In my post about calculating IRR, I promised to come back to the subject of making projections. Like many other aspects of buying commercial real estate, making projections is more of an art than a science. A friend of mine who works at a private equity firm likes to say, "All financial projections have one thing in common; they are all wrong!" His point is that despite the complex math involved, all acquisition models involve some, and often several, guesses or assumptions about the future. Some of these guesses are conscious, and some are not. For instance, in my example of the small retail property in downtown Reading, PA, we guessed that we could get a commercial mortgage at a 6.5% interest rate. This assumption was made consciously. We also assumed that the tenant would stay in business and pay its rent for the entire term of the lease. This was not an issue that I even mentioned while discussing the projections. Over the years I have found that most of the time it is the guesses that people don't realize they're making that tend to get them into trouble.
So what are some of the common assumptions that many people don't realize that they make when they purchase commercial property?
- The tenant will pay the rent
- Market rents will stay flat or improve
- TI costs will remain relatively constant
- The tenant will renew their lease
- Commission structures in the market won't change
- The property manager won't embezzle the rent
- The tax codes for real commercial real estate investments will remain unchanged
- The property won't be taken by eminent domain
- Aliens won't attack
- etc. etc.
Now clearly some of these assumptions are safer to make than others, but the more eventualities that you contemplate on the front end, the less likely you are to be surprised. I guess my point today is that it is easy to get yourself into trouble if you don't know what to consider while making your projections. One thing that I like to do at each point in my analyzes is to stop and ask myself, 'what assumptions have I made that I can't justify?' Hopefully this post has helped you start to think about the guess work involved in making financial projections. I know that it is much less concrete than calculating NOI or DSCR, but that's what makes it an art.
What are some of the unconscious assumptions you've made while analyzing commercial real estate in Reading, PA?