Under Promise, Over Deliver

Even good returns can be overshadowed by the disappointment of missed expectations 

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An opportunity’s projected return is an alloy of paradoxes: unknown and known factors, conservatism and optimism, past performance and projections.  Managers of those opportunities may benefit from incorporating an “under promise, over deliver” attitude in their presentations. 

Missed Expectations

One real estate investment company decided to move forward with an attractive, risk-adjusted opportunity.  They presented the projected returns to the investors in a reasonable way, cautioning investors that actual returns may vary from projected returns, of course.  They secured the investment, which went well for a time, however, unforeseen circumstances years later rendered their building more vacant than they had foreseen in their estimates, forcing them to miss the seven percent preferred annual return hurdle that year to their investors. More than one investor made efforts to liquidate their position because of this missed expectation.  

Despite reviewing the original documents which stated the risk of missing the preferred return and even losing money, these investors remained adamant about liquidation.

A Lesson

Regardless of the debate that can be had about the event, one point that both sides can concede is this: the impact of missed expectations should not be underestimated.   These unsettled investors (who were not new to investing but new to real estate investing) had apparently converted in their mind that the seven percent was less of a preferred annual return and more of the minimum return they should expect.  

Investors pulling out because of lower-than-expected returns is not new.  It happens in public markets, debt markets, real estate, private equity, and more.  Even when the investment is presented with adequate risk statements, investors sometimes learn that their own risk profile is much less tolerant of loss or missed expectations than they had previously considered.  

But how can managers and investors work together to manage these expectations?

Managing Expectations

One of the most successful methods for managing expectations is to lower projected returns and even lower preferred returns in real estate, even if all the data support higher figures.  Then, if an annual return exceeds the minimum projected returns, the manager can make a special annual distribution of the excess free cash flow to the investors.  Many investors would rather internalize an expectation of a lower return and then realize the distribution of a higher one, even if the actual investment return is the same in both scenarios.  This psychological reality is true for most people.  It is because of this truth that the adage “under promise, over deliver” was originally coined.  

Manager Responsibilities

A manager could leverage this psychological phenomenon by adjusting their preferred return from 7% down to 5% vis-à-vis a less optimistic occupancy or more aggressive inflation in vendor costs. While the presentation might not seem as compelling, seasoned investors would consequently view both the projections and the managers as more credible. 

Investor Responsibilities

An investor could do the same by tempering their own internal projections. They could research the average national annual real estate returns over the long term compared this particular opportunity, providing them with a time-tested frame of reference.  An investor should always be prepared for the worst-case scenario in any investment opportunity, but also allow hope for the best.

Wrap Up

Experience has shown us that, in investing, exceeding expectations trumps overexuberance.  A manager that prepares conservatively and employs the strategy of “under promise, over deliver” will more consistently impress his investors and exceed expectations. Those higher-than-expected returns can motivate high-level investors to turn their capital over to responsible managers repeatedly.