In previous articles, we’ve discussed the pivotal role real estate sponsors play in the success of an investment project. This week, we take a closer look at how sponsors evaluate real estate deals in order to give you a better understanding of what to look for when presented with an opportunity. 

Because there’s a lot of information to unpack here, we’ve split this article up into two parts. The first part will cover the tools sponsors use, the assumptions they make, and how they deal with risk. In part two, we’ll explore how lenders evaluate risk and the metrics to focus on when presented with a deal. Let’s get started. 

 

The Base Financial Model

 

Real estate investment and asset management companies have a lot more resources than the sole investor. Acquisitions teams are responsible for evaluating multiple commercial properties across many markets to determine where the best opportunities lie.

As head of acquisition at MG Properties Group since 2010, Paul Kaseburg has been involved with the purchase of over 12,000 units totaling $1.7 billion in total consideration. Whenever a deal is brought to the table, the analysis starts with the base financial model.

The purpose of this model is twofold Kaseburg says. “One reason is to determine an appropriate price and make decisions regarding the assumptions that are going into it. The second is for the sponsor to have a marketing piece to tell investors about the returns that are possible from the deal— there’s a marketing aspect to it, and then there’s an evaluation aspect to it,” he explains.

While some companies use ARGUS Enterprise to create their models, the acquisition team at MG uses a multi-tab Excel spreadsheet to put the numbers together. “What really matters is the math and how the numbers are manipulated,” Kaseburg says. This manipulation involves making key assumptions to arrive at the final outputs.

 

How do Sponsors Make Assumptions?

 

Sponsors rely on their experience to make assumptions like rent growth and operating costs. Kaseburg says those are mostly made from their portfolio properties. “We can pull up a couple of different comps and just look at comparisons for all sorts of costs—what are we spending for on other properties in the neighborhood—to build up the numbers from the ground up.”

This is why choosing a sponsor is a crucial first step. The returns promised in their marketing material is based on their acquisitions teams making assumptions on such things as payroll cost, alternative income, marketing costs, and other operating costs.

Kaseburg says some sponsors can be aggressive with their assumptions, and the complexity of the models makes it difficult for the average person to tell the difference. It’s going to be nearly impossible to evaluate the financial model they create,” he cautions. “That’s why it’s more important to pick a sponsor you can trust, and from there look at the deals themselves.”

 

The Most Important Assumptions to Consider

 

Any small change to a base financial model can have significant impacts on the outcome. And because these models are complicated and hard to evaluate yourself, Kaseburg highlights two very important assumptions to take note of: rent growth and exit cap.

“Your rent growth really is going to define how much revenue you have over time, and if you’re looking at a long-term hold, this rate will make a big difference in valuation and return,” Kaseburg says. Exit cap is based on your rent growth so let’s focus on this number for now.

The rent growth is a dynamic forecast that depends on drivers such as job growth, migration, household formation, elevated home prices, and lifestyle preferences. And yet, it is standard practice in the industry to use a rate that stays within 2.5% and 4% — regardless of the area.

Kaseburg admits that in reality, rent growth does not fall within these boundaries. “At one point a couple years ago, I was just curious about this, and so I had about 30 years of data, and I looked at these different sub-markets, and the proportion of time that a five-year rent growth on average fell between 2.5 and 4% was only 15%.”

“The reality is that rent growth is much more volatile than many of us like to admit, and we systematically kind of underestimate that volatility, and that’s probably your most important assumption going into a model,” Kaseburg adds. With this in mind, how should investors approach evaluating a sponsor’s deal? What should they get from these models?

 

The Real Value of the Model is to Evaluate Your Risk

 

Most investors focus on the internal rate of return (IRR). But Kaseburg says this is the wrong approach. “The value of these complicated financial models is not the IRR that you’re getting out of it because whatever you forecast will be wrong for one reason or another, the real value that we place on modeling is understanding your risks,” he says.

If something doesn’t go as planned, what does that mean to the deal? What’s my upside? What’s my downside?

Kaseburg tells investors to evaluate the risk-adjusted side of risk-adjusted return and to focus on factors that could deviate the investment from the baseline pro forma returns that you see in the marketing materials. And there is one group that cares the most about the risk in a deal — the lenders.

“One of the best ways to evaluate risk is to use the metrics that lenders use because lenders tend to be very risk-focused,” Kaseburg says. “They’re not participating in the upside, they just want to get their money back and a coupon on it so if a lender flags something as scary, then the equity investor should be really scared about it.”

A key metric Kaseburg suggests all investors look at is loan-to-value. “Loan-to-value is really simple. It’s just the loan amount divided by the property value,” he says. “In reality, the number is more complicated. It could change over time as in the case of a loan that takes down draws over time.”

Same goes for the property value. “Is that your purchase price? Is that your purchase price plus the capital that you’re investing in the deal? Does it include all of the fees that are going into that transaction? Is it the value of the property once you do all of the work?” Kaseburg asks. And so loan-to-value starts off simple enough but can lead a savvy investor down a path to discover much more about the deal at hand.

 

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Real estate evaluation can seem complicated when looking at it as a whole. With Kaseburg’s suggestions, investors can start to break up the analysis and focus on the parts that are most important. Those parts include understanding the assumptions made by sponsors and considering scenarios when those assumptions might be wrong.

With practice, this can become second nature. But regardless of how well you get at evaluating a sponsor’s deal, the best advice we can give is to partner with a sponsor with the right experience and reputation to steer you in the right direction. In part two of this series, we take a closer look at the loan-to-value and other metrics lenders use to evaluate risk.

*If you like this post, be sure to enroll in our free six week course on the fundamentals of commercial real estate investing — Enroll Now.*

 

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Tyler Stewart is VP of Investor Relations at RealCrowd. All opinions expressed by Tyler and interviewees are solely their own opinions and do not reflect the opinion of RealCrowd. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.