by Greg Brown, Head of Real Estate
Assumptions are a necessary evil of projecting and attempting to predict the performance of real estate investments. If anybody had the ability to predict the future, they wouldn’t be in real estate….they would BE real estate. And not reading this piece.
When evaluating an investment it is important to understand where the income/revenue comes from. Not just what is contracted for today or at the time of investment, but where it is coming from in the future. This is where things can get tricky because many leases can be for five years or longer. Again, predicting or projecting what will happen beyond five years is still more of an art than a science.
Below are assumption characteristics of which to be mindful:
- Make sure returns are not dependent on overly aggressive future assumptions.
Is the deal sponsor projecting they will be able to lease space for two times current rent when the current tenant(s) vacate? Are they projecting that the asset will be worth 50% more in three years? Remember the assumed Internal Rate of Return (IRR) is NOT the same as annual cash flow. Do not assume that if a deal is predicting a 20% IRR that you’ll be receiving annual checks for 20% of your investment.
- Understand the sources of revenue.
Most projections include revenue from two places: cash flow and proceeds from sale. If you are looking for a stable cash flow investment, make sure the investment return projections are not heavily dependent on exit proceeds.
- Understand how many different assumptions are going into the model.
Below are some assumption examples:
- Lease renewal probabilities of existing tenants: what is the likelihood a tenant will stay and at what rental rates?
- Lease-up probabilities for new developments: how long is the sponsor projecting for a deal to reach projected occupancy hurdles? And at what rental rates relative to the market?
- Exit sale assumptions/appreciation: most models project a hold period, and during this time it is likely assumed that the asset will go up in value. If the sponsor is projecting the asset to appreciate significantly over the hold period, there needs to be well-founded reasons for that projection.
Broker-dealer issued securities must be transparent regarding all of the assumptions included in a projection model. However, it is still the duty of the investor and (and the investor’s advisors) to understand the impact of the assumptions in order to identify opportunities, understand the risks, and mitigate them.