It’s important to remember that targeted metrics are just that, targets. These metrics, which include target The Internal Rate of Return (IRR) is the rate at which each invested dollar is projected to grow for each period it is invested. It differs from other metrics in that it accounts for the concept of the “time value of money”, or the fact that a dollar received and reinvested elsewhere today is worth more than a dollar expected... More, target In commercial real estate, the equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Essentially, it’s how much money an investor could make on their initial investment. An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means... More, and target In commercial real estate, the hold period is the time between when the investment is made and when the property sells. Since real estate investments are illiquid, investors are unable to sell their investment before the end of that hold period, unlike public stocks which can be sold at any time. Sponsors generally target a hold period of 3-5 years,... More, are a sponsor’s best estimate of how specific data points might measure throughout and at the end of an investment’s long-term holding period.
To understand targeted metrics, start with the underwriting process
Underwriting is the process a In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More uses to forecast the future performance of a property. Similar to an insurance underwriter, generally the sponsor performs a thorough review of a potential real estate investment opportunity with the following aims:
- Assess risk;
- Establish the present-day value of a property; and
- Shape the business plan as a function of a desired targeted return on investment.
This review will usually incorporate many information sources, including third-party due diligence reports on the property, financial analysis, and surrounding market analysis.
Additionally, a sponsor’s underwriting is typically based on several assumptions, such as rental rates, lease expiration dates, occupancy rates, length of the investment period, and exit The capitalization, or “cap”, rate is used in commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. The calculation is based on the Net Operating Income the property generates divided by the Purchase Price. Lower cap rates (3-5%) generally point to safer / less risky investments and are... More. The sponsor inputs these variables into an underwriting model, which calculates estimated investment returns that the offering is projected, or targeted, to achieve—assuming all goes according to plan.
An investment outcome that falls within a slight deviation of what the model predicted can be considered “in line with pro forma.” On the other hand, an outcome that comes in substantially above or below is considered outperforming or underperforming, respectively.
The underwriting model will have different degrees of sensitivity to different variables, meaning that the targeted returns will move up or down as assumptions change.
Here are a few examples:
Example 1 – Potential impact of conservative assumption in the investment period.
A sponsor with a multifamily property plans to execute a light, Properties are considered value-add when they have management or operational problems, require some physical improvements and/or suffer from capital constraints. By making physical improvements to the asset that will allow it to command higher rents – remodeling the kitchens in multi-family, installing more energy efficient heating systems in a medical office, etc. – improve the quality of tenants and increase... More business plan in year-one (e.g., minor upgrades to unit interiors and certain cosmetic exterior enhancements), hold the asset for four more years to earn cash flow from the improved rents, and exit in year-five. However, in year four, they are approached by a potential buyer who offers to buy the property at the same sale price the sponsor had initially modeled in year five. In this scenario, the IRR would likely come in higher than pro forma (the assumed outcome) because of the shorter-than-assumed investment period.
Example 2 – Potential impact of ambitious assumptions in rental rates.
A sponsor acquires an unoccupied, distressed asset that needs significant renovations to get it into a leasable state. However, the asset is in a healthy real estate market, so they anticipate robust leasing prospects once it’s repositioned and, as a result, the sponsor plans to sell in year three. The sponsor executes the capital expenditure-heavy business plan, but in the meantime, many competing properties have come onto the market. To remain competitive, the sponsor is forced to lease at rental rates below their initial assumptions and struggles to hit the occupancy rate they had modeled. At the end of year three, the sponsor is faced with the choice to either sell the property at a lower price than what they underwrote due to the lower-than-anticipated Net operating income (NOI) equals all revenue from the property minus all operating expenses. In addition to rent, a property might generate revenue from parking and/or service fees such as laundry, housecleaning services, pet rent, and more. Operating expenses include the costs of running and maintaining the building and its grounds, including insurance, property management fees, legal fees, utilities, property... More or hold the property for longer than the targeted investment period and hope the real estate market turns in their favor; in either case, the IRR would likely come in lower than initially projected.
Differing philosophies: Conservative In commercial real estate, the sponsor is an individual or company in charge of finding, acquiring and managing the real estate property on behalf of the partnership. The sponsor is usually expected to invest anywhere from 5-20% of the total required equity capital. They are then responsible for raising the remaining funds and acquiring and managing the investment property’s day-to-day... More vs. Aggressive Sponsors
Another important factor at play in a sponsor’s underwriting is where they fall in their approach philosophically on the spectrum of aggressive to conservative.
Some ultra-aggressive sponsors will underwrite their offering with very high targeted returns because they assume everything will go according to plan.. Meanwhile, some ultra-conservative sponsors may take the opposite approach and cite targeted returns in terms of, “how much would the project stand to make if numerous aspects of the business plan went wrong?” Most sponsors fall somewhere in between these two extremes.
To get a sense of how conservative a sponsor is in their underwriting, consider the sponsor’s assumptions. Suppose the sponsor anticipates leasing at rental rates that have yet to be proven, growing rents at a rate that the market has not yet seen, and selling at a record price per square foot for its asset class. In that case, they may take an overly aggressive approach to their underwriting. In contrast, rent and sale price assumptions that fall in line with comparable properties within the submarket may signal a more conservative approach.
Volatility of returns: How likely are return metrics to be accurate?
The investment profile designation of an offering (e.g., Core commercial real estate investments are the least risky offering. They are often fully leased to quality tenets, have stabilized returns and require little to no major renovations. These properties are often in highly desirable locations in major markets and have long term leases in place with high credit tenants. These buildings are well-kept and require little to no improvements... More, Core-plus commercial real estate investments are known as “growth and income” investments. The cash flow is less predictable, but they often predict a higher rate of return than core investments. The term "core plus" was originally defined as "core" plus leverage. Leverage is the use of borrowed capital to purchase and/or increase the potential return of an investment.... More, value-add, Opportunistic real estate investments are the most high risk/high reward investment opportunities, requiring major development work. Opportunistic properties tend to need significant rehabilitation or are being built from the ground up. They have the chance to reach the highest rate of return for investors, but they little to no in-place cash flow at the time of acquisition and have the... More) is a good starting place to assess how likely it is that a given offering will achieve its targeted returns.
While an opportunistic investment has the greatest potential for a high return, it also has significant potential for a loss of capital. In contrast, a core or core-plus investment will have lower potential returns, but because these investments also have less volatility (i.e., higher likelihood of achieving the business plan), there is relatively lower potential for losses.
Thinking about targeted metrics
Now that you know how some sponsors approach the offering underwriting process and how changes to the assumptions in an underwriting model may yield different outcomes, it follows that any metric preceded by the word “targeted” should be considered highly variable. This includes return metrics such as targeted Cash-on-cash return calculates the cash income earned on the cash invested in a property. It’s sometimes also referred to as the cash yield. Cash-on-cash measures the return on the actual cash invested, whereas standard ROI take into account the total return on investment.... More, targeted equity multiple, and targeted IRR, as well as certain other elements of the offering, including the targeted investment period and targeted distribution dates.
The two examples above outlined where the targeted investment period might change as a result of circumstances. Likewise, there are many possible scenarios in which the targeted distributions might change as well.
Example 3 – Potential impact of overestimating occupancy rate.
A sponsor has underwritten a core-plus office offering in which they anticipate starting distributions in Q2 of year-one. Soon after acquiring the asset, they learn, unexpectedly, that a large tenant will not be renewing their lease. The sponsor will likely need to adapt their business plan and incur some unplanned expenditures to lease up the vacated space. They may need to withhold the year-one Q2 distribution that was initially underwritten and use that cash to pay for marketing and leasing expenses. That being said, it is entirely possible that when distributions do commence later than planned, the rents achieved upon leasing the space may exceed what had been conservatively underwritten, and therefore targeted returns might ultimately outperform the pro forma.
Example 4 – Potential impact due to unforeseen event.
A sponsor is executing a value-add strategy on a multifamily offering. They have been renovating blocks of apartments in waves, raising rents for the refurbished units, and leasing them up. All is proceeding according to plan, and distributions have been steady until year four when a fire damages 10% of the units. This sponsor may temporarily pause distributions to redirect cash as available to repair the damaged units, continue leasing up, and then pay an outsized “catch-up” distribution to investors once the insurance payment comes through. In this scenario, the investment’s performance could still be considered in line with pro forma if total distributions match up with what was underwritten.
How to cope with the uncertainty
It bears repeating that the most important thing to remember with respect to targeted metrics is that they are targets. Commercial real estate investing is inherently risky, which means that the investment may not play out according to expectations.
Investors who are uncomfortable with volatility and downside potential (i.e., significant risk of loss of capital) may wish to forego the high targeted returns characteristic of the riskier value-add and opportunistic deal profiles. Instead, less volatile core and core-plus investments make a better fit for investors with lower risk tolerance.
Focusing on highly experienced sponsors who have deep expertise in their chosen asset class and access to favorable debt terms could potentially mitigate some of the risk of a deal going sideways.
Finally, diversification is and always will be a critical consideration in building a commercial real estate portfolio that could withstand the unexpected turns that some investments may take.