Passive investors should never view a pro forma as a predicable outcome.
“The purpose of margin of safety is to render the forecast unnecessary.” -Benjamin Graham.
A pro forma is a forecast. An educated guess. A target. A crystal ball. A plan. But not all forecasts go according to plan.
I’ve still yet to see one deal I’ve been involved in, actively or passively, hit the forecast. It’s either fallen short, or exceeded it.
That’s why “margin of safety,” as Graham referred to it, i.e. room for error, is so important.
Without it, as we’ve seen with many sponsors this year, aggressive projections can lead to missed pro forma, paused distributions, capital calls, or foreclosure. Deals purchased at a high valuation based on overly optimistic forecasts can result in poor outcomes for investors if even a single variable falls short of expectations.
The trouble starts when investors start to ignore these truths and throw caution to the wind.
I expect projections to be missed. But I also expect that when they do miss, the outcome will not be a wipe out, maybe just a disappointment for the effort involved in allocating to the investment. A single instead of an extra base hit. I always try to protect the downside, plan for the worst and hope for the best. But hope is not an investment strategy.
The truth is, we don’t know what the future holds. Nobody does. So if you are going to invest passively, above all else you have to trust the sponsor and their experience in the market. Trust develops over time. In order to give them the opportunity to earn that trust, i.e. make your first investment with them, you must have a baseline understanding of the asset class and market in question. Otherwise, you are setting yourself up for disappointment, misalignment, or worse. Trust, but verify.
IRR Manipulation
To illustrate how a pro forma can be tweaked to sell the narrative of the storyteller, let’s consider how easily IRR (internal rate-of-return) can be manipulated.
Example Assumptions:
- LTV: 75%
- Annual Rent Growth: 3%
- Hold Time: 5 years
- Exit Cap Rate: 6%
- IRR = 14.4%
Below are changes to each one of those 4 inputs, respectively, while leaving each of the other 3 inputs unchanged, and how that one input changes pro forma IRR:
- LTV: increase from 75% to 80% and the IRR = 15.9%
- Annual Rent Growth: increase from 3% to 4% and the IRR = 16.4%
- Hold Time: decrease from 5 years to 3 years and the IRR = 17.0%
- Exit Cap Rate: decrease from 6% to 5.5% and the IRR = 16.9%
Change all 4 inputs to the more aggressive assumptions and the IRR = 23.9%
Subtle changes to inputs can mean drastic changes to outputs. Many sponsors are motivated to transact, as capital events trigger windfall GP compensation in the form of acquisition fees and waterfall hurdles. By “stretching” the pro forma, they can pay more to be “awarded” to the deal by a broker/seller, while additionally attracting equity/capital to close the deal.
Exit Cap Rates: The Easiest Lever to Pull
The easiest lever for a sponsor to pull to achieve a better spreadsheet outcome? The exit cap rate assumption. A cap rate is essentially a measure of market sentiment – what an investor is willing to pay for a growing income stream. Net Operating Income, divided by the cap rate, gives you an estimate of what a property is worth. Due to cap rates and property values being inversely related, if you reduce the denominator of the equation, the sponsor’s exit (sale) value goes up. And if they sell it for more, they can show more attractive potential returns to prospective passive investors. Charlie Munger stated, “show me the incentive and I’ll show you the outcome.” In this context, the incentive is to attract capital for a deal. The outcome is that everything must be executed perfectly, with a macroeconomic environment providing tailwinds, for passive investors to hit projections.
Ask for the Underwriting
I always ask for the underwriting file of every deal I’m evaluating. It will not typically be provided by sponsors, unless you ask. Sometimes, you will be told “no,” or “my model is proprietary.” Don’t accept this as anything but a red flag. Any sponsor who is unwilling to share their underwriting with you, but is asking you for $25,000, $50,000, $100,000 or more of your capital investment, shouldn’t get a nickel. The underwriting file can give you key insights into the assumptions made, the level of financial sophistication in the sponsors evaluation process, and ideally, allow you to see sensitivity analysis surrounding key assumptions. This is critical to evaluating a range of outcomes.
Getting the underwriting also allows you to subjectively determine whether the sponsor’s risk tolerance aligns with yours. Perhaps the more aggressive assumptions aren’t necessarily wrong. As I mentioned, we don’t know what the future holds, so the example projections may very well come to fruition. However, if you feel that the projections are more aggressive than you are comfortable with, perhaps your risk tolerance and the sponsor’s are not aligned. Perhaps you need a higher “margin of safety” to feel comfortable with the investment.
Conclusion
Passively investing in real estate is a great tool to diversify away from traditional investments and reduce portfolio volatility. It also offers a way to access the key benefits of real estate ownership without the hassle of late night calls, tenants and toilets! But don’t let the word “passive” fool you. There is work to do on the front end of any investment, in identifying the sponsor and validating the assumptions of the deal you are looking at. Understanding how a spreadsheet can be manipulated to speak the narrative of the storyteller will enable you to make smarter, more informed, investment decisions.
About Paul Shannon
Paul has acquired over 200 residential units, by “recycling equity” and/or joint venturing. He has experience in underwriting, acquisitions, raising capital, property management, project management, and is a licensed Realtor.
Paul is also a limited partner, investing in over 40+ deals as a passive investor – Multifamily, industrial, sale leasebacks, preferred equity, 1st and 2nd position notes, ATMs, mixed-use development and private equity.
These experiences have led to the formation of InvestWise Collective, a customizable fund aimed at helping investors diversify out of traditional markets into passive real estate opportunities.