Essay

Why I Read the Return Last

A projected return is a projected output, not a fact. I want to understand what produces it first.

Tim Fergestad

Almost every deal I am shown opens with a number.

It is on the first slide, usually in the largest type on the page. Sometimes it is a target return, sometimes a projected multiple, sometimes a range with the word “conservative” nearby. Whatever form it takes, it is the first thing my eye lands on, and it is placed there on purpose.

I have come to treat that number as the least useful place to start.

Not because it is dishonest. Most of the people showing it to me believe it. It is the least useful place to start because of what it is: a return projection is not a fact about a deal. It is an output. It is what falls out the bottom of a spreadsheet after a series of assumptions have been entered at the top. Change any one of those assumptions and the number changes with it, and nothing about the building, the neighborhood, or the person running it has changed at all.

Leading with the return is like reading the conclusion of a paper and skipping the methods. The conclusion is where the author tells you what they found. The methods are where you find out whether to believe them.

The assumption doing the quiet work

In Every Investment Is a Hypothesis I wrote that every projection is a stack of assumptions wearing a suit, and that two or three of them usually carry the weight. In value-add multifamily, one of the assumptions doing the most quiet work is the exit cap rate.

The cap rate is the relationship between a property’s net operating income and its value. Divide the income by the rate and you get the price. Which means a lower cap rate produces a higher value on exactly the same income, and a higher one produces a lower value on exactly the same income. Nothing has to happen to the building for that number to move. It moves because the market’s appetite moves.

Through 2021 and into 2022 I read a great many underwriting models that assumed the exit cap rate would be equal to the entry cap rate, or lower. The reasoning was rarely stated, because it did not feel like an assumption at the time. It felt like a description of the world. Cap rates had been compressing for years. Capital was abundant, debt was cheap, and everyone buying had watched everyone before them get paid for that continuing.

That is the moment to ask the question from the pillar: what else could explain this?

Cap rates had not been falling because of anything intrinsic to the assets. They were falling because of a set of conditions sitting underneath them, and those conditions were not permanent features of the world. The problem was not that they were certain to reverse. Nobody knew that. The problem was that the underwriting treated their continuation as though it were certain.

That is the failure. Not a bad forecast. An unpriced uncertainty presented as a fact.

What actually happened next

At the same time, expenses began moving against many of those models.

Property taxes rose in some markets as assessed values caught up or properties were reassessed. Insurance costs climbed sharply as replacement costs and risk pricing increased. Neither expense cared what the original underwriting had projected, and neither waited for the business plan to work.

Revenue growth slowed. Expense pressure increased. Net operating income compressed. Then cap rates widened.

Value got hit from both directions: less income, and a lower multiple on that income.

Equity is the thin layer at the top of that stack, and it absorbs the difference. A move in the exit assumption that looks small on a page can consume the entire projected gain of a deal, and it can do it without a single unit going vacant or a single thing going visibly wrong at the property.

None of that was hidden. It was sitting in one cell of a spreadsheet, on a tab most people never opened, while the number on the first slide got all the attention.

The order I actually use

I invert the order. Not the depth of the diligence, the sequence of it.

The operator, first. Not the biography or the pitch. I want to know what this person has actually done, how they behaved when something went wrong, what they told investors while it was happening, and whether realized results resemble what they originally underwrote. A capable operator cannot make bad economics disappear. But a weak operator can destroy perfectly good economics.

The business plan, second. What has to be true for this to work, and how many of those things are inside the operator’s control versus handed to them by the market.

The structure, third. Where I sit in the capital stack, what the debt looks like and when it matures, what the fees are and when they get paid, and what the documents say happens when things go badly. The legal terms are the part nobody enjoys and the part that decides what actually happens to you.

The return, last. By the time I get to it, I already know what it is made of.

By the time I get to the return, I am not evaluating the number. I am checking whether it is consistent with everything I just learned.

A projection that is out of step with the operator, the plan, and the structure is not an opportunity. It is a red flag.

There is a great deal more to say about that first step, and specifically about separating an operator’s skill from a favorable decade. That is its own piece and it is the one I am writing next.

Why the order matters more than the effort

Here is the uncomfortable part, and the reason I do not simply resolve to be disciplined and leave it there.

Whatever you read first sets the frame for everything after it. If the return goes in first, every subsequent piece of information gets sorted into evidence for or against a number you have already absorbed. You are no longer evaluating the deal. You are building a case. And because you are intelligent and diligent, you will build a good one.

My training was molecular neuroscience, not behavioral psychology, so I am not going to invent a tidy neural explanation for what happens when someone reads an investment deck. I do not need one. The practical problem is simpler: once a number becomes the target, intelligent people become very good at finding reasons it might be right.

We are also not calm, objective processors of investment material. We are people, looking at something that promises to change our lives, usually on a timeline someone else set. Wanting it to be true is not a character flaw. It is the default condition. The mistake is expecting to out-discipline it in the moment.

So design a system that protects you from yourself. Not a system that makes you smarter. One that makes the order of operations something you decided in advance, when nothing was at stake and no one was waiting on your answer.

That is all a checklist is. It is not a substitute for judgment. It is a way of ensuring your judgment gets applied to things in an order you chose while you were calm, rather than in the order someone else’s deck presented them.

A simple test

If you are evaluating a deal, try one thing.

Cover the return. Physically, if it helps. Then read the rest of the package and write down, in one sentence, what has to be true for this to work. Then find the exit assumption, wherever it is buried, and ask the sponsor to defend it. Not “what is your exit cap rate,” which invites a number. Ask what has to remain true about the market for that assumption to hold, and what happens to investor capital if it does not.

The quality of that answer will tell you more than the first slide ever could. An operator who has genuinely stress-tested their own thesis will have an answer ready, because they have already had this argument with themselves. One who has not will reach for the trend.

A good story is something someone tells you. A good deal is something the facts support.

Read the number last, and you get to find out which one you are holding.

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