The real estate market ebbs and flows in cycles. Historically, real estate evolutions have endured anywhere between seven and twenty years. Numerous elements can impact the real estate cycle, from a national recession to a real estate-specific supply and demand imbalance. Few things are as crucial as a well-aligned supply and demand. Inequality between the two can lead to all sorts of trouble. Too much demand can lead to inflated prices and rapid appreciation, while too much supply can stagnate the market and create depreciation.
Knowing where we are in any given real estate cycle is paramount to those weighing investing in a real estate syndication and affects a deal’s overall performance. For example, let us say, if a newly-constructed building is brought to market on the brink of a market downturn, the profitability will be vastly different from that same building pushing to lease up or sell when the economy is strong.
Nevertheless, real estate sponsors must assess each deal based on their best conjectures about how the market will behave when property stabilization is reached and at the exit.
There has been much talk lately about the future of real estate. Some experts say it is on the brink of a significant slowdown, while others remain optimistic. Whatever your opinion may be, one thing is for sure; the market is constantly changing and evolving. This means that real estate sponsors need to stay ahead of the curve to stay successful. To do this, they often turn to forecasting tools and techniques to predict what will happen next. So, what are some of these considerations? Moreover, how dialed-in are they? Let us take a look.
The Role of Real Estate Sponsors
Real estate sponsors oversee every aspect of a real estate syndication. The all-around focus is optimal overall deal performance. This is the anatomy of a Commercial Real Estate Deal. The process of real estate syndication can be broken down into four main phases: origination, due diligence, closing, and management. Each stage has its own unique set of tasks that must be met to succeed for the syndication.
When folks invest in a real estate syndication, they hope that the sponsor will make appropriate and profitable decisions and expect them to be analytical enough to make the best of passive investors’ hard-earned capital.
One of a sponsor’s fundamental obligations is to generate a forecast that outlines a property’s income and expenses. Unless the sponsor is acquiring an already-stabilized property, where the income and expenses are known, the sponsor must make several informed assumptions.
In the case of a reposition or value-add deal, for example, a sponsor has to make hypotheses about how much it will cost to enhance the property and, in turn, what rents they can achieve after that. The sponsor also has to make conjectures about the rate of lease-up (often referred to as the “absorption rate”) and what capacity they will have vacancies over time.
Of course, these deductions must be underpinned in both experience and market context. An adept self-storage sponsor, for example, might know that a specific size unit generates more income per square foot and lease-up faster than others. Accordingly, the sponsor might design the redone facility to supply more units of those types than average.
Considerations for Predicting the Future
While nobody can predict the future, there are many aspects a sponsor can (and should) consider when positioning their pro forma. These factors include:
Economic growth: Both macro and micro-level economic factors and demographic trends affect how real estate performs. The national economy is strong, and unemployment rates are low; greater investor confidence usually strengthens the actual market. However, micro-economic factors typically are more likely to impact a specific real estate deal. For example, real estate in the North East might not be doing well, but a property within a particular sub-market might be blossoming based on hyper-local prerequisites.
A sponsor will want to pay keen attention to those hyper-local economic situations. Who are the major employers? What type of employment diversity exists? Are the local job market and pay growth expanding or contracting? What is the average pay of people employed locally? How have COVID and the Work From Home phenomena impacted the region? How 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 significantly impact how an individual property performs. A sponsor should figure out the supply of the product type in question. How much competition exists? What is the quality of the current competition? What are these competing properties’ rents and occupancy rates, and are they rising? If so, at what rates? Have similar projects been permitted, and if so, what are the fees and their construction and delivery timeline, and how does that correlate to local regulations? How long will “in-migration” last? How much available inventory is on hand? All of the above and more go into pro forma assumptions.
Capital markets: Most real estate sponsors fund their deals with debt and equity. The cost of debt can fluctuate depending on where we are in a real estate cycle. Today, interest rates are closer to the 4 -to-6% range, pushing the total cost of debt higher than in recent memory. However, if your forecast has debt at 3% and now it is 4%, that is a 30% increase in lending costs.
The availability of debt also matters. For example, capital might be readily obtainable in a strong economy and at record-low prices. However, capital markets become restrained during a market contraction, as we recently saw during the depths of the COVID crisis. As a result, it becomes more challenging to access capital which can, in turn, drive costs up.
A sponsor readying their forecast today might be making suppositions predicated on the availability and cost of capital today. However, the capital markets may look dissimilar five or seven years down the road, along with the inflation costs on construction material and labor between now and exit. A deal that may have been effortless to refinance under existing market conditions may be more complicated or pricey to refinance in the future, impacting the total profitability.
Predicting the future: “Past performance is no guarantee of future success.”
Sponsors are considered to be knowledgeable and held are held to a higher standard. Those who invest want some loose guarantee that they will inevitably earn a return on their capital. Nevertheless, as noted above, many factors can control how well a deal performs.
It is always different on a go-forward basis. Given this arm-twisting to “guarantee” returns, many sponsors will make conservative projections about a deal’s future profitability. After all, it is sounder to “under-promise and over-deliver” than vice versa. However, when a sponsor delivers several projects that outperformed expectations, the new anticipation becomes that a sponsor will generate the same level of returns on their future deals – something a sponsor cannot always guarantee. It is a tricky sponsor catch-22!
Modeling Forthcoming Outcomes Absent Perfect Information
There are numerous ways for real estate sponsors to enhance their ability to predict the future. Some develop highly sophisticated, in-house models that assign values to several incomes, cost, and vacancy factors. Based on certain market assumptions, numbers can be squeezed, turned up, or down. However, these assumptions are grounded in experience, historical and current market conditions, and concentrated analysis by many individuals.
They are now turning to predictive analytics to help them do this. Predictive analytics is the practice of using data mining and modeling techniques to predict future events. The real estate industry is constantly changing, and as a result, sponsors are always looking for new ways to predict the future.
Recently, some have turned to artificial intelligence to make more informed decisions about their investments. While this technology is still in its early stages, it could significantly impact the industry in the years to come.
By analyzing trends and predicting future changes, these companies hope to stay ahead of the competition and ensure their success in the market. Conversely, sponsors who do not experiment with AI may find themselves at a disadvantage in the competitive market. Therefore, it is essential to look at how big data is being used in real estate and what it means for the industry.
It is presumably best to present some range of best, worst, and most-likely outcomes. Experienced investors will want to ensure that the worst-case scenario supplies an outcome (i.e., returns) that they are still pleased with, all while hoping that the sponsor will crush that worst-case scenario.
Sophisticated sponsors will likely have made conservative assumptions. For example, they may bake in a higher-than-average vacancy rate than in today’s tight market or include a higher-than-average contingency budget in case of inflation around construction cost overruns and higher labor costs. This conservative strategy increases the chances that a sponsor will supersede investors’ expectations.
Conclusion
Many factors can influence the profitability of syndication, some of which are out of the sponsor’s control altogether. While a sponsor does not have a crystal ball nor control the future, they can make safe assumptions and take measures to minimize the risk of a market downturn.
When vetting syndication, be sure to ask the sponsor about their assumptions. Understand how they draw conclusions about specific numbers and what strategies they might use if market conditions change.
Finally, it is crucial to understand that a syndication’s past performance does not assure future success, neither does a sponsor’s past performance. A sponsor is equally motivated to generate results, but their predictions about a deal’s profitability will invariably be imperfect until they have a crystal ball.