Real estate financial modeling is an increasingly popular form of sophisticated financial analysis used by investors. Financial modeling assumes you're an equity or debt investor in a property and uses a number of different metrics to provide you with a sense of the return on investment of a particular asset.
As investors grow and scale their real estate portfolios, becoming familiar with financial modeling is a logical progression to help ensure you're investing in the right assets. Here's an overview of real estate financial modeling for investors, the steps and metrics involved, and quick tips on how to protect your assets using defensive modeling calculations.
Foundations of real estate financial modeling
Financial modeling can be as complex or simplistic as you need it to be. As investors, we're comfortable with numbers, formulas, and metrics, but we're not all mathematicians or professional data analysts. And as with anything in life, there's a balance.
The foundation of real estate financial modeling for investors begins with understanding your strategy and action plan. Your financial modeling will be different if you're building a new apartment versus renovating an old one. Or if you're acquiring a new property and converting it, your modeling and pro forma will look much different than a standard resale purchase.
Here are the steps to take when undertaking real estate financial modeling.
Step 1: Decide what type of project you want to model
New acquisition? Renovation? Real estate development? Commercial? Residential? You not only need to know the type of project but the asset class as well. Options include office, retail, storage, residential, short-term rental, and more.
Step 2: Decide on the assumptions that will inform your financial modeling of investment scenarios
These include vacancy rates, rents, operational expenses, management costs, and the list goes on. If you're looking at building a new multifamily property, market rents will be a critical assumption, whereas if buying a resale, the rent rolls will give you that data.
These assumptions form the basis of your financial analysis, so investors need to be well-versed in their particular asset class and market to ensure they're making accurate financial pro forma models.
Step 3: Use steps 1 and 2 to inform and build your pro forma
A pro forma can be a simple spreadsheet or sophisticated software. Whatever your choice, you need to put all the numbers associated with a particular real estate transaction together to give you a holistic view of how that asset may perform under various circumstances. You may want to put more or less money down, increase rents, add or remove amenities to reduce costs or increase rents, and so on.
This step is critical and is often referred to as underwriting. If you skip or do this step incorrectly, you could be in for a world of financial trouble.
Step 4: Review the real estate pro forma metics
Internal rate of return (IRR), cash-on-cash return (CoC), and cash flow will allow you to model this investment as if you were a debt or equity investor in the project.
Do the returns look favorable from an investment perspective? How do they compare to the average returns of other asset classes? More on metrics in a moment.
Step 5: Make a decision, and consider the exit strategies
What opportunities exist to exit this asset if the numbers don't end up working out? Can you sell it? Sever and sell off units individually? Can you convert the space into a different asset?
Types of metrics in real estate modeling
Several important metrics are critical for investors performing real estate financial modeling. Depending on the type of real estate transaction you're working on, your time frame, and asset type, some metrics may be more important than others. Here are the critical ones:
- IRR: Your internal rate of return is a complex formula that combines the time value of money and the value of your real estate asset. IRR calculates your return on an annual basis and is a foundational metric for investors when considering an investment asset.
- Cash flow: This is the net amount of funds remaining at the end of a period -- usually monthly or annually. If this number is low or negative, your real estate modeling may have saved you from a poor investment choice.
- NOI: Your net operating income is the amount of revenue, minus all expenses excluding debt service. Your NOI gives you a yearly return figure, which can be combined with other metrics such as cap rate, to give you the overall value of an asset. NOI can be used in before-and-after scenarios, such as a renovation or development project.
- Cap rates: A capitalization rate, or cap rate, is a simple return on investment calculation. If you see a cap rate of 5%, you're roughly getting that return over a year's time. Cap rates are great to compare different assets and markets and also to factor in the cost of acquiring an asset. Cap rates are calculated using the value of the property and NOI.
Defensive real estate financial modeling
Now you know the basics of real estate financial modeling, but let's take it one step further and optimize your analysis to include the dreaded "what if" scenarios. What if vacancy skyrockets? What if tenants don't pay (not too far off from the headaches of 2020)? You get the picture. These are all defensive modeling techniques that help prepare you and your investors for the worst-case scenario.
Here are a few defensive strategies to consider as you build your financial modeling document:
- Vacancy: Factor in different vacancy scenarios into your real estate financial modeling. For instance, start with a 10% vacancy assumption, but move that up to 20%, 30%, and even 50%. What is the break-even point for this asset in terms of vacancy?
- Interest rates: In your modeling, you'll use an interest rate for your debt. What if interest rates rise? We are using 3% to 4% these days, but does this investment make sense if you increase that rate to 6%, 7%, or 8%?
- Appreciation: What if there's zero, or negative, appreciation over the next five years? Run some financial modeling to understand how your numbers look if there's a significant market correction and housing prices drop or stay flat.
- Capital expenditures (capex): What if you're stuck with a $30,000 roofing bill? Or your furnaces stop working? Or you're hit with a lawsuit your insurance doesn't cover? What if your project sees an additional $100,000 in cost overruns? Factor in major capex mistakes and overruns to see how your asset performs under that stress.
The bottom line
As investors, we must master real estate financial modeling to protect ourselves from bad decisions. Whether considering a new acquisition, real estate development, or a value-add project, you need to be able to explain in numbers and metrics the value of that endeavor. This is both for you and potential other investors involved in your real estate projects.
Using a mixture of your pro forma and investing metrics, you'll be able to accurately estimate whether a particular investment fits your goals and portfolio. Further, by leveraging defensive scenarios in your financial modeling, you can also forecast potential headwinds that could turn a good investment into a terrible one.