Unwrapping Assumptions in Real Estate Analysis

By Adam Gower Ph.D.

Unwrapping-LI

The Promise of High Returns

 

It is easy for investors to be seduced by the promise of high returns on a real estate deal and while there is nothing wrong, of course, with wanting a high return it’s important for investors to understand what assumptions underpin a sponsors’ projections.

Credible, professional sponsors with an eye to the future and establishing long term relationships with investors will want to manage expectations by under promising and over delivering.

However, competition for investment dollars on the kinds of open platforms that crowdfunding websites offer can lead to a temptation to tweak assumptions so that projected returns compare favorably to competitor projects.

This can lead to projections inflation where the sponsor with the highest projected returns wins the race for investor dollars.

The challenge for investors is in making the distinction between a sponsor who is aggressive with the numbers and one who is conservative because, let’s face it, generally all sponsors will tell you they are looking at the numbers conservatively.

Drilling down on the assumptions the sponsor uses will help investors resolve this quandary.

3 Core Metrics for Evaluating a Project

 

There are many assumptions built into projections, but the three most commonly used metrics upon which assumptions have the greatest influence are the internal rate of return (IRR), cash on cash, and equity multiple.

The IRR takes into consideration the time value of money to generate a return.

It is generated by looking at cash flow distributions from operations added to net proceeds from an exit and compounds that to generate a return over time.

A technical definition is the rate of return when the net present value of the original investment is discounted over time to equal to zero.

Cash on cash is much easier to calculate and understand because it's simply the after-debt service distribution from operations divided by the original equity investment.

Some people think of it as a dividend yield.

And equity multiple is the sum of all distributions including exit proceeds plus return of original investment, divided by the original investment.

All three of these key metrics are based on how much cash flow a building is expected to generate, with a set of assumptions that lead to the calculations resulting in returns projections.

However, by playing with the assumptions it is possible to dramatically alter the returns that investors are being shown.

FREE Real estate syndication education and insight newsletter. Subscribe now.

Unwrapping the Assumptions

 

When looking at a new offering, a good place to start is to turn to the financial summary and look at the pro forma (projected) cash flow – the net operating income (NOI) – because this drives everything.

There's no standardization for how these are laid out but there are always going to be financial projections in the documents somewhere and once inside them, a key assumption to look at closely are the cap rates being used.

The cap rate is calculated by dividing the net operating income by the property’s purchase price or total cost to purchase and develop.

It's similar to the cash on cash return but differs in that it is calculated solely on non-levered numbers.

There are two key cap rates to pay attention to; the cap rate the market is bearing today for the kind of asset being acquired, and the cap rate the sponsor is assuming the market will bear when they sell.

If you believe that interest rates are going up in the future, then you should expect cap rate assumptions will also go up.

While they are not perfectly correlated, a (truly) conservative sponsor will assume a higher exit cap rate than going-in cap rate or at most aggressive, the same.

Stress Testing Assumptions

 

This doesn’t mean that in some cases sponsors get great deals on real estate where they can buy properties that are high cap rates and then sell them for lower cap rate.

But if a sponsor is buying a property at a 7% cap rate and then assuming it's going to sell in a few years at a 5% cap, that kind of assumption dramatically impacts return projections and warrants deeper analysis.

On the other hand, a sponsor who projects out several years and assumes that each year cap rates are going to go up, with the underlying implication that pricing is going to be going down, and whose projected returns are still compelling, that sponsor could be using (truly) conservative assumptions.

Similarly, on rare occasions sponsors may use declining rent assumptions during periods where they are predicting a recession during the hold period for a project.

Whether they are right or wrong, that they are willing to incorporate declining revenue projections in their assumptions is cause for optimism that they are resisting the temptation to inflate numbers solely to make them look good for investors.

Another important variable that can dramatically impact projected returns is the amount of time a sponsor uses for their deal life cycle.

For example, a 16% IRR might result from assuming a 6.5% exit cap rate versus showing a 25% IRR by assuming a 6% cap rate.

Similarly, allocating for a four-year exit will show significantly higher IRR returns than by allocating for a five-year exit.

 

***

 

Sponsors exercising best practices will stress test their own assumptions and share the results with investors.

Look for matrixes that compare a range of cap rates and a range of deal life cycles and ask the sponsor what they believe to be the best, worst, and most likely scenarios.

If these are consistent with your own view of how a transaction is likely to play out this could be cause for optimism that you are on the same page as the sponsor and that the proposed project is one worthy of further examination.

POSTED BY

UCL In Background

ADAM GOWER PH.D.

Adam Gower is a 30+ year veteran real estate investment and finance professional.  He expands investor networks for real estate developers by implementing best-of-class digital marketing programs.

Dr. Gower has written several books, the latest, Leaders of the Crowd, chronicles the legislative origins of crowdfunding and how real estate came to dominate the industry.

His podcast series, The Real Estate Crowdfunding Show, Syndication in the Digital Age, provides best practice guidance for real estate sponsors looking to raise capital for their projects online.

Copyright 2018 - ADAM GOWER PH.D. - All Rights Reserved

Website Disclaimer:  All Content contained on this website is intended for informational purposes only and does not purport to be complete or accurate. No recommendations are made or intended to be made regarding investment in real estate of any kind. For further information on any investment opportunity contained in any content of this website, you should visit the respective crowdfunding portal or site where such investment opportunity is published. None of the content presented on this website has been prepared with any reference to any particular user’s investment requirements or financial situation, and you are encouraged to consult with professional tax, legal and financial advisors before making any investment decisions or including the decision to invest at all. GowerCrowd makes no representations or warranties as to the accuracy of any information and accepts no liability or fiduciary responsibility whatsoever. Offers to sell, or the solicitations of offers to buy, any security can only be made through official offering documents through registered portals outside of this website. Investors should conduct their own due diligence, not rely on the financial assumptions or estimates displayed on this website, and are encouraged to consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks associated with any investment opportunity. Neither Adam Gower nor GowerCrowd or any related entities are a registered broker-dealer, funding portal, or investment advisor and does not conduct any activity that would require any registration as such.