Unmasking Return Inflation Tactics in Real Estate Deal Modeling
While most sponsors operate with integrity, it’s crucial for investors to understand how some might manipulate financial models to make returns appear more attractive. In this post, we’ll explore common tactics used to inflate projected returns.
1. Optimistic Revenue Projections
The Tactic:
Sponsors might overestimate rents, rent growth or occupancy rates.
How to Spot It:
- Always review historical performance
- Review market data (Cap10 ensures you have access to market data)
- Review growth rates. A long term average over 3% or rent growth that exceeds expense growth is worth a deeper review.
Impact on Metrics:
- Inflates IRR and Cash-on-Cash returns
2. Underestimating Expenses
The Tactic:
Sponsors might utilize aggressive operating expense assumptions.
How to Spot It:
- Compare expense ratios to industry standards for the property type
- Proforma expenses that do not align with historical expenses should come with an explanation from the sponsor to support the assumption.
- Look for suspiciously low allocations for maintenance or capital expenditures. To maintain value, the property must be properly maintained.
Impact on Metrics:
- Boosts projected Net Operating Income (NOI), inflating all return metrics
- Can lead to unexpected and immediate cash flow issues
3. Aggressive Exit Assumptions
The Tactic:
Sponsors might use optimistic cap rates for the exit valuation or assume unrealistic property appreciation.
How to Spot It:
- How does the exit cap rate compare to the acquisition cap rate? Traditionally there should be a spread of 50-100 basis points between the exit and acquisition cap rates. If not, it is worth deeper review.
- Per pound value. Is the acquisition and exit value per unit (or per square foot) supported by sale comps?
- How does the purchase price compare to replacement cost of similar properties.
Impact on Metrics:
- Significantly inflates IRR and unlevered ROI due to its sensitivity to the exit value.
- Does not affect early-year Cash-on-Cash
4. Mid-Investment Refinance Assumption
The Tactic:
A refinance in the middle of an investment hold that returns equity might greatly enhance the projected IRR on an investment opportunity.
How to Spot It:
- Review the debt schedule and the flow of investment cash flow looking for large lump sums in the middle of the hold period.
- Examine if refinancing assumptions are realistic.
- It likely makes sense to understand what returns would be without the refinance assumption.
Impact on Metrics:
Material impact on IRR and unlevered ROI.
May inflate the cash-on-cash assumption because of the return of capital during the term of the investment (many sponsor take steps to adjust cash-on-cash in this scenario).
5. Manipulating Hold Periods
The Tactic:
Sponsors might assume a shorter hold period that maximizes projected returns, even if it’s not realistic to exit in that time horizon.
How to Spot It:
- Question whether the proposed business plan aligns with the modeled hold period.
- Consider how returns might be impacted by a longer hold.
Impact on Metrics:
- Can significantly affect IRR, which is sensitive to investment duration
- Won’t impact Cash on Cash Return
How to Protect Yourself as an Investor
- Do not be overly reliant on the sponsors modeling: Institutional investors will always build their own models to review opportunities. At a minimum, a sponsor should provide you with an excel model that you can manipulate as you review to perform your own assesstment of a deal.
- Perform Sensitivity Analyses: Test how returns change under different scenarios for key variables like rent growth, expenses, and exit cap rates. This is easier when you have an excel model from the sponsor. I would never invest in a deal if the sponsor refused to provide me with a copy of their model.
- Focus on Multiple Metrics: Don’t fixate on a single return metric. Use IRR, Cash-on-Cash, Unlevered ROI, and others in combination to assess a deal.
- Demand Transparency: Ask sponsors to justify their assumptions and provide market data to support their projections.
- Compare to Market Benchmarks: Use industry databases and your own experience to benchmark key assumptions against market norms.
- Consider Downside Scenarios: Always ask, “What could go wrong?” and ensure the deal has sufficient cushion to withstand setbacks.
- Understand that a return is not a single number: What do I mean by this? I evaluate deals to a range of outcomes and like to assess where the risks are. At the end of the day, I like to do my best to assess whether the deal has a better chance to beat the projections or fall short and what the scale of the miss might be.
Conclusion
While these tactics can make a deal look more attractive on paper, they often lead to disappointed investors and damaged reputations in the long run. As an investor, your best defense is a combination of skepticism, due diligence, and a solid understanding of both the metrics and the underlying real estate fundamentals.
Remember, a truly good deal should stand up to scrutiny. If a sponsor is confident in their project, they should be open to questions and willing to provide detailed, realistic projections. By understanding these common inflation tactics and how they impact different metrics, you’ll be better equipped to separate the truly promising opportunities from those that are too good to be true.
In real estate investment, as in many areas of finance, the old adage holds true: if it looks too good to be true, it probably is. Stay vigilant, do your homework, and don’t be afraid to walk away from a deal if the numbers don’t add up.
