How and Why Real Estate Sponsors Try to Predict the Future

August 12, 2021
Categories: All Market Volatility

The real estate market moves in cycles. Historically, real estate cycles have lasted anywhere between seven and twenty years. There are many factors that can influence the real estate cycle, from a national recession to a real estate-specific supply and demand imbalance.

Understanding where we are in any given real estate cycle is important to those considering investing in a real estate syndication. Depending on the nature of the deal being offered, a syndication might last from between three and seven years. A value-add real estate deal, for example, might have a three- to four-year lifecycle whereas a ground-up development deal might take seven or more years for the sponsor to bring the project to fruition.

Where we are in a real estate cycle can impact the overall outcome of a real estate deal. For example, if a newly-constructed building is brought to market on the verge of a market downturn, the profitability will be much different than that same building trying to lease up or sell when the economy is strong.

Trying to predict the market's future six months' from now is no easy task, let alone three, five or seven-plus years down the road. Nobody has a crystal ball. Nevertheless, real estate sponsors must evaluate each deal based on their best assumptions about how the market will perform at property stabilization and exit. In this article, we look at how sponsors go about making those very assumptions.

The Role of Real Estate Sponsors

Real estate sponsors are charged with overseeing every aspect of a real estate syndication—from identifying prospective properties, to conducting due diligence, underwriting deals, creating a business plan for those opportunities, and more. When someone invests in a real estate syndication, they are entrusting the sponsor with their hard-earned capital, and in turn, expect the sponsor to make decisions in the best interests of their passive investors.

One of a sponsor's key responsibilities is developing a pro forma that outlines the predicted income and expenses associated with a property. Unless the sponsor is purchasing an already-stabilized property, where the income and expenses are known, this requires the sponsor to make several assumptions.

In the case of a value-add deal, for example, a sponsor has to make assumptions about how much it will cost to improve the property and in turn, what rents they can achieve thereafter. The sponsor also has to make assumptions about the rate of lease-up (often referred to as the "absorption rate") and to what degree they will have vacancies over time.

Of course, these assumptions must be grounded in both experience and market context. An experienced self-storage sponsor, for example, might know that certain size units generate more income per square foot and lease up faster than others. Therefore, the sponsor might design the renovated facility in a way that provides more of those unit types than average.

Considerations for Predicting the Future

While nobody can actually predict the future, there are many factors a sponsor can (and should) take into consideration when putting together their pro forma. These factors include:

  • Economic growth: There are both macro- and micro-level economic factors that impact how well real estate performs. For example, when the national economy is strong and unemployment rates are low, there is usually greater investor confidence that bolsters the real market as a whole.

However, micro-economic factors are usually more likely to impact a specific real estate deal. For example, the national economy might not be doing well, but a property in a specific sub-market might be thriving based on hyper-local conditions. A real estate sponsor will want to pay close attention to those hyper-local economic conditions. Who are the major employers? What type of employment diversity exists? Is the local job market expanding or contracting? What are the average wages of people employed locally? An area experiencing hyper-local economic growth is positioned to fare better amid a real estate cycle's general ebbs and flows.

  • Real estate inventory: Supply and demand has a major impact on how well an individual property performs. A sponsor will want to look at the existing supply of the product type in question. How much competition exists? What is the quality of the existing competition? What are the rents and vacancy rates of these competing properties? Have similar projects been permitted and if so, what is their construction and delivery timeline? All of this influences the assumptions a sponsor will make when creating their pro forma.

  • Capital markets: Most real estate sponsors finance their deals with some combination of debt and equity. The cost of debt can vary depending on where we are in a real estate cycle. Twenty years ago, it was not uncommon for lenders to charge 12- to 18% interest on their commercial real estate loans. Today, interest rates are closer to the 4- to 7% range, which makes the total cost of debt more affordable. In addition to the cost of debt, the availability of debt also matters. In a strong economy, capital might be readily available and at record-low prices. During a market contraction, as we recently saw during the depths of the COVID crisis, capital markets become constrained. It becomes harder to access capital which can in turn, drive costs up. A sponsor crafting their pro forma today might be making assumptions based on the availability and cost of capital today, but the capital markets may look might different five or seven years down the road. A deal that may have been easy to refinance under existing market conditions may be more difficult or costly to refinance in the future, which may impact the total profitability of a deal.

These factors all inform the sponsor's assumed exit cap rate. Of course, it is impossible to predict where market demand will be for a particular asset five to seven years down the road. However, a keen understanding of the region's economic growth trajectory, existing and planned competition, and the general direction of capital markets should all factor into a sponsor's projected exit cap rate.

Related Link: The Worst Deal Reliant Has Ever Done

Predicting the Future: Public vs. Private Entities

Those who invest in stocks, bonds and other traditional equities have likely been told that "past performance is no guarantee of future success". When you invest in publicly-traded equities, you can look back on historical performance but most do so with the understanding that the returns those equities generate on a go-forward basis can be drastically different.

The same is true in real estate - though real estate sponsors are often held to a different standard. Those who invest in real estate syndications usually want some guarantee that they will earn a certain return on their capital. As noted above, there are many factors that can influence how well a deal performs.

Given this pressure to "guarantee" returns, many sponsors will make very conservative projections about a deal's future profitability. After all, it is better to under-promise and over-deliver than vice versa. However, when a sponsor then delivers several projects that beat expectations, the new expectation becomes that a sponsor will then generate the same level of returns on their future deals - something a sponsor cannot always guarantee. It's a difficult catch-22, but one that real estate sponsors must address.

Modeling Future Results Absent Perfect Information

There are many ways for real estate sponsors to navigate this desire to predict the future. Most will develop highly sophisticated, in-house models that assign values to several income, cost and vacancy factors. Numbers can be tweaked, turned up or down, based on certain market assumptions. Again, these assumptions are grounded in experience, historic and current market conditions, and robust analysis by many individuals.

Real estate sponsors will generally create some range of best, worst and most-likely outcomes. Conservative investors will want to be sure that the worst-case scenario provides an outcome (i.e., returns) that they are still comfortable with, of course with the hope that the sponsor will beat that worst-case scenario.

Experienced sponsors will likely have made conservative assumptions. For example, they may assume a higher-than-average vacancy rate or may include a larger than average contingency budget in case of construction cost overruns. This conservative approach increases the likelihood that a sponsor will not only meet, but exceed investors' expectations.

Lastly, as noted above, one of the key determinants of a deal's overall profitability has to do with the sponsor's projected cap rate. In fact, some would argue that the exit cap rate is ultimately the most important assumption in a sponsor's financial model. Projecting the exit cap rate, especially five or seven years into the future, is far from science. There are many factors that can influence the exit cap rate, especially that far out. A prudent sponsor will generally assume 5-10 basis points in cap rate expansion for each year of the hold period, which provides sufficient padding in the event of a market correction or worse, a downturn that has a negative impact on real estate values.r's projected cap rate. In fact, some would argue that the exit cap rate is ultimately the most important assumption in a sponsor's financial model. Projecting the exit cap rate, especially five or seven years into the future, is far from science. There are many factors that can influence the exit cap rate, especially that far out. A prudent sponsor will generally assume 5-10 basis points in cap rate expansion for each year of the hold period, which provides sufficient padding in the event of a market correction or worse, a downturn that has a negative impact on real estate values.

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Conclusion

Just as it would be unfair to ask a doctor to predict how long an individual might live, it is somewhat unfair to ask a real estate sponsor where the market will be five, ten or even twenty years from now. There are many factors that can influence the profitability of a syndication, some of which are out of the sponsor's control altogether. That said, while a sponsor cannot predict nor control the future, they can make conservative assumptions and take steps to mitigate the risk of a market downturn.

When evaluating syndication, be sure to ask the sponsor about the assumptions they have made. Understand how they have come to conclusions about certain numbers, and what strategies they might use in the event market conditions change.

Then, putting deal specifics aside, look at the sponsor's track record. Who is on their team? What sort of experience do they have? It is important that a sponsor have experience with the product type in question, and moreover, should have a track record of executing the business plan they anticipate using with the deal currently being offered. Look at how these other deals have performed. Have they been able to meet (or better yet, exceed) investment expectations? Has the sponsor been able to weather multiple real estate cycles, including economic downturns? If so, how?

Remember: when investing in a real estate syndication, the team behind the deal will usually have more influence on overall returns than the actual deal specifics. Absent perfect information about future market conditions, the sponsor's track record is usually one of the best indicators of future results. Investors want to be sure they trust and have confidence in those who are executing the business plan on their behalf.

Of course, it is important to understand that just as a stock's past performance does not guarantee future success, neither does a sponsor's past performance. A sponsor is equally motivated to generate results, but until they have a crystal ball, their predictions about a deal's profitability will always be slightly imperfect.

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