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Hi A.CRE:
Is there ever a time in the real estate cycle when you would value property on historic actuals financials vs. pro forma financials/operations?
I understand the using pro forma numbers is the general practice, but I feel like you are giving up some of your profit to the current owner at the acquisition by making pro forma assumptions that improve NOI.
I guess this means you need to walk a fine line between aggressive enough operating assumptions to be competitive in your underwriting but not so aggressive that you leave no cushion or room for error. Seems like this line would get very thin in a competitive market or upcycle like we are currently in.
Any thoughts you can share would be appreciated. Best, Nick
This is a good question. I think it depends on who you are. If you’re a lender, you likely already value a fully stabilized property based on the actuals rather than the forecast. Lenders don’t buy the dream, they lend on the reality. Now I recognize there are lenders who underwrite more aggressively, but generally speaking the lender will look to the past more than to the future.
If you’re a seller, you’ll certainly value the property based on the forecast rather than the actuals. You’re trying to sell the dream, because the dream brings more money at closing. The broker works for the seller, and their job is to maximize proceeds to the seller. So they’ll push as far as the market (and ethics) will allow them to push.
And if you’re the buyer, it’s a balance between maximizing profits and winning deals. What’s most important is to recognize what’s realistic and what’s not. If payroll at the property for the last three years has averaged 1600/unit/yr, and the broker is underwriting 1200/unit/yr because “the current owner is running the operation heavy”, you have to ask yourself is that a realistic assumption to make?
Let me make a second point about the pro forma and the buyer. The direct cap pro forma and resulting asking price, from the buyer’s perspective, should be secondary to the DCF returns the buyer is solving for. Michael gets into this in course 2, but the purchase price is just one input that determines the ultimate outputs (i.e. equity multiple, IRR, average rate of return, etc). And those metrics aren’t solved for by doing a direct cap pro forma.
I agree on the lenders perspective. The proforma method in this exercise really is about “sizing up” a property’s “potential” for deal “aquisition” purposes really. –the value add play to intice investor returns or “what can I do with the asset once in my control”. A lender takes a different approach, really. However, there are ways that a lender would lend into the value and play along with the value add play from a new owner operator once aquired on projected rents. For e.g., they could initally lend into the “as-is” on historical numbers, and build in a “hold back” dollar amount provision that is “advanced” once the new stabilized rents are in-place, as verified by a new appraisal or X. But this is leveraged spaek i guess
Typically, especially in “refinance” transactions, where like expenses in managements are control- so are the rents. So if an operator is receieving lower rents because of many factors, they are indirectly penalized by getting the “as-is” value despite the underperformance or potential for a higher valuation. So historical figures (“in-place” “or as-is”) or estimated market rents serve two functions in my opinion.
Ryan – Thanks for bringing this point up about how lenders view potential value. You’re absolutely correct that certain lenders (or loan programs ) will “lend into the value.” The “hold back” concept, sometimes also referred to (or structured) as an “earn-out” or “staged funding”, is a form of “structure” that lenders will use to recognize value when/if it’s created.
I think what’s important as we consider the lender’s perspective, is that prudent lenders lend on actual operating history and based on value that has already been created.
Sure, a lender may offer structure or size a loan based on the borrower’s projections. But the loan funds won’t be funded until that projection has been proved out.
Take for example a construction loan. Lenders size the loan amount and structure the loan terms based on the borrower’s projection of cost and lenders projection of value at completion and stabilization. However, loan funding is only made after the lender has verified actual construction progress and only in proportion to the actual costs deployed.
Likewise with those lender that offer earn-outs (i.e. hold backs, staged funding). The borrower says, “as-is rents are X, and we believe they’ll go to Y once we do Z.” And the lender responds, “Great! We’ll lend A based on your X rents, and are willing to lend an additional B once you prove out Y rents.” Again though, only after history has proven out the borrower’s projections will the lender fund.
We’ll get into this more in course 7. Introduction to Real Estate Debt.
Appreciate your contribution here!
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