The key thing to understand about targeted metrics, is that they are targets. They are a sponsor’s best estimate of how specific data points will measure through and at the end of an investment’s long-term holding period, but there are numerous potential sources of uncertainty, which we will discuss in detail in this article.
To understand targeted metrics, start with the underwriting process
Underwriting is the process a sponsor uses to forecast the future performance of a property. Similar to an insurance underwriter, in the context of commercial real estate, 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 incorporate many sources of information, including due diligence on the property, financial analysis, and surrounding market analysis.
Additionally, a sponsor’s underwriting typically hinges on a number of assumptions, such as rental rates, lease expiration dates, occupancy rates, length of investment period, and exit cap rate. The sponsor will input all of these variables into an underwriting model, which will calculate estimated investment returns the offering is projected, or targeted, to achieve — assuming all goes according to plan.
An investment outcome that falls within a small deviation of what the model predicted can be considered “in line with pro forma”, while an outcome that comes in substantially above or below can be considered outperforming or underperforming, respectively.
Underwriting models are sensitive to changes in variables
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. A couple of examples follow:
Example 1: A sponsor with a multifamily property plans to execute a light value-add 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 initially modeled selling at in year five. In this scenario, the IRR would likely come in higher than pro forma because of the shorter-than-assumed investment period.
Example 2: A sponsor acquires an unoccupied, distressed asset that needs significant renovations to get it into a leasable state. However, the asset is situated in a healthy real estate market, so they anticipate robust leasing prospects once it is 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 compete, 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, or hold the property for longer than the targeted investment period and hope the real estate market turns in their favor; in either case, it is likely that the IRR would come in lower than initially projected.
Differing philosophies: Conservative Sponsors 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. These offerings likely have the most downside risk if anything unexpected happens. Some ultra-conservative sponsors 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?” These offerings likely have the most potential upside, because the probability is relatively lower that most of the plan will go wrong. Most sponsors fall somewhere in between these two extremes.
To get a sense of how conservative a sponsor is in their underwriting, one thing you can look at is counting how many assumptions set new highs. If 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, it is possible they take an overly aggressive approach to their underwriting, whereas rent and sale price assumptions that fall in line with comparable properties and 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, core-plus, value-add, opportunistic) is a good starting place to assess how likely it is that a given offering will achieve its targeted returns.
In the chart below, you can see that, while an opportunistic investment has the greatest potential for a high return, it also has significant potential for a loss of capital; by contrast, a core or core-plus investment will have lower potential returns, but because these investments also have less volatility (i.e. likelihood of achieving the business plan), there is relatively lower potential for losses.
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Thinking about targeted metrics
Now that you know how sponsors approach the offering underwriting process and how changes to the assumptions in an underwriting model will 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 yield, targeted equity multiple, and targeted IRR, as well as certain other elements of the offering, including the targeted investment period and targeted distribution dates.
We outlined two examples above 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: 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 that a large tenant will not be renewing their lease unexpectedly. It is likely the sponsor will need to adapt their business plan and incur some unplanned expenditures to lease up the vacated space, and they will now almost certainly 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 pro forma.
Example 4: A sponsor is executing a value-add strategy on a multifamily offering, where 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 4, when a fire damages 10% of the units. This sponsor may pause distributions temporarily in order to redirect cash as available to repairing the damaged units and continue leasing up; 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 risky, and that means that the investment will not always 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 lofty 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 highly concerned with risk.
Focusing on highly experienced sponsors who have deep expertise in their chosen asset class and can obtain the best debt terms can help mitigate some of the risk of a deal going sideways, since experienced sponsors are more likely to make better decisions and have more tools to rectify asset performance.
Last but not least, diversification is and always will be a critical consideration in building a commercial real estate portfolio that can comfortably withstand the unexpected turns that some investments may take.
