This is Heuristics - where assumptions are called out and broken down so that you can invest with greater clarity.

Confidential is used a lot in syndicated investments, but what does it mean for LPs?

What is “Confidential”?

It’s complicated: subscription agreements are unique, and rights and restrictions can vary widely regarding confidentiality obligations for LPs and GPs. However, the terms of confidentiality generally apply to four areas: 1) Pre-Investment; 2) Active Investment; 3) GP Control; and 4) Disputes.

Before we cover each area in detail, keep in mind that:

subscription documents are written by the GP’s legal team to protect the GP’s interests - which are not necessarily the same as the LPs’ interests;

and generally speaking,

confidentiality covenants persist indefinitely. Even after the deal exits, confidentiality endures.

1. Pre-Investment

Before investing, LPs typically sign (or more often check a box) agreeing to basic confidentiality terms restricting the use of the offering materials, such as:

• Exclusive Use: materials are provided for the sole purpose of evaluating the deal.

• No Sharing: Copying, reproducing, or forwarding documents is prohibited.

• Return or Destroy: If you do not invest, you must return or destroy all materials.

So, oops. Sharing a new offering with your friend is not allowed. And you’d better track down and delete all those old pitch decks…

2. Active Investment

As an LP in a deal, you have an obligation to exercise discretion such as:

• Non-Disclosure: You cannot share non-public fund details with outsiders, except for professional advisors with a “need to know” such as your CPA or attorney.

• No Market Trading of Material Non-Public Information (MNPI): Investor updates often contain MNPI; using this data to trade securities or tip off others is prohibited.

• No Publicity: Issuing press releases or speaking to reporting publications about deal terms is not permitted.

OK, so…

Sharing with your attorney and CPA: OK. Everyone else: not OK.

Insider trading: not OK.

Sharing with a publication: not OK.

3. GP Control

The GP also has confidentiality rights and responsibilities such as:

• Information Withholding: The Manager can choose to withhold data to protect business interests.

• Reduced Reporting: Management may restrict disclosures during sensitive periods (e.g., distressed-asset workouts or to mitigate insider leaks).

• Privacy: Contact lists are generally kept confidential to protect investor privacy.

Basically, the GP can choose what is and is not shared “to protect business interests” - which could become a very big umbrella that leaves LPs in the dark.

4. Disputes

These terms outline what happens during a dispute, and may include:

• Secrecy in Disputes: The existence, proceedings, and outcomes of any internal arbitration or litigation must remain entirely confidential.

• Subpoena Mandate: If subpoenaed, you must immediately notify the Manager before releasing data.

If you get into any sort of dispute, the details of that mess stay private.

In Practice

So, what does all this confidentiality legalese mean in practical terms? Again, I am NOT a lawyer and this is my interpretation and opinion.

• No sharing with anyone outside of the deal with a few exceptions for legal or business purposes.

• The term never expires. Even if the deal or the GP no longer exists, confidentiality obligations never sunset - they can live on in perpetuity.

But what information is considered confidential?

Are LPs expected to behave like CIA special agents, never uttering a word about anything to anyone?

Clearly, that is not realistic.

Under normal circumstances, an LP has a few practical ways to determine what can never be shared, and what is acceptable to share.

Never Share

Outside of your “need to know” contacts, you should never share:

• Raw documents.

• Granular-level investment details.

Acceptable to Share

Again, review your documents for specifics but the following generally apply:

Anything already in the public domain (that you didn’t place there).

• Acceptable: if Google can find it (such as court filings or information in a publication), you can share it.

• Not Acceptable: Documents, quotes, or communications sent to LPs by the GP or other LPs.

Generic opinions about GP performance without deal-level specifics.

• Acceptable: “The GP was timely and transparent with communications” (a personal opinion that does not reveal deal specifics).

• Not Acceptable: “The GP’s negotiated debt with XYZ Bank was a terrible decision” (an opinion coupled with granular-leve deal specifics).

• Not Acceptable: “The GP is a fraudulent crook” (unless the GP actually committed fraud, this is slander and is not acceptable).

• Acceptable: “I believe the GP is (un)trustworthy” (an opinion).

Generic non-specific and unidentifiable deal performance.

• Acceptable: “my best investment to date was a deal that performed according to plan despite requiring a capital call” (generalized performance that does not identify the deal specifics).

• Not Acceptable: “MakeMeRich.com’s Fantasy Lane project located on Sunshire Road in Miami promised to deliver a 29.5% IRR using preferred financing from MoneyBags Bank, but the principal, Mr. BigShot, had a heart attack and the deal went into foreclosure and all capital was lost - here’s the link to the last investor meeting notes” (divulgence of granular-level deal specifics).

• Not Acceptable: “GP based in Arizona (whose name rhymes with Fast) did a deal in Dallas for a 368-unit ground-up development that started in April 2022” (divulgence of information that could be triangulated to identify the deal and/or GP mentioned).

Points to Consider

When thinking about confidentiality, an LP should consider:

1. What are my obligations? Review your documents to fully understand what you have agreed to.

2. What do I want to share? If you’re discussing general terms with trusted peers, that’s probably OK. If you want to comb over a pitch deck, that could be out of bounds.

3. Why am I sharing? If you’re looking to slander or otherwise lay waste to a GP as an emotional outlet, it’s probably best to find another way to vent. If you’re looking to share meaningful, objective information that could be OK but is certainly treading the line if it extends beyond opinion.

4. What will the receiver do with the information? This is potentially the most important point since the intent of confidentiality is to keep important information from falling into the wrong hands. While sharing with one’s investment professionals is permitted, sharing with trusted contacts (while legally not permissible) can be a benign act.

5. Does anyone care? The prevailing norm is for GPs to ignore and/or generally accept when information is shared for legitimate and benign purposes.

Option C: All of the Above

What if you want Option A: to adhere to your confidentiality agreements AND Option B: to have detailed conversations about a deal?

AI can help provide an Option C: anonymization.

Stay tuned for my AI guide to providing anonymized deal information.

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Your Call

We all knowingly or unknowingly violate rules. Like driving 60 in a 55 zone, for example. You may or may not realize you are exceeding the speed limit. You may or may not choose to continue to do so. Maybe you didn’t see the sign. Maybe you’re late for an appointment. However, should you be caught, the law is not on your side. Ignorance or justification does not negate one’s obligations.

• Will the law be enforced? Maybe.

• Is it enforceable? Yes.

• Are you being sensible or reckless? Depends.

Given the long and complex nature of subscription documents, it is unlikely that many LPs are aware of confidentiality other than the prevailing social norm of their environment. And GPs don’t seem to care about enforcing violations.

But choosing to not enforce does not mean unenforceable.

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This is Heuristics - where assumptions are called out and broken down so that you can decide with greater clarity.

This post will stress test a market correction: when interest and cap rates increase, and when supply outpaces demand.

Before then, let’s revisit the rosy future predicted by the pro forma for the fictional project, Fantasy Acres - a value-add multifamily project with a five-year hold, and the historical market data shown below.

Projected Returns

Pro Forma

50-year Market Measures

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Testing the Assumptions

Interest and Cap Rates

In 2021, commercial real estate had been borrowing at less than 4% for the better part of 13 years - a period that was unusual not only for its length and stability, but for holding, without precedent, at the historic low.

In 2022, the run ended when the Fed raised rates steadily for 16 months from near zero percent to 5.5% - a pattern more aligned with norms than anomalies.

Back at Fantasy Acres, the GP and LPs were in shock - they had never seen anything like this - having built their business models on the previous ten years’ liberal lending terms with predictably low interest and cap rates - which produced high purchase values and all but guaranteed equivalently high sale prices. Anything more than a half a percentage point deviation was not considered possible. Reversion to the mean relegated to economic theory, not market reality. This was the 2020s, not the 1980s.

But, revert it did.

The effects of interest rates on Fantasy Acres are covered in no. 3 of this series, which demonstrated how an interest rate increase from 3% to 8% consumed all cash flow and reserves by the end of Y2 that necessitated a capital infusion in Y3, but exited in Y5 with a below-expected IRR of 17%.

In no. 4 of this series, the increase in the cap rate from the projected 5.1% to 6% realized at disposition, reduced investor returns by 30% to a 16% IRR.

But these are mathematical experiments; the returns did not account for the reality of cap rate changes that follow interest rate changes. Here is how rate changes affect cash flow and investor returns when accounted for more accurately: in tandem.

How Interest and Cap Rate Increases Destroy Value

Since we’re using actual (not hypothetical) conditions we will retain the previously-modeled interest rate change of 3% increasing to 8%, and assume that the prevailing exit cap rate in Y5 (2026) is 6.5% (not the previously modeled 6.0%). Under these conditions, much remains the same as before:

• Increasing debt load consumes cash flow and reserves by Y2.

• Rescue capital is provided in Y3 by the GP (structured as a non-interest-bearing, non-dilutive loan).

• Cash flow turns positive in Y3 as the value-add strategy performs to plan.

• Investors receive zero distributions from free cash flow Y1-Y5; all returns are provided via sale proceeds at the exit.

When adding the expanded cap rate at exit to the equation, investor returns are reduced by 54% to 85% from pro forma projections, with the actual return coming close to the risk-free rate on a very much not risk-free investment.

Effect on cash flow and return metrics

To understand how this happened, let’s look at the cash flow.

Note:

• The larger cap rate reduced the sale value (within the red circle) by 22% and $6.3M from the projected $29.1M to the realized $22.8M.

• The addition of the interest-free rescue capital (highlighted in yellow), saved the project from ruin in Y3, but further reduced the project’s profitability.

• The project’s profits (within the blue circle) are nearly completely erased from the forecasted $6.4M to little more than $240,000.

• The final distributions in Y5 (within the green circle) fulfill ~$1.2M of the $1.7M cumulative preferred equity due to LPs.

• Funds never reach the second tier of the waterfall agreement - the promote split. All parties were returned their investment, but LPs received a small return on their investment, and the GP received no return.

Supply and Demand

Supply in excess of demand drove strong rental increase rates across many regions - until the tables turned and rental increases turned into decreases and concessions.

The reasons for the dramatic rise and fall of rental rates are multifaceted but the following graphic helps to put the market drama into perspective.

Again, the GP at Fantasy Acres was facing a reality it had never seen before: rent decreases. The pro forma assumed a steady 5% YoY increase in rents with a 10% vacancy rate - safe assumptions that worked for the previous ten years.

2021 was a dream: 3% interest rates, zero vacancy, and rents increasing in excess of 10%. But 2023 was a nightmare: 8% interest and 10% vacancy rates, rent reductions, and concessions all coalesced to dramatically erode NOI. Multiply the reduced NOI by the expanded cap rate and the exit returns quickly go into the red.

Effect on cash flow and return metrics

Let’s look at the cash flow to see what went wrong.

Note:

• The reduced NOI (resulting from lower rents and higher vacancy) multiplied by the larger cap (driven by increased interest rates and market uncertainty), resulted in a much lower final sale price (shown in the red square).

• Despite the reduced NOI, Fantasy Acres was cash flow positive by Y3 and continued as such through Y5: the value-add lifted NOI to a level sufficient to service the debt (as shown by the green boxes).

• The DSCR never reached the required 1.2x. By Y5 the lender was no longer willing to extend and pretend. Like many other deals, the GP was unable to float additional rescue capital and the LPs weren’t interested in additional capital calls. As a result, the lender forced a sale in Y5 under terrible market conditions.

• Sale proceeds were nearly $3M less than the total capitalization - sufficient to pay off the debt principal, but LPs lost ~$2.1M of their $4.9M; the GP lost ~$0.4M of equity plus its entire $0.5M rescue loan (as shown in the red text).

• A historically accurate reenactment of the full array of market stressors experienced from 2023 through 2026 was not accounted for in this example. Increasing material and labor costs, insurance premium hikes, losses to extreme weather, the high interest rate of rescue capital, and a higher cap rate typical of a forced sale were all conveniently ignored. At this point, it should be clear that the addition of any one of these items could easily wipe out all equity and potentially part of the debt principal.

Conclusion for Today

The dual market stress of higher interest and cap rates coupled with reduced rental income has vaporized millions in equity capital across the US. Add in the plethora of other challenges to profitability, and asset values go underwater and the bank starts taking losses too.

Some say “interest rates rose at an unprecedented rate to a historic high”.

Others blame “unforeseeable rental rate softening”.

But is “unprecedented”, “unforeseeable”, and “historic” an accurate depiction of a normal market correction?

Whatever the reason(s) and no matter how surprising or predictable they may be, the flaw is in the assumption that the market will remain stable and favorable. This series shows how those flawed assumptions resulted not only in distressed assets but lost capital at every layer of the capital stack.

Next in the Series

Now that the mechanics of the pro forma, its assumptions, and market variation are clear, the last post in this series will show how AI can take a pitch deck and provide two crucial pieces of information:

1. the risk profile (as plotted on the Risk Radar), and

2. sensitivity analysis (to show where the pro forma breaks).

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This is Heuristics - where assumptions are called out and broken down so that you can invest with greater clarity.

This post stress tests the disposition assumptions: cap rate and hold time. The pro forma and market data for the fictional project, Fantasy Acres, are shown below.

Projected Returns

Pro Forma

50-year Market Measures

Testing the Assumptions

Cap Rates

In the simplest of terms, the cap rate is the rate of return on an investment. But the cap rate incorporates many variables, is highly volatile, and is subject to many exceptions. Check out the Investopedia cap rates page to learn more.

For this discussion, we’ll focus on two of the mathematical mechanics that use cap rates:

• Cap Rate = NOI ÷ Price

  • typically provided for the acquisition/purchase price

• Market Value = NOI ÷ Cap Rate

  • typically used to calculate the disposition/sale price

Fantasy Acres Example

The Fantasy Acres pro forma is using cap rates at two important points:

Acquisition: 4.75% cap rate

• 4.75% cap rate = $780,000 (NOI) ÷ $16.4M (Price)

• These figures are known and fixed at the time of acquisition.

Disposition: 5.1% cap rate

• 5.1% cap rate = $1.5M (NOI) ÷ $29.1M (assumed sale price)

• These figures are estimates. The sale price is entirely dependent on the actual NOI and actual cap rate at the time of disposition.

To contextualize the previous numbers, consider the inputs and how accurately they may forecast returns:

The 50-year historical low cap rate is 4.7%; the average is 7.5%. The purchase price is at a 4.75% cap rate - a figure near the historical low edge. And, the sale price is anticipated at a 5.1% cap rate - an allowance of just 35 bps from the purchase cap rate and far closer to the historical low than the historical average.

The NOI is assumed to nearly double from $780,000 to $1.5M in five years. Is this estimate accurate?

The Effects of Cap Rate Expansion

Let’s assume that the projected NOI is achieved but true to the Fantasy Acres timeline, which planned a sale in 2026, cap rates expanded in tandem with interest rates and market uncertainty and are currently at about 6.0%.

By simply adjusting the assumed exit cap rate of 5.1% by 90 bps to the current market norm of 6.0%, the exit figures change as follows:

Effect on Investor Returns

A 0.9 pt expansion of the cap rate (an increase of about 18%) reduced investor returns by 23% to 40%. A small movement resulted in an outsized impact.

Effect on Return Metrics

Recall the math: Market Value = NOI ÷ Cap Rate. In this scenario, the assumed NOI at exit was realized but the cap rate expanded 0.9 pt / 18% to 6.0% - a variable that is subject to market forces and cannot be controlled. If NOI remains the same and is divided by a cap rate that is a larger number, the result (the sale price) will be smaller.

Note:

• The assumed sale price was $29.1 M = $1.5M (NOI) ÷ 5.1% (cap rate), but

• The realized sale price is $24.7M = $1.5M (NOI) ÷ 6.0% (cap rate).

• The 0.9pt / 18% cap rate expansion reduced the exit value by $4.4M or 15% - as shown by the red arrow.

• Y1-Y5 cashflow distributions were made according to plan, but the reduced exit value also reduced the profit on the sale by 61% from $6.4M to $2.5M, which then reduced:

  • the promote split to common equity investors by 53% from $5.9M to $2.8M, and

  • total return to investors by 23% to 40%- depending on the measurement method.

Hold Time

Let’s assume the GP decides to not sell in 2026 and wait for better market conditions - and all other variables stay the same: the debt terms, NOI, growth rates, etc. But the hoped-for reduced cap rate market conditions aren’t forthcoming. After 24 months of waiting, the GP decides to sell in 2028 at the same 6.0% cap rate.

Effect on Investor Returns

The returns have improved: the equity multiple increased from 2.0x to 2.8x (and outperformed the projected 2.6x), the IRR improved by 2 pt from 16% to 18% (but still fell well behind the projected 23%), and the ARR increased from 20% to 26% (but also fell behind the projected 33%). Maybe waiting was the right move?

Effect on Return Metrics

To understand how extending the timeline by 24 months actually improved investor results, let’s look at the numbers…

Note that:

• By holding all variables steady and only adjusting the timeline (and the expanded cap rate already accounted for), the NOI increases steadily year over year, which meaningfully improves the exit value (as shown by the red arrow) and free cashflow that boosted investor returns (as shown by the blue arrow). Here’s the math showing how that happened:

• The final exit value was lifted to $27.3M from $24.7M in the previous scenario since the cap rate remained the same but the NOI increased from $1.5M in Y5 to $1.65M in Y7 (a larger number divided by the same number = a larger result). The NOI increased by ~$150,000 and 10%, but provided $2.5M and an equivalent 10% increase in value.

  • $1.5M (NOI) ÷ 6.0% (cap rate) = $25M*

  • $1.65M (NOI) ÷ 6.0% (cap rate) = $27.5M*

  • * rounded figures; actual metrics are as previously stated: $24.7M vs the rounded $25M; $27.3M vs the rounded $27.5M.

• The free cashflow resulting from the value-add plan started yielding strong cashflow in Y3-Y7, which flowed through to investor distributions and ultimately buoyed the investor return metrics.

  • Remember: IRR is time sensitive. By returning cash to investors sooner via the strong cashflow in Y3-Y7, the IRR increases.

  • Equity multiple is NOT time sensitive. The actual amount of cash returned to investors did improve meaningfully via the strong cashflow of Y3-Y7, but a 2.8x multiple received in 7 years is not as valuable as a 2.6x multiple received in 5 years - which the IRR accounts for.

Conclusion for Today

Some metrics can be controlled, others not at all, and others are somewhere in between. NOI is one of the in between variables: subject to change based on market conditions and GP management decisions. Cap rates cannot be controlled; rates move freely with market conditions. Small changes in NOI and cap rates have the power to erode a property’s value - and investor returns. When considering this mathematical fact with the reality that future market conditions cannot be known in advance, the risk becomes apparent: no pro forma can predict investor returns and business plans that rely on favorable market conditions to persist into the future indefinitely are a high-risk gamble.

Real estate does NOT always appreciate. Riding out unfavorable market conditions can be the right choice. The numbers here verify both. However, surviving a market downturn can be difficult if not mathematically impossible.

The next post in this series, Market Corrections can be Avoided, will show what happens during a market correction when nearly every assumption is proven false and every number is off-target.

Anticipating the impacts of a market correction and showing how much margin for error the business plan permits is where sensitivity analysis comes in. That will be covered at the end of this series: How to use AI for Stress Testing and Sensitivity Analysis.

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This is Heuristics - where assumptions are called out and broken down so that you can invest with greater clarity.

This post covers how costs affect investor returns - specifically debt and operating expenses. In 2022 interest rates nearly tripled, moving from a historical low of about 3% to a more historically typical 8%. At the same time, operating expenses increased by 20% to 30% as a result of rising insurance premiums, rapidly increasing material and labor costs, and - in some places such as Texas - substantial changes to property tax policy. The combination of these two factors had a huge and unavoidable impact on profitability and has wiped out not only investor capital but also driven many deals into foreclosure. Let’s break down how this happened.

Pro Forma Baseline

The projected returns, expense sections of the pro forma and market data for the fictional project, Fantasy Acres, are shown below.

Projected Returns

Pro Forma Expenses

Notice that the DSCR is below 1.0 and cashflow is negative in Y1. This is due to renovation expenditures and vacancy loss, so this dip in cashflow is a normal part of a value-add project.

50-year Market Measures

Testing the Assumptions

What happens if the pro forma assumptions aren’t realistic? To understand how cashflow and investor returns are impacted, we will adjust the numbers on the Fantasy Acres pro forma to see how the results change.

Interest Rate

Assumption:

Debt will remain at the assumed 3% interest-only rate throughout the life of the project.

Challenge Question #1:

What are the terms of the debt and how well can the project meet those terms throughout its lifetime?

The assumed debt terms are typical of a 2021-vintage deal:

• Floating rate; currently at 3%

• Interest-only for the initial term

• Five-year term with option for two one-year extensions

• Requires maintaining at least a 1.2x DSCR and no more than a 70% LTV

As projected, the project has a 70% LTC (not LTV on acquisition cost), and a skinny 0.98x DSCR in Y1 that is covered by the reserves. However, after Y2 and renovations are complete, the boosted NOI brings the DSCR to 3.57x by Y5. There is seemingly little threat from the floating rate debt.

However, recall that the floating rate debt is assumed to remain at 3% over the five-year hold time - although this rate is at the extreme low of the historic rate range. What if rates revert to the mean and increase?

In 2022 interest rates started to rise rapidly. By Y3 of our hypothetical deal, the floating rate interest had risen from the assumed 3% to 8%, which increased the debt burden by 2.7x. By Y3, reserves are tapped, and additional capital of $520,000 is added to the deal. Let’s assume the GP funds the cashflow gap themselves without altering the capital stack.

Note that the addition of capital can have dramatic effects on common equity investors. Depending on the subscription documents, the GP may have broad discretion to insert additional cash (and layers) into the deal.

Effect on Investor Returns

Although the debt burden nearly tripled, investor returns took a relatively modest hit of between 15% and 31%. But that’s just part of the story…

Effect on cashflow and return metrics

An abbreviated version of the pro forma is provided here to illuminate how the increased debt burden flows through all of the resulting calculations.

Note:

1. Debt payments rise far beyond the pro forma, ultimately growing by 2.7x.

2. Total free cashflow (shown in blue) goes negative quickly and consumes all reserves by the end of Y2.

3. An infusion of rescue capital in Y3 is required to restore reserves and ensure the project has sufficient cash to achieve stabilization - and positive cashflow - in Y4. But the rescue capital is not a donation - this is an additional layer of capital repayment obligations, as shown in yellow. However, due to the generous nature of the GP, this is added to their equity position with no preferred return accruing on it. A possible but unlikely scenario; rescue capital typically demands steep preferred rates of return.

4. Distributions (shown in green) were suspended until disposition.

5. The DSCR falls to half of the lender requirement in Y1 and Y2. A lender could call a loan at this point, but let’s assume the GP has a strong working relationship with the lender and convinces the bank to hold off based on the value-add performing to plan and a positive NOI being an imminent reality.

At this point, you may be wondering why rising interest rates are killing deals when this example shows only a small bump in the road. Well, debt has a shadow named cap rates who we’re ignoring for now, but the compounded effect of rising interest and cap rates will be illustrated in the market correction post towards the end of this series.

Challenge Question #2:

What if operating expenses increase?

The pro forma assumed average operating expenses of about 40% of revenues during the renovation period and a stabilized expense rate of 30% post-renovation. These are reflective of industry norms, but 2022 and 2023 saw material, labor, and insurance costs rise rapidly - effectively increasing operating expenses by about 30%.

If we factor in this 30% increase and raise the cost of operations to 52% during and 39% post-renovations, the cashflow is immediately impacted.

Effect on Investor Returns

The increased expenses coupled with the ballooning debt burden dropped investor returns by nearly 50-80% - nearly two-and-a-half to three times the impact of the increased debt burden alone.

Does it seem strange that a relatively small increase of 30% in expenses had a large effect on investor returns, yet the 2.7x increase in debt only decreased investor returns by 15% to 31%? Let’s look at the pro forma to see how this happened…

Effect on cashflow and return metrics

Here is the abbreviated pro forma with operating expenses modified.

Note:

1. Operating expenses (shown in purple) are 30% higher than the pro forma.

2. Free cashflow (shown in blue) goes negative in Y1 before recovering in Y4, reserves are depleted before the end of Y2, and an infusion of nearly $1M of rescue capital is required in Y3.

3. Distributions (shown in green) are not made as planned in Y1-Y4, but the sale still yields enough to fulfill the accrued preferred return due to equity investors plus a small promote. Let’s assume that again, the GP is very generous and self-funds the additional capital needed in Y3 as an addition to their equity position - a highly unlikely reality since the addition of $1M in capital placed as equity with the reward of a small promote is not a compelling financial arrangement for the GP. A more likely rescue capital scenario could be the addition of mezzanine debt or pref equity, which would have added an expensive layer to the capital stack that could erode some to all of the profits before reaching common equity.

4. The DSCR is below the required minimum of 1.2x for the life of the project. Again, we are assuming that the GP has a very generous banker that is willing to “extend and pretend” indefinitely. In a more likely scenario, the lender could require buying down the principal in order to meet loan performance standards. This would require yet more rescue capital, which - as illustrated above - could further compromise equity investors’ capital returns.

5. Sale price (shown in orange) is $4.5M (16%) less than projected. Sale price = NOI x cap rate; a reduced NOI automatically translates into a lower value. As the sole source of investor returns, the reduced sale value coupled with the absence of interim payments had severe impacts on the investment’s performance metrics.

Conclusion for Today

Not all metrics have the same effect on cashflow and investor returns. Although both operating income and debt burden reduced investor returns, the impact of operating income had the greater effect since depressed NOI flows directly into the exit valuation. Debt is not part of valuation, so the impact of debt is strictly on the cashflow without flowing through to the exit value.

So far, Fantasy Acres has been able to return all invested capital plus a modest return. However, this example has made some meaningful allowances in favor of equity investors: rescue capital was provided as GP equity without expensive interest or preferred returns, and debt buy-down to meet DSCR requirements was avoided. Both are possible, but unlikely outcomes. Had either or both of these scenarios occurred, common equity investors may have recognized capital losses.

Also, look at the risk premium: is a 7% IRR reflective of the risk position of common equity? It’s easy to look at a projected return of 23% IRR and accept that as fair compensation for risk. But that 23% is only attainable should everything go right. Understanding how and where risk occurs and erodes returns puts the 23% in the correct context for better understanding risk.

The next posts will continue to test variables in a vacuum until it all comes together as a market correction at the end. Once the mechanics are understood, I’ll show you how AI can expedite the process.

• Exit: cap rates and hold time

• Market Correction: when everything goes wrong

• AI Assist: how to use AI for stress testing

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This is Heuristics - where assumptions are called out and broken down so that you can invest with greater clarity.

In 2020 and 2021, asking rents on Sunbelt apartments were rising at double-digit annual rates. Phoenix was up 24%. Tampa was up 22%. Charlotte, Austin, Nashville - the returns were undeniable. New units were being absorbed before they were finished. GPs were pitching value-add multifamily deals with five-year hold projections that did little more than extend the steep upward ramp of rent growth like a flight path.

Two years later, the same submarkets were offering two months free on twelve-month leases. Lease-up timelines had doubled. Rents in several MSAs were down year-over-year for the first time in a decade. Deals underwritten in 2021 with assumed rent growth of 5% per year were left with a cash flow gap between the pro forma and reality that was rapidly consuming reserves and triggering capital calls.

The wise could see the folly of these forever upward revenues. But it doesn’t take decades of experience to see the warning signs; anyone can do it.

Let’s analyze the Fantasy Acres pro forma to see the signs that were ignored.

Pro Forma Baseline

Projected Returns

Pro Forma Rents

50-year Market Measures

Compare the assumed rental and vacancy rates used by the pro forma to the historic data provided here. A pitch deck will rarely provide this context, but it’s vitally important to consider.

How realistic do you believe the projections are?

Testing the Assumptions

What happens if the pro forma assumptions aren’t realistic? To understand how cashflow and investor returns are impacted, we will adjust the numbers on the Fantasy Acres pro forma to see how the results change.

Rental Income

Assumption:

Renovation will provide a 60% “lift” in rental rates from $1.90 per square foot to $3.00 per square foot.

Challenge Question #1:

What is the anticipated lift based on, and how realistic is that expectation?

Future rental rates for a property that are unproven are, essentially, made-up numbers. A figment of the GP’s imagination. If a project has not already achieved at least a small number of post-renovation rents to test the hypothesized rental rates, the next best option is comps. By reviewing rents for similar projects, a reasonably accurate guess can be made for the market rental rate. The accuracy of these assumptions is contingent on:

• Geography: Are the comps in the same neighborhood?

• Time: Are the comps recent?

• Quality: Are the comps and planned renovations and community of similar quality?

• Renter economics: Are the projected rents affordable to the resident population? What demographic trends are at play and why?

• Supply economics: How much new inventory is coming available, and what is the projected absorption rate?

Hopefully solid comparables are provided in the pitch deck to clearly illustrate how the rental rates were calculated. However, it’s prudent to check the provided data against industry data yourself to ensure the comps are accurate and not aspirational.

Challenge Question #2:

What happens if the renovations don’t achieve the anticipated lift?

If any one of the above-listed factors is inaccurate or changes during the life of the project, the assumed rental rate may not be the market rental rate. Since this is a 2021 deal, let’s assume the number of deliveries of new apartments was not accurately accounted for and the resulting flood of supply cut the rent lift in half to 30% ($2.45 sq ft) from the planned 60% ($3.00 sq ft).

Effect on Investor Returns

The result of a 55-cent lower rental rate is effectively 35% to 55% lower investor returns.

How can a 20% reduction in gross cash flow result in a 50% lower return? Let’s look at how the rental revenue flows through the pro forma.

Pro Forma

Adjusted rents

NOI is the driving number of investor results. As as result:

1. Distributions (shown in green) from free cash flow (NOI - debt service [shown in blue]) are depressed but sufficient to fulfill the LP pref return and the promote.

2. The sale price (NOI ÷ cap rate = value) is $5M (18%) less (shown in orange).

3. The reduction of distributions and terminal returns to investors reduced the overall cash returned to investors and the associated metrics.

You may be thinking, the returns aren’t so bad. But, lower rental rates are rarely the only factor at play. Softening market demand also increases vacancy rates.

Challenge Question #3:

What happens if market demand softens and both rental and vacancy rates are impacted?

Softening demand can result in a longer lease-up time and/or concessions (such as one month free) over the projected five-year hold. If we increase vacancy by 5 pts to 35% during the renovation period, and post-renovation to 15% (in addition to the reduced rental rates) the impacts are compounded.

Effect on Investor Returns

The combined effect of a 55-cent lower rental rate plus a 5pt higher vacancy rate is roughly half to three-quarters of investor returns wiped out, depending on the metric.

Effect on cash flow and return metrics

Pro Forma

Adjusted rent and vacancy rates

As NOI is depressed, the compounding effects become apparent:

• Reduced NOI results in a much lower valuation at sale, which results in a net negative in proceeds. There are not sufficient funds to fully repay investor capital from the sale.

• Cash flow remains positive in Y3 to Y5, but distributions are a fraction of expectations.

Investors were effectively returned all of their investment plus a modest return, but a small change to net income variables has destroyed most of investor returns.

Conclusion for Today

The seemingly trivial change to rental and vacancy rates had exponential impacts on investor returns. And notice what we did not change: Annual rent growth stayed at a healthy 5%. Debt remained fixed. Renovation came in on plan. And the “stressed” rental rate of $2.45 still sits above the 50-year mean of $2.10.

Recall the market history:

What happens when two assumptions break at once? When three do? When the cycle turns and they all break together?

That is the rest of this series. Because rents don't always go up – no matter what the pitch deck says.

Next in the Series

The next posts will continue to test variables in a vacuum until it all comes together as a market correction at the end. Once the mechanics are understood, I’ll show you how AI can expedite the process.

• Expenses: debt and operating costs

• Exit: cap rates and hold time

• Market Correction: when everything goes wrong

• AI Assist: how to use AI for stress testing

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This is Heuristics - where assumptions are called out and broken down so that you can invest with greater clarity.

“That’s enough, sit down.”

We were on slide three.

This was Entrepreneurial Finance. Week after week, team after team never made it to the end of their slide deck. The professors cut off presentations with the abrupt indifference of a guillotine.

“Where did you get that number? Why do you think that’s accurate? Sit down.”

Another week’s work, in the trash.

The weekly failure in Entrepreneurial Finance was the foundation for every success I later earned. The lesson was clear: the pro forma is a powerful yet fragile tool where one flawed assumption can result in a meaningless conclusion.

Understanding the Pro Forma

Pro forma mechanics are baseline knowledge for every accredited investor. A cornerstone of business school curricula, the pro forma is something anyone can learn to build, analyze, and stress test.

If you'd like a refresher on or introduction to pro forma mechanics, I recommend Accredited Investor Insights’ series on How to Read a Real Estate Pro Forma.

Just as crucial as the mechanics is understanding the source data and assumptions that are the foundation of the pro forma’s results. The product is only as good as the process.

Setting the Scene

The Pro Forma

I have created a fictional project and pro forma for “Fantasy Acres” with the following characteristics:

• Value-add, class B, multi-family project located in the north Chicago submarket.

• Purchase date is June 2021 with a five-year hold.

• Capital stack: senior debt, common (LP) equity, common (GP) equity.

• Waterfall: 7% cumulative common equity preferred return; 80/20 LP/GP split.

Market Data

To test the data assumptions, we need to compare the pro forma numbers to market data. The following shows the 50-year highs, lows, and averages for the same asset profile: class B, multi-family in the north Chicago submarket.

This type of framing is NOT typically provided in a pitch deck; few GPs frame their thesis this way. But, as an investor, you must understand where the business plan sits relative to historic market variations - that is the only way to assess the deal's true risk profile.

Conclusion for Today

How aggressive or conservative does the pro forma appear to you?

What assumptions are evident?

What questions do you have about the business plan?

Next in the Series

I will stress test the pro forma for changes to:

• Income: rental and vacancy rates

• Expenses: debt and operating costs

• Exit: cap rates and hold time

• Market correction: when everything goes wrong

I’ll also show how AI can make this process much more manageable.

Don’t miss the next part of this series. Subscribe for delivery to your inbox.

Subscribe now

This is Heuristics - where assumptions and short-cuts are called out and broken down so that you can invest with greater clarity.

Are you an Accredited Investor?

If so, you have certainly had to check the box to access many private real estate syndications.

How did this make you feel?

Special? Part of a secret club? Smart? Entitled?

Like a monkey with a knife?

What Exactly is an Accredited Investor?

Certainly sounds fancy. With such an appellation, one must certainly have some special skills or knowledge.

But what did you DO to get this special title that gives you access to restricted investment opportunities? Take a course? A test?

None of these?

The History of Accredited Investors

The term was coined in 1982, and was intended to apply to the top 2% of households. The purpose was to prevent people from facing irrecoverable financial hardship as a result of making bad investments.

Definition of “Accredited Investor”

An Accredited Investor is a person or entity that the SEC allows to invest in private, unregistered securities (like startups, hedge funds, or private equity). Since these investments don't have the same rigorous disclosure rules as public stocks, the SEC uses this status to ensure the investor has enough "financial sophistication" or wealth to handle the risk.

There are three ways to qualify:

• Income: >$200,000 (single) or >$300,000 (married) for both of the past two years.

-or-

• Net Worth: >$1M (excluding primary residence).

-or-

• Expertise: Series 7, Series 65, and Series 82.

The Accredited Investor Today

Note that the static “Accredited Investor” definition of 1982 has completely lost its intent of limiting access to the top 2% of households, as shown in the table below.

Nearly 20% of households now qualify as accredited. This has effectively expanded access to private offerings from the ultra-wealthy to the working rich.

The Take-Away

Being awarded accredited status is an accomplishment that may be well-earned. Having income or wealth at any of the levels mentioned is no small task.

However, the human brain can be easily misled to believe that access to private investments means they have the skills and knowledge necessary to navigate the complexity of such investments. But this is completely false and highly dangerous.

Money ≠ Skill

So take accredited for what it is: a pass to accessing the most complex and potentially high-risk investments available. It’s a responsibility, not an entitlement.

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This is Heuristics - where assumptions and short-cuts are called out and broken down so that you can invest with greater clarity.

Investor forums are full of finger pointing. But how often does that analysis extend to the plaintiffs? How many points of failure did the investor fail to see? to consider? to educate themselves?

I support transparency and sharing of information, but overlooking ourselves as part of the equation is missing a large - and possibly most important - part of the story.

Learn radical responsibility

The idea of radical responsibility is one of the most difficult yet liberating practices I have ever undertaken. I admit - it’s really, really hard. Oftentimes painful. Yet, it is the path to growth and ultimately better life outcomes.

Which of these two statements is more likely to result in learning and making a better choice in the future?

The GP did a poor job of underwriting the deal.

or

The LP did a poor job of underwriting their investment.

I prefer the latter. Which is why radical responsibility is the underlying principle of my work here. To review the infinite aspects of how we make decisions as people, as investors; review the data, the facts; and learn how we can do a better job of not only investing but living.

If you’re an LP looking to learn, you’re in the right place. Welcome.

If you’re looking to point fingers, I invite you to reconsider.