I’d like to discuss how this concept applies to the world of commercial real estate.
If you work in this industry, you likely see a variety of proformas on a regular basis. They are used by investment brokers, appraisers, property managers, asset managers, lenders, mortgage brokers, individual investors, developers and many others.
We all rely on their outputs to make important decisions but they are only as good as the assumptions that determined their inputs.
Let me preface the following by saying there are legions of highly skilled, intelligent people working in real estate and creating spectacular and accurate proformas. This is a criticism of the small but persistent minority offering poor investment advice.
Unrealistic annual return
When a proforma has truly detached from reality, it is obvious. We’ve all seen a condo broker’s investment calculation that promises an annual return that would make Apple jealous.
I was once given a cash flow projection that included three per cent interest rates for the next 15 years. Even with this overly optimistic outlook on debt, the deal barely worked. I wouldn’t sleep well knowing my investment return was relying on being able to secure three per cent money in the year 2025.
A common fault found in apartment marketing material, is assuming 85 per cent of the purchase price can be financed. CMHC does technically allow 85% loan to value, but very few purchases would reach this level.
To find out why, read here. A more probable and realistic loan-to-value is 73%. The effect on IRR and equity requirement resulting from this gap would be enormous.
Not all are obvious
Not all Garbage In items are as obvious as the examples above. Many proformas are compromised by a more gentle and subtle massaging of the figures.
* 0% vacancy;
* 0% structural reserve;
* large annual rent growth;
* little growth in expenses;
* little or no property management cost;
* top-of-market rents;
* aggressive cap rates;
* no repairs and maintenance allowance;
* interest rates below market;
* exclusion of fees in predicting cash flow,
My preference is to see a three-scenario proforma. The first displays expected results based on market norms and conservative figures.
The second showcases the blue-sky outcome. If the tailwinds are all favourable, how great could this investment realistically be?
The third shows the effects of an under-performing asset. Not a doomsday scenario but simply the bottom of the range of probable outcomes.
I doff my hat
I’ve only ever encountered a handful of proformas that did this and they were all from syndicators seeking equity. My hat goes off to them and their dedication to quality forecasting.
Why do people do this? Personal gain would obviously play a large part. Finessing some numbers to get a deal closed is well within the realm of human nature. Genuine ignorance would be another coupled with minimal research.
What is the antidote? Get information from sources you trust. There is no barrier to offering real estate investment advice and almost anyone can offer it. So be careful who you take it from.
There are also limited consequences for those that consistently get this wrong, especially when real estate has been in a very long bull market.
The other advice is to do your own homework.
Create your own excel masterpiece, make your own assumptions and avoid the Garbage In, Garbage Out effect.
Adam Powadiuk is a business development manager with First National Financial, Canada’s largest non-bank lender. He’s active in most markets in the country, with a focus on investment real estate. All feedback is welcome and he can be reached at adam.powadiuk@firstnational.
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