating data on a regular basis. They are very likely to call out optimistic assumptions or overly conservative ones.
As for the output, I recommend they “lock themselves in a room” for an hour or so and just run through the model to check for mistakes. A fresh set of eyes is valuable regardless, but the AM teams are usually detail oriented and well-versed in following the money.
I also prefer Asset Managers with this task because they have a vested interest in making sure the numbers are solid. If they do not check the work of the underwriting model and the acquisitions team puts a ton of impossible goals in there, the Asset Managers are the ones who have to deal with it when the budgets inevitably miss. It is miserable to get blamed on assumptions you had no control over, so you want to avoid this.
If the AM team signs off on your numbers, you know you are in great shape.
Summary:
Implement systems to check your underwriting with simple math, multiple valuation methods, and peer review. This will give you confidence that your numbers are sound. Utilize this mindset across anything important that you work on in life.
