Demystifying real estate financial models

Real Estate financial models are mainly spreadsheets used extensively as an aid in decision support in the areas of property investment and lending. These spreadsheets will ascertain the present value of a stream of cash flows and generate risk / return ratios.

How do I create a real estate financial model?

Being proficient in real estate financial modelling takes years; in my case it took me over ten years. As a start, you will need a good grasp of financial theory, a mastery of real estate principles and advanced knowledge of Excel.

Having said that, you can create simplistic models featuring short-cut valuation techniques, such as conventional valuations and this can still be classified as a financial model. For that all what you need to know is some basic formulae and good intuition. These methods can be used for valuation purposes; however it is very unlikely that someone will make an investment or lending decisions based on short-cut methods these days.

In our Real Estate Investment & Financial Modelling class, we discuss this in more detail and show you a step-by-step approach to creating both short-cut and extended discounted cash flows.

Overall I would say that a proper real estate financial model should incorporate a cash flow projection with rents, costs, expenditures, borrowing, profit shares, taxes and risk simulations. Once these have been modelled, you will need a solid and defensible discount rate to estimate the present value. Financial ratios, such as IRR, cash-on-cash, return on equity, worth, and risk-adjusted return ratios such as the Sharpe Ratio will also need to feature in your financial model. Other than that, you should also need to add sensitivity, scenarios, simulations, graphs and a dashboard in order to portray the investment profile and create meaningful reports.

In our RICS Masterclass, we discuss risk calculations in more detail and show you a step-by-step approach to creating Sensitivity, Scenario and Monte Carlo analysis.

How important is it for real estate professionals to master financial modelling?

It depends hugely on how close you are to the investment and lending decision-making process: the closer you are, the more financial models are an integral part of your job. But to any real estate professional, a good understanding of finance, real estate and Excel are fundamental and cannot harm any careers. My opinion is that the more exposed real estate professionals are to the idea that property is a financial asset class, the more rational and sustainable the decisions will be overall.

Is financial modelling always done in Excel?

Yes but no. In real estate there seems to be a trend of extensively using Excel as aid in decision support. This differs from applications created by IT professionals, such as Argus.

As much as I love Excel for financial modelling as it gives me the flexibility I need, I know that for a business it can pose high risks due to being more error prone than standardised software applications. It will also increase costs as creating bespoke Excel models need specialised skills, which are far from cheap.

In the securities markets, banks and other financial institutions massively invest in IT infrastructure to build their own models in standardised platforms using Java, SQL, C++ and other programming languages. This is less so the case in real estate.

Therefore, Excel spreadsheets are still the industry’s application of choice but as long as the inputs and calculations are right, they should give a good estimate of value, risks and mitigating options to the investor and lender.

For further training in real estate financial modelling in Excel, visit Cambridge Finance’s Calendar page to find out more about our training programmes that can help you improve your financial modelling skills.