What Can Real Estate Financial Models Do For You?
A financial model is a hypothetical forecast of a real-world financial situation or decision.
Models are useful for all real estate professionals (and even non-professionals). They’re useful regardless of the stage of one’s career or the stage one is in with a given property—from pre-acquisition, underwriting, and pre-leasing, to decisions made during ownership, or even after a sale or expiration of lease term.
Most decisions that involve numbers can be supported and improved with the use of financial models—as long as they’re thorough, accurate and populated with quality inputs. We cover a few best practices for modeling here. Models can be used internally, intended for nobody but oneself or when interacting within your sphere of influence (team members, partners, service providers, investors, clients) to bring clarity and direction.
Simply put: the right models with quality inputs allow for better, faster real estate decisions. This means better results—as long as circumstances outside of one’s control cooperate.
The Character of Investor Decisions
Investors invest to receive a return on investment. The return they are seeking, whether it’s the lowest they’re willing to reasonably expect and/or accept or a lofty target, is based on the risk they are taking.
It’s reasonable to conclude that as an investor takes on more risk, they should receive more return. However, it is often true that taking on more risk does not yield a greater return. For example, as competition increases (in markets, by asset class, etc.), investors take on incrementally more risk (via higher prices) out of necessity. Rising prices can and do outpace net operating income, resulting in lower returns, despite taking on more risk.
Almost everyone who projects a certain investment outcome is aware that things may turn out different than they expect. The best they can do is determine their risk tolerance, figure out what returns they should accept, and try to make decisions within their control while striking an acceptable balance of minimizing risk and maximizing return.
In the course of each investment journey, all of the decisions that go into minimizing risk and maximizing return occur during the three phases of real estate investing: acquisition, hold-period, and disposition (which occurs during the hold-period but is a different animal).
Financial models can help with each of these three phases and are equally valuable for applications outside of a specific investment. Here’s a breakdown of how financial models help investors, brokers, and other professionals make investment decisions, learn and grow in their fields, and collaborate with others.
So, What Can Real Estate Financial Models Do For You?
Determine investment returns.
Returns are often the basis for decisions around all facets of a real estate investment and its various phases. During the acquisition phase, financial models can help you understand which properties to buy, which sources of equity/debt should be used, and the target acquisition price and terms. Using financial models throughout the hold period can inform which repairs or improvements should be made and when, whether debt or equity should be replaced, whether the terms of debt or equity should be changed, whether a property should be held or sold, and if/how the strategy should be changed. During disposition, financial models can tell you the right asking price, the range of acceptable sale pricing, and the range of likely sale pricing.
Project several outcomes based on the possibility of variances between actual outcomes and projections.
Investors often run multiple models for the same property and use-case, using different inputs for variables in which their assumptions may be inaccurate. For example, you may run variations of a model using different times to complete a project, different construction budgets, etc.. A sensitivity analysis using changing stress variables can achieve this goal.
Project several outcomes based on if/when market conditions change or in case primary assumptions are incorrect.
As every investor knows, markets can change suddenly and dramatically. Creating different versions of models showing the impact of various market conditions can help with game-planning how one would handle negative outcomes, like lower than expected debt service coverage, declining property values, etc.
Keep track of past deals, progress on goals, and changes in performance.
Keeping a history of not only deals done, but also details around the performance of past deals, helps an investor refine future acquisition criteria and garner insights from the best and worst deals they’ve done. Keeping detailed records can also be used to earn the confidence of partners, lenders, or other stakeholders.
Partnering and Collaborating with Others
Communicate with a common language and fill gaps in knowledge by sharing and collaborating.
People can get lost in stories. Numbers serve all parties as a mutually understandable middle-ground from which adjustments can be made, justified, easily explained, and agreed upon by all parties. With numbers, very little gets lost in translation.
Win funds and influence people.
Models help people understand, and when they understand, there is a better chance of getting on board with an idea or venture. By starting with a model derived from well thought-out inputs, an investor can start a conversation and guide others through their research, opinions, and thought process—all helping them gain momentum. Models of previously done deals that achieved some level of success can also be used to inspire confidence in others.
Be the “expert” who knows the numbers and can help others.
Models help leaders and those in a position to make decisions justify current or future recommendations or actions. Doing this helps others gain clarity and gives them an opportunity to voice their opinion, whether they are in agreement, need further explanation, or disagree.
Learning + Growth
See new perspectives.
Seeing a model for the first time can open you up to new ways of getting the results you need. Sometimes this means seeing new perspectives or performance metrics that you weren’t considering, and other times it means realizing that you omitted certain critical input prompts or entire sections of inputs that are relevant.
Expose new insights.
Once a project is underway or complete, looking back at models that were completed before acquisition can uncover some very eye-opening tendencies (or flaws) in critical assumptions that lead to significant inaccuracies. Those who are always looking ahead can fail to catch these mistakes and continue to repeat them.
Explore how others analyze and make decisions.
Seeing the construction of models and the presentation of performance metrics from others highlights what others think is important. Whether or not there is agreement on the importance of a given metric or display of information, this can lead to a better understanding of what questions others care about, which can be used when presenting information.