We have reviewed more than 500 cash flow reports and appraisals this year, and we are stunned by what we are finding. It is very common to find:
- “Updated cash flows” with home price assumptions that are much higher than we can negotiate in 5 minutes with the sales agent and significantly higher than the most recent closings in the neighborhood.
- “Supposedly conservative” assumptions of flat home pricing and rising sales rates in a market with foreclosures down the street and job losses in the metro area.
- Completely untrue statements that appear as caveats, such as “We have assumed that the property is fully entitled.”
- A high pro forma IRR on paper that is really a very, very low IRR when the proper assumptions are used.
Here are some tips for getting to the answer quickly:
- Challenge Third-Party Data: Anyone who relies on third-party new home prices, net of the real incentives that are difficult to uncover, is grossly overstating revenue. Some recent deals have been done using bad information, with a very happy seller and an upset buyer.
- Investigate the Caveats: Many of the caveats in an appraisal basically invalidate an appraisal. “We have assumed that the property is entitled” when indeed the property is not fully entitled and in fact is facing litigation over its entitlements may protect the appraiser in court, but it also renders the appraisal worth less than the paper it is printed on.
- Pay Attention to Costs: Everyone seems to have an opinion on the market, but it is cost overruns that are some of the greatest risks, particularly on partially completed projects where the budgets have not been updated.
- Ignore Your Auditor: The auditors are costing home builders hundreds of millions of dollars. All of the buyers and equity firms we are working for and who have announced major acquisitions recently are assuming further price deterioration, and we agree that further price declines are the most likely scenario. Yet builders and developers are assuming flat prices because they do not want to give ammunition to their auditors and, in turn, their bankers. That may be acceptable business practice and in perfect compliance with GAAP, but don’t use these cash flows to run your business or conclude that you have plenty of equity in your company. Call it a “downside scenario” if you must, but run your business according to the most likely cash flows you can project.
- Focus on Execution: All builders and developers will tell you that successful execution makes a huge difference. Since that is true, would a startup entity be able to execute a project as well as an established company with a great track record, very little baggage from the recent cycle, and only their best people remaining?
- Use the Right IRR With the Right Assumptions and Risk: A high IRR might look great, but if your assumptions are aggressive, your real pro forma IRR is very low.
In summary, the market is changing quickly and companies are being asked to perform analysis they have never performed before. Use the right information and you will make the best decisions possible.