Pro Forma Assumptions: Rent Growth, Exit Cap Rate, Reversion
Most of the projected return in a typical syndication comes from the sale, and the sale price comes from two numbers somebody chose. Those two numbers are the model.
The arithmetic in a syndication model is almost always correct. Spreadsheets add up. Reading a projection therefore has nothing to do with checking the sums and everything to do with testing the handful of assumptions that produce the answer.
There are five that matter.
The five¶
Exit capitalization rate. The rate applied to projected income in the exit year to produce the sale price. In most syndication models the sale generates the majority of the total return, so this single number carries most of the projection.
Rent growth. The annual increase assumed for the whole hold, on top of whatever premium the business plan claims from renovation. Two separate claims that are sometimes presented as one.
Expense growth. Frequently assumed below revenue growth, which means margins improve every year indefinitely. Insurance and property tax in particular have their own trajectories, and a reassessment after a sale is a known event that models sometimes omit.
The business plan timeline and cost. Units renovated per month, cost per unit, and the rent premium achieved. Delay is the most common failure and its cost compounds: an extra year is an extra year of debt service against unimproved income.
Refinance or exit financing. What debt is assumed available at what rate, and whether the projection assumes proceeds that depend on conditions nobody can know years ahead.
Why the exit cap rate dominates¶
Because value is income divided by a rate, small movements in the rate move the price a great deal.
That sensitivity is why the assumption deserves more scrutiny than any other number in the document, and why an exit rate assumed at or below the entry rate is worth noticing: the model is not merely projecting the property's performance, it is projecting that the market will be at least as favorable at sale as at purchase.
Rent growth, and the double count¶
A value-add projection contains two rent claims and they are sometimes blended.
The first is the renovation premium: renovated units achieve a higher rent than unrenovated ones. That is a property-level claim, testable against what comparable renovated units in the submarket actually achieve.
The second is market rent growth: rents in the submarket rise generally, year after year.
A model that applies market growth to a post-renovation rent for the whole hold is compounding the two. That may be correct. It is worth separating, because the first claim is about the sponsor's execution and the second is about the market, and only one of them is within anybody's control.
For a reference point on the general trajectory of rents, the Bureau of Labor Statistics publishes rent of primary residence within the Consumer Price Index, and the Census Bureau publishes vacancy data. Neither is a substitute for submarket data, and both are checkable, which is more than can be said for most numbers circulating in offering materials.
What a model cannot contain¶
Worth stating so that the exercise is kept in proportion. Even a conservatively built projection is a set of assumptions about the future, and there are categories of event that no model includes.
An insurance market that reprices. A property tax reassessment following the sale. A large employer leaving the submarket. A change in local regulation. A construction cost shock. A credit market that closes for a period.
None of these is exotic and none of them appears in a five-year model, because a model projects trends rather than discontinuities. That is not a criticism of modeling; it is the reason reserves and debt maturity dates matter more than the elegance of the projection, and it is the reason the stress test above is worth running even on a model you find credible.
Sensitivity analysis, and what makes one honest¶
Many offerings include a sensitivity table. Two questions determine whether it is informative.
Does the range include a losing scenario? A table whose worst case still returns capital comfortably has tested nothing. The purpose of the exercise is to find where the deal breaks, and a range that never breaks has been chosen rather than tested.
Which variables move? A table varying only rent growth, while the exit cap rate stays fixed, is holding constant the assumption that matters most.
The most useful format is a grid varying the exit rate against rent growth simultaneously, because those are the two assumptions that tend to move together in the real world — and they move in the same direction, which is the point a single-variable table cannot show.
The related reading is IRR, equity multiple and cash-on-cash for what the resulting numbers mean, and the risk factors, which should be read beside the model rather than after it.
Primary sources
Every factual claim above is traceable to a filing, a rule or an agency publication. These are the ones this article relies on.
- Federal Reserve, Financial Stability Report and commercial real estate exposuresfederalreserve.gov
- SEC, private placements under Rule 506(b)sec.gov
- Census Bureau, Housing Vacancies and Homeownership surveycensus.gov
- Census Bureau, American Housing Surveycensus.gov
- Freddie Mac Multifamily, market data and loan productsmf.freddiemac.com
Questions readers ask
What is a pro forma in real estate syndication?
The sponsor's financial projection for the hold period: revenue, expenses, financing, capital spending and the eventual sale. Every figure after the first year is an assumption.
What is the most important assumption in a pro forma?
Usually the exit capitalization rate, because it sets the sale price and the sale generally produces most of the projected return. Rent growth is second.
What is an exit cap rate?
The capitalization rate the model assumes will apply when the property is sold. Dividing projected net operating income in the exit year by that rate produces the assumed sale price.
Should the exit cap rate be higher than the entry rate?
Conservative underwriting generally expands it, on the reasoning that the asset will be older and future conditions are unknown. A model assuming an exit rate at or below the entry rate is assuming the market will be at least as favorable at sale as at purchase.
What is a sensitivity analysis?
A table showing how returns change when key assumptions move against the projection. Its absence is informative, and its presence only helps if the range tested includes a scenario where investors lose money.
Read next
- DocumentsHow to Read a Private Placement MemorandumThe memorandum is written to protect the issuer by disclosing what could go wrong, which makes it the most informative document in the package.
- DocumentsThe Risk Factors Section: Boilerplate vs Deal-SpecificMost of the list appears in every offering and carries no information. The entries written for this deal are where the sponsor's real concerns show.
- DocumentsThe Operating Agreement: Control, Voting and Removal RightsThe binding document. It holds the real waterfall, the short list of things you vote on, and the conditions under which a sponsor can be replaced.