What is Real Estate Financial Modeling? Here are the Basics You Need to Know.
Real estate is a numbers game.
Whether you’re an investor, broker, or service provider, nearly all decisions regarding an asset merit quantitative analyses to increase the likelihood of a desired outcome.
Being proficient in real estate financial modeling (or having a team that is proficient) separates the dabblers from the producers, the theorists from the objective analysis-based action-takers, and ultimately, the majority from the top performers.
Picking the right questions to ask, running the right numbers well, and presenting the results in a compelling manner, is the most valuable skillset in the real estate pro’s toolbelt.
What Is Real Estate Financial Modeling?
A financial model is a hypothetical forecast of a real-world financial situation or decision.
More simply, a model tells a story about numbers using numbers. Models add an analytical framework to one or many inputs which consist of facts and assumptions. A completed real estate financial model will outline the amount, source, and timing of money going into a project as well as money coming back out.
In the real estate world, financial models not only tackle abstract representations (e.g. a multi-year cash flow model showing the projected performance of an income-producing real estate asset) but also generate facts based on the inputs of other facts (e.g. populating a loan amortization schedule by inputting facts about the loan such as origination date, interest rate, and amortization).
How is Real Estate Financial Modeling Done?
For real estate applications, a financial model is often a spreadsheet-based analysis that contains three basic elements: prompts, inputs, and results.
Prompts indicate the facts or assumptions you need to provide about a property, and can relate to a sources of income, expenses, loans, hold period decisions, market assumptions, taxes, partnership details, etc. If something affects a real estate investment and it has to do with numbers, it can likely be added to a model to yield greater accuracy or additional useful data.
Inputs are the facts and assumptions, a mix of descriptions and numbers that you enter based on the prompt.
Results are the output of the model, a product of number-crunching which is organized and displayed in varying levels of detail and quality. Results can be a single dollar figure, a series of cash flows, one or many related performance metrics that can be pulled from the model, charts, graphs, insights, and more.
Who Uses Real Estate Financial Modeling?
Whether you’re one of the top real estate developers in the nation or dabble in real estate investing on the side, financial modeling and analysis is a key part to your success.
Here’s a brief look at how each participant might employ financial modeling in their day to day:
Brokers: A broker’s job is to win listings and get those listings sold—and financial modeling helps them do both. To win a listing, brokers can stand out and add value to prospective clients with their ability to think critically about a specific asset and educate the client on why their unique perspective and recommendation can improve the client’s outcome. To sell a listing, the broker can dominate the logical side of buyers’ brains by doing the legwork to present different perspectives of a property that could lead to previously unforeseen benefits: better value, cash flow, returns, etc. The right financial model, showing the right metrics, presented well, can be the reason clients sign a listing and buyers pursue a deal.
Investors: Investors spend most of their time generating leads, underwriting deals, executing hold period strategies and making hold-period decisions around leasing, renovating, financing, and holding vs. selling. While the results of a given model can be open to interpretation by the subjective opinions of stakeholders as to what components or metrics are important, coming to an agreement on which model is useful for a given situation and what inputs are within an acceptable range is a relatively easy undertaking.
Service provider: Like brokers, service providers (lenders, loan brokers, advisors, attorneys) have to attract and engage clients and nurture client relationships to get paid. To keep clients happy and to advise them appropriately and fulfill fiduciary duties, service providers have to present relevant information in compelling ways that enable clients to learn what is worth consideration and ultimately take appropriate action. Financial models can bridge the gap between a client’s vague understanding and a clear view of a situation.
Everyone else: Maybe you’re looking to make improvements on your house and you want to see if it makes sense based on increased resale value. Or maybe you’re just wondering if it’s better to rent or buy, or rent out your property versus sell it. There are many scenarios in which someone not professionally involved in real estate would need to employ financial models.
The Results: From Modeling to Decision-making
Financial models are the primary tool that enable real estate participants to answer fundamental questions about how each decision impacts financial performance, and to do so unambiguously with a high probability of acceptance across professions, geographies, and preferences.
To get the most out of a financial model, it helps to develop a sound grasp of basic real estate finance principles, such as the time value of money and the various types of return/performance metrics (cash on cash, leverage, IRR, etc.).
Analyzing the results of a model can mean different things to different people—all depending on your role in real estate and what you’re modeling. For instance, if you’re an investor and you’re running an analysis to show the profitability of a short term investment, you may just be looking for one number and one metric, e.g. dollar profit and return on invested capital. However, if you’re a broker doing a discounted cash flow model, you may want to visualize the results with a detailed table showing detailed line items along with an interactive graph showing net operating income growth and half a dozen performance metrics.
The key takeaway here is that the quality of the results are directly related to the quality of the inputs and the model itself. The better your understanding of the factors involved—property details, market information, finance concepts, etc.—the better your chances of getting accurate information that leads to the right actions.
As they (not sure who) say when it comes to financial modeling: “garbage in, garbage out”.
Onward and Upward
The exciting part about the financial side of real estate is that the learning never ends. One can always find a new opportunity that requires asking new questions, or find a new model that does a better job of answering questions.
There is a reason that real estate professors and some of the best minds in finance are, self-admittedly, not successful real estate investors. And it’s not for lack of trying. There is simply more to being successful a real estate professional, and if often involves hitting the pavement and getting real-world experience.
From my career in real estate (asset manager, commercial investment sales broker, investor), advice from mentors, candid conversations, interviews with successful brokers and investors with unique niches, and simply observing those around me, here’s what I realized:
When it comes to the financial side of real estate—analysis, opinions and related decisions—the vast majority of people fall into one of two categories: they know what they don’t know or they don’t know what they don’t know.
And taking action with incomplete information can be costly. I’ve lost deals, missed opportunities to get clients, made poor investment decisions, advised others incorrectly and have made other errors that aren’t coming to mind (probably because I don’t want them to). I can clearly point to what would have helped me in many of these situations: better financial models that helped me identify what information and questions were important and would get me the right results.
I co-founded Dropmodel to help keep the “not knowing” to a minimum.
Our ultimate goal with Dropmodel is to help real estate professionals become better investors and/or advisors, with our platform and our content.
Thanks for joining us—more to come!