It’s easy to get caught up in the buzz on a new deal once it gets announced. In our quest to continue to educate investors and be transparent in how we view and operate our projects, we wanted to share a few things to keep in mind that many folks don’t call out when you are reviewing a new opportunity and they are looking for you to decide to invest!
1. Returns are not guaranteed
Similar to most investments, the returns shown in an investment summary are a projected return based on how a sponsor expects the project to perform. Most sponsors stress test their deals by performing a series of “what if” scenarios that highlight an average, above average, and below average return scenario to help inform their projections. These scenarios should be based on real market data and accurate assumptions on rents, expenses, and take into account the existing performance of the property as a baseline to improve upon.
Since most deals operate over multiple years, you can expect some variation in the returns and expect the projected returns shown on a deal are their best approximation of how they expect the deal to perform…. but it is not a guarantee it will return the exact number stated.
2. Preferred Return is not the same as Cash on Cash Return
Preferred Returns are about prioritizing cash flows from a project to investors. It is not a measure of a direct “cash on cash” return. A preferred return provides a portion of any active cash flows to the investors first, before sharing any profits with the General Partners. However, if there is not enough cash flow to support the full return, it will accrue and get paid out once sufficient cash has been accumulated.
As a quick example, if a sponsor is projecting a 6% preferred return, this does not mean the limited partners (LPs) will earn 6% on their capital every year. It means the limited partners will receive a 6% return BEFORE the cash flows are split between the GPs and LPs.
3. The Projected Holding Period can be variable
Sponsors are constantly keeping an eye on the market and determining when the best time to exit a project will be. It is common practice to underwrite a project with an assumption for a 5, 7, or 10 year hold period to complete their business plan. However, if the project does extremely well and can pay investors their expected return or higher in an earlier timeframe, they may make a decision to exit sooner. Conversely, if there is a major market hiccup, they could also decide to hold longer until the market stabilizes if they believe that is also in the best interests of their investors. Most operators try to hold to their planned timeframes but investors need to be aware the market may dictate an earlier or slightly later exit depending on what is happening in the greater real estate markets.
