How to Identify Conservative vs. Aggressive Financial Projections
Latest from SMK – Analyzing the financial projections or pro-forma of a real estate investment is a critical step when conducting due diligence on any opportunity. The pro-forma is essentially a set of calculations that projects the financial return and the cash flow that an investment is likely to create.
It is important to look closely at the assumptions being used to calculate the Net Operating Income to determine if they are aggressive and may be difficult to sustain, or if they are conservative and have a high chance of being achieved.
How to Identify Conservative vs. Aggressive Financial Projections
After a decade of investing for cash flow, our firm has evaluated thousands of investment opportunities. Let’s review a real example of a 24 unit multi-family investment in Ohio that was recently sent to us in early 2018 by a Commercial Real Estate Broker.
The broker remarks state: “Currently 100% occupied and has historically been very strong. Owner directs immediate sale at $960,000 or $40,000 per unit or an 9.42%. Projected Cap rate based on 100% occupancy at current market rate rental amounts.”
Wow, only $40,000/unit and a cap rate over 9.4%, this sounds like a pretty good investment doesn’t it?
Let’s look at the pro-forma financial projections provided and evaluate how the Net Operating Income (NOI) is calculated:
The gross potential income is $180,800 and when we take out the Operating Expenses we are left with $90,476 which is our Net Operating Income. From there we divide that by the list price of $960,000 to get the advertised 9.42% capitalization rate which represents the potential rate of return.
On the surface this may look like a good investment opportunity, but there are several items that are red flags that must be taken into account that will negatively impact the rate of return:
1) Vacancy rate – you’ll notice there is no vacancy rate built into the pro-forma. Vacancy rates vary among asset classes and must be built into an investment’s projections. After a tenant moves out it is not uncommon for an apartment to take a few months to rent to a qualified tenant especially if the property needs repairs. Watch out for a pro-forma that projects a very low or no vacancy rate. A good guideline for a property in good condition and in a desirable location is 8% which is about 1 month.
2) Management fee – there isn’t even one built in! Many multi-family brokers these days neglect to include a management fee in their projections. This is not an honest oversight! Rather, they may be trying to project the highest net income possible to justify the probably inflated list price! Management fees can range between 4-10% of collected income.
notice the fine print at the top which says “Expenses are estimated and are based on similar properties”. Estimating expenses often leads to inaccuracy which results in an under-performing investment. By doing a little extra work, most expenses can be verified including: property taxes, utilities fees, snow removal, landscaping, insurance etc. Don’t rely on estimates when doing your due diligence on an investment opportunity!
3) Estimated expenses – notice the fine print at the top which says “Expenses are estimated and are based on similar properties”. Estimating expenses often leads to inaccuracy which results in an under-performing investment. By doing a little extra work, most expenses can be verified including: property taxes, utilities fees, snow removal, landscaping, insurance etc. Don’t rely on estimates when doing your due diligence on an investment opportunity!
Now let’s look at the current rent roll provided:
What you’ll see here is that each unit lists the actual in place rental income which totals $11,770/mth, $141,240/yr., and the broker also lists the “Potential Market Rent” totaling $14,900/mth, $178,800/yr. So the broker is stating that the potential market rent is 26% higher than the current rents.
There could be a logical explanation for the very low in place rents, perhaps the owner has had long term tenants and has chosen not to increase the rental rates to avoid the risk of tenants moving. This could provide a strong value to a new buyer to acquire, raise rents and increase the property Net Operating Income and value. But, as we dive deeper you’ll notice that the 2 most recent tenants that moved in on 1/2/18 were leased at $495/mth, even though the broker is stating that the potential market rent is $600/mth.
One must ask, if the market rent is $600/mth why is the owner only renting the units for $495/mth? Most likely the units are outdated and in need of updating and repairs. If so, you will need to determine the cost of renovating each unit in order to achieve the higher rental rate and verify if it is even worth it. Renovating 24 apartments can be a very costly capital expenditure!
Let’s leave the $2,000 laundry income out of the picture for a moment. As you recall, the annual “potential market rent” of $178,800/yr is what is being used on the pro-forma! When we substitute $178,800 for the actual current rental income of $141,240 our capitalization rate drops from over 9.4% to 5.3% and this is with estimated expenses, no vacancy built in and no management fee. Once you factor in these additional costs the capitalization rate drops down to about 2-3%.
Not quite as attractive of an investment anymore is it?
As you can see, it is imperative to closely analyze the pro-forma and financial projections and determine if the advertised rate of return is aggressive or conservative. This is a crystal clear case of a highly aggressive financial projection.
Forecasting Future Net Operating Income
Our previous example was a straight forward snapshot of the financial projections at the beginning of the investment. This is an important first step in the analysis. The next area to evaluate is the financial forecast, which predicts the future Net Operating Income for the coming 5-10 years.
When analyzing the investment performance projections of future years, pay close attention to the financial assumptions which are used to calculate the future financial performance.
Let’s look at the an example of a value-add apartment investment where the strategy was to renovate the units over the first 2 years, raise the rents and increase occupancy:
As you can see, many of the financial assumptions are adjusting each year based on the specific investment strategy. The vacancy rate is declining and the rental growth rate spikes in years 2-3 and then drops again in years 3-10.
Here are the 5-year projections with these financial assumptions built into the pro-forma:
You’ll notice that the scheduled rents are increasing by the amounts noted in the assumptions and the vacancy rate is decreasing accordingly as well.
Line items to pay close attention to:
Annual expense growth rate – Expenses increase annually, this includes property insurance, taxes, utilities etc. When analyzing a long term investment double check to ensure that the pro-forma is calculating an increase in expenses each year. A good starting point is about 3% annually to keep up with inflation.
Income growth rate – what is the year over year annual income (rental) growth rate? Example: If there is a value-add strategy taking place in year 1 and the rental rates are projected to increase 15%, you want to verify that this income growth rate is reduced after the value add measures are complete. In the example above you’ll notice the rental growth rate drops after year 2 which is a good sign of conservative forecasting.
2 More Helpful Hints:
Exit cap rate – generally speaking, commercial real estate is traded based on the capitalization rate (cap rate) which represents the potential rate of return on an investment. The cap rate is the Net Operating Income / Current Market Value. A property that produces $100,000 in net income and is sold for $2,000,000 would have a 5% cap rate. There are several variables that determine what cap rate a property will trade at including: asset risk, supply, demand and interest rates. Conservative projections will calculate the future resale price based on a higher cap rate than what it is trading at today. This is an important variable in ensuring the pro-forma has conservative future sale price projections.
Property tax rate – Another critical step in your due diligence is to verify the property taxes – what is the current property tax rate? When and how is it reassessed? If you acquire a property it will most likely be at a price that is higher than the current assessed value you may need to assume an increase in the property tax rate. The increase in property tax value can often be a deal killer so be sure that this is accounted for before proceeding!
As you can see, it is important to closely analyze and question the set of assumptions built into the cash flow projections of an investment opportunity. This will ensure you are selecting investments structured in a conservative manner that will lead to a much higher chance of success!