Do you frequently create real estate financial models? If so, do you have the proper procedures in place to test for accuracy and reliability? Financial models can be great at projecting future results to guide decision-making, but what happens if your model is incorrect? A mistake in just one input could create drastically different results.
This is where real estate financial model validation comes into play, ensuring accuracy in your financial models. In this article, we’ll cover the basics of validation in real estate financial modeling, including tactics to validate your models and the advantages of spending extra time testing for accuracy.
What is Validation in Real Estate Financial Modeling?
Real estate financial modeling validation is the process of testing the inputs and assumptions of a financial model. The goal of validation is to identify any incorrect data, broken formulas, or flaws in the model before it is used in the decision-making process. By identifying any errors and limitations, you are able to reduce the risk of negative consequences from flawed model outputs.
Validation in real estate financial modeling takes place after the model is complete but before it is used to make decisions. For example, you might put together the financial model, which is then reviewed by a manager before it’s sent to the owner. Sometimes, companies will hire an independent third party to review the accuracy of financial models when making high-level and costly investment decisions.
The Advantages of Validating Real Estate Financial Models
Real estate financial modeling validation offers a variety of advantages. Let’s cover a few of the advantages in more detail.
Reveals Potential Weaknesses
The first advantage of validating real estate financial models is the revelation of potential weaknesses. By going back through your model, you can detect errors and deficiencies that could sway results. For example, from the time you started building a model until the time it was complete, there could have been changes in the market that impacted your assumptions. Going back through and reviewing your work allows you to catch these changes and improve the accuracy of your model.
Strengthens Reliability
Reliable data is crucial when it comes to making real estate decisions. Validating your real estate financial model guarantees that you are making decisions based on reliable data. For example, if a new development project in your area was announced, it could result in prices appreciating faster. Going through the validation process allows you to catch these items, strengthening reliability.
Supports Informed Decision-Making
Informed decisions are based on data that your financial model creates. With a robust financial model that demonstrates different scenarios and options, you can make an informed decision that supports your financial goals. For example, you might find that creating two-bedroom apartments instead of three-bedrooms results in a 5% increase in profit. Uncovering these insights guides your decisions toward your goals.
How to Validate a Real Estate Financial Model
There’s no one-size-fits-all approach to validating a real estate financial model. In fact, the procedures that work best depend on the type of model you’re building. For example, a cash flow model would require the checking of rent rolls, while an acquisition model would require a review of similar transaction sale prices. Nevertheless, here are some strategies you can use to validate a real estate financial model.
Initial Accuracy Checks
Some of the simplest mistakes can derail your financial model results. The first strategy to validate your model is to check for input errors, such as transposed numbers, broken formulas, and missing inputs. Going through each box or segment of your financial model and verifying that the numbers are accurate is a great way to catch input errors. Remember, you want to check both your inputs and your formulas. A broken formula can create errors even if all of your inputs are correct.
Simulations to Test Model Assumptions
The next way to validate your real estate financial model is to actually run simulations. Test different assumptions and analyze the results. For example, if you are testing the financial impact of different purchase prices, input a few different amounts. Do the results make sense? If you input a higher acquisition price and the model kicks out more profitability, that’s an indicator that something is wrong. Take the time to use the financial model and make sure the results are accurate. Be sure you run numerous simulations, not just one. The more times you can verify the accuracy of the model, the better.
Comparison with Historical Data
Comparing your financial model with historical data is another great way to validate your real estate model. Cross-check historical data and see if your outcomes are similar. For example, if you just closed a similar real estate deal last year, enter the input factors to determine if the output matches the actual results. If your model kicks out results nowhere near what actually happened, you need to dig deeper into the differences.
Feedback from Industry Peers
A real estate financial model might seem to work well on paper, but it might fall short of projecting reality. Asking industry peers to review your financial model provides you with real-world input that can highlight overlooked details and incorrect assumptions. For example, maybe your industry peer notices that your interest rates seem low for the current environment or that there was a recent legislation passed that impacts fees. You might not uncover this information without getting feedback.
Summary
Are you already validating your financial models? Implementing initial accuracy checks, simulations, historical data checks, and industry peer feedback are four ways to validate your real-state financial models, but they aren’t your only options. To learn more about the financial modeling process and real estate finance, check out Wisdify’s extensive list of CPE-eligible courses.
Not only can you receive CPE credits, but you can expand your knowledge about real estate financial modeling validation, helping you better position yourself in the workforce and make more informed deal decisions. Reach out to a team member or explore Wisdify’s course catalog to learn more.