FREE TRAINING
What is Real Estate Crowdfunding?
Learn how to build wealth and earn passive income in real estate while someone else does all the work.
Unwrapping Assumptions in Real Estate Analysis
By Adam Gower Ph.D.
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.
Get access to our FREE weekly newsletter exclusively covering the latest updates from the real estate crowdfunding world
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 IRRÂ 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.
Newbie
If you want to build your wealth and earn passive income from real estate investing and are looking at deals on marketplace platforms or through developers online, then I recommend you start by the 8 Key Financial terms so you can understand every deal you look at.
The 8 Financial Keys are not only a great way to get started, they are also essential to understanding how you’ll make money in any real estate deal.
You’ll learn the most important financial concepts you need to know in real estate investing that apply to every type of real estate no matter the asset class (office, industrial, residential, hospitality, retail).
Intermediate Investor
If you’ve got some online real estate investments under your belt already and are beginning to receive passive income checks each month, or have been paid off with profit – or (hopefully not) are finding that some deals are not quite panning out the way you expected, then check out this page for a wealth of free resources.
Here I cover everything from beginner all the way to very advanced real estate concepts.
You’ll find podcasts with developers, researchers, professors and other industry experts, detailed articles, and lots of videos, both short and long that are all easily searchable and totally free.
Advanced Investors
I am not shy about being straightforward about real estate investing; it is exciting, lucrative, and can help you build wealth and income as part of your investment portfolio, but it is not without its risks.
As an advanced investor you know this already, so I’ve put together a webinar for you that guides you through one of the most important components of real estate investing: Real Estate Contracts – reading between the lines.
This is advanced learning and based off conversations I had with three of the top real estate attorneys in the country, combined with my own personal experience. Access it here; it could be the most important webcast you watch all year.
