How do you estimate the future cash flow of an apartment building? How about measuring the profitability of a tentative acquisition? Financial modeling is a fundamental component of real estate deals, helping investors and business owners project upcoming expenditures, costs, and profits.
There are four main types of real estate financial models: development, acquisition, cash flow, and sensitivity analysis. In this article, we’ll explore each of these financial models in more detail, including their potential use cases and real-life examples, giving you the necessary information to apply these models to your own real estate transactions.
Development
Before real estate investors or firms pursue a project, they need to test for feasibility. This includes evaluating the tentative appraised value, cash flow, upfront expenditures, and sources of funds. Although each development financial model will be slightly different based on your project needs, there are a few assumptions a development financial model covers:
- Property Details – The property location, land size, development type, number of units, and unit size are all assumptions that need to be outlined in your financial model.
- Development Timeline – The expected development timeframe, including the acquisition date, construction start dates, completion dates, and leasing start dates, are assumptions that should be found in your development financial model.
- Financial Assumptions – The cost of land, construction costs per square foot, sale or lease price per unit, sources of funds, and legal fees are outlined in a development financial model.
Development financial models are used for ground-up projects. This could be testing the viability of a parcel of land for residential apartment buildings or determining if tearing down a business costs less money than remodeling. Let’s say that your financial model projects a 15% profit margin if 80% of units are occupied. If your financial model isn’t projecting 80% occupancy for three years, you may need to change your sources of funds. This kind of insight is crucial for real estate development projects.
Acquisition
An acquisition financial model focuses on the long-term viability of an investment. This type of real estate financial model is commonly used to evaluate the profitability of a project, including closing costs, rehab costs, future appreciation, operating costs, and gross revenue. In addition, acquisition financial modeling is also used to determine if a quick resale is more profitable compared to a long-term hold. As a result, the following assumptions will be found in an acquisition financial model:
- Legal and Professional Costs – One of the largest expenses related to acquiring real estate are legal and professional fees, including commissions and due diligence expenses.
- Purchase Price – The purchase price of real estate is often negotiable. Acquisition financial modeling shows the financial impact of different purchase prices, helping you make an informed and profitable decision.
- Rehab Expenses – Distressed properties come with a financial cost, which is outlined in an acquisition model.
- Financing Sources – The capital structure of the deal, including the expected flow of funds and required investor returns, are outlined in this model.
- After-Rehab Value – Whether you are pursuing a quick sale or are implementing a long-term hold strategy, the after-rehab value impacts how much you’re willing to spend for the property.
- Income and Expenses – Rental income and operating expenses will also be outlined to back into the acquisition cost.
Let’s say that you want a 12% return on investment to pursue a deal. An acquisition model will evaluate the impact of purchasing the property at different price points to determine the price you can pay. For example, you might find that you need to put in an offer for $20,000 less than the list price to make the deal work.
Cash Flow
A cash flow financial model helps you determine if the cash inflows are sufficient to cover operating expenses and generate a profit. Using a real estate cash flow model is a common strategy applied to long-term holdings that generate regular cash flow. There are a few pieces of inputs needed to build a cash flow financial model, including:
- Revenue Volume – One of the main assumptions is current revenue levels, like gross rents. The occupancy rate will also be determined when pulling revenue volume.
- Operating Expenses – Operating expenses are all of the costs paid out of revenue, such as maintenance, property taxes, and insurance.
- Growth Rate – Revenue growth rate is used to view the impact on cash flow from increasing rents and occupancy rates.
- Capital Expenditures – These are large costs, such as putting an addition on one of the buildings or adding a fitness room.
These four assumptions give insights into how much cash is left over each month, where improvements may be needed, and how you can maximize profit. For example, you might find that rents need to increase by 5% each year to cover the cost of increasing insurance and property taxes.
Sensitivity Analysis
A sensitivity analysis real estate financial model measures the risks of a transaction under various market conditions. This type of financial modeling is commonly used to determine the viability of a real estate deal. The goal of sensitivity analysis is to analyze how changes in projections impact overall profitability and the deal structure. The factors included in a sensitivity analysis financial model will vary based on the goal. For example, if you were testing the impact of changing interest rates, you would pull the following factors:
- Interest Rates – Current and projected future interest rates will be worked into the calculation.
- Purchase Price – The purchase price of the property will be included.
- Loan Amount – The amount of the purchase price expected to be financed will be a core component.
Sensitivity analysis financial models will have a best-case, base-case, and worst-case scenario. For example, the base case for our interest rate model might be 5%. If interest rates rise, the worst-case scenario would be 6%, but if they drop, the best-case scenario would be 4%. Going through this information helps you make more informed decisions and adds transparency to your deals.
Summary
Are you ready to apply these four financial models to your real estate deals? If you are looking for more education surrounding financial modeling and real estate financing, head over to Wisdify to enroll in one of our CPE-eligible courses.