Your Model will Always be Wrong, Make Sure it's not Too Wrong

There are many important things to keep in mind when creating financial models. I have learned a lot by working through various models and refining them with help from my colleagues. For one, we as humans are generally optimistic and tend to be liberal in our assumption-making. Keep this in mind and also have people check your work to push back on inputs that might seem unrealistic. 

Awareness is key to understanding where your biases lie and making sure you do not get too aggressive. Aggressive, and unrealistic, underwriting has led to terrible business decisions and was one of the causes of the last recession.

Another important thing to remember when creating financial models, of any kind. DO NOT HARDCODE. If you are a hardcoder then hopefully someone will correct you some day or else: 

There are very few cells that should be hardcoded in a financial model. Your model should flow through when you make changes, so ensuring that as few as possible cells are hardcoded will increase the integrity of your model. When you hardcode, make sure that you comment on the cell where you got that number from so you, and anyone else who looks at your model, does not spend hours trying to track down the reasoning behind a single number. If you want to maintain the efficiency and integrity of your model, don't do hardcode. 

Refine, refine, and refine again. For the nth time, your model will never be right, but that does not mean that you cannot get it as close as possible to reality. Getting updated construction bids, interest rate quotes, rental rates, etc. will make sure that your model is as accurate as possible. And it will need to be unless you want endless questioning from investors, your lenders, and anyone else who plays a role in the development process that views your model.

Creating a financial model is the preliminary process to see if a deal meets your criteria as an investor or developer. If it does, great, you will look at this deal more closely and allocate greater resources to see if it could turn into a real development. If it does not pass the litmus test in the beginning, you can try to refine your model and see if you are being too conservative; after checking it again, you might find that the deal is not viable, and move all of your work to a dead deals folder to rot away until something changes.

At some point, a viable deal will get to the point where you will right an LOI, letter of intent, to purchase the property for development. After an agreement is reach, your deal will finally become more of a reality, and after a period of time for due diligence and closing, you will finally be the proud owner of a piece of land and begin construction soon.

This is clearly an oversimplification of how the underwriting process plays into the development of a piece of real estate. The main point is that: this step is important, and is the basis for your entire development. However, the model is not the end all be all. It does miss some of the intangibles of real estate, even though it tries to take them into account.

A development can look great on Excel, and even be somewhat realistic, but there are still underlying real estate principals that should never be forgotten, including: location, location, location. Location is paramount to a real estate investment; it will determine the rents a property can obtain, the likelihood of even obtaining tenants, and especially the price of the property once it is sold. 

Learning how to underwrite deals has been a big learning goal for me and I know I have a lot more to learn before I can do this process by myself. Thank you for following along with me and I hope you learned something new!

Farewell, friends.

The Last Piece: The Development Budget

Budget Summary

The last assumptions component of the model is the development budget. The Budget Summary is an overview of the budget, giving total costs, hard and soft costs, and land costs. Hard Costs are associated with the actual construction of the property: developing the site by demolishing buildings, moving around dirt, etc. and the vertical construction of the new buildings. Soft Costs are other costs associated with development, including: architectural design, third party reports, development fees, taxes and insurance, business expenses associated with the development, furnishing the new units, other fees and reserves associated with the lender, and a contingency/developer fee which is in place to pay for unexpected costs, and whatever is leftover will be given to the developer.
Sources & Uses breaks out where the funds for the project are coming from and a high-level overview of how they are being used. Generally, sources are solely equity or debt, but some projects also have varying funding sources. Uses are the top-level line items like construction, taxes, and contingency.

Development Budget

The broken-out development budget is largely based off of previous developments. The main variable is the actual construction of the property which is based off of the number of units but also uses previous developments as a market to see the price of construction per unit. This is where different variable would be added in such as, if the apartment community will have a pool, a parking garage, or any other large construction expense. Other line items of this budget include everything else that the developer must spend funds on to reach a completed development.

The rest of the budget does not require new assumptions to be created for each new deal. Components like Appraisal and Printing tend to stay the same for different deals. Fixtures, Furniture, and Equipment (FF&E) can be different for different developments, and you can garner this number from whoever is in charge  of the design. Any of these line items can be adjusted if anything major changes in terms of taxes, insurance, reserves & fees, etc. Having a general contractor and experienced construction professionals will help you make this aspect of the financial model as accurate as possible.

Summary:

• The Development Budget is your roadmap to where the money is being spent in the project
• Hard Costs: costs associated with the actual construction of a tangible building
• Soft Costs: expenses dealing with the non-construction development activities like legal fees

How Will the Property Run Once it is Built? The Operating Assumptions Section

The Operations Assumptions section pertains to the more micro details of the apartment complex: income, expense, unit mix, and payroll assumptions. This is the second part of the model that I began learning about. Many of the aspects of this section are abstract finance and real estate concepts that are hard to visualize or understand without experience in the business. As a result, many of the assumptions in this section are based off past results and altered as needed based on new macro and micro economic conditions and other factors that relevant to specific markets and types of developments.

Income assumptions are important to the model. Rent growth decides how your current rents will grow in future years; having this around the rate of inflation is generally a safe assumption. Loss to Lease is the real estate term for renting apartments below market rents. If Market rents are $1,000 and you rent an apartment for $990 then your Loss to Lease (LTL) is 1%. 1% is a safe assumption considering you price your market rents correctly—meaning, you do not make your rates too expensive. The LTL is a direct reflection of your confidence in both the development (its location, and general draw to tenants) and the property management’s ability to accurately price and effectively lease units. Vacancy Loss refers to how much of your property you think will be vacant; rarely is an apartment community 100% occupied, because people are constantly moving in and out. Researching the average vacancy for the area in which you are developing the property can give you a guide of what vacancy loss should be. 6% is a safe number in this case.

Bad debt is a small figure which refers to tenants not paying their rent. Rent concessions are specials offered when apartments need to be leased; if you believe you are building in a good area and pricing your apartments correctly, large concessions should not be necessary to lease a property. Non-Revenue units are usually models to show prospective tenants on tours because you cannot rent those out to tenants; office/staff units are usually prorated units for property management employees. Other income is made up of utilities and cable reimbursement, and anything else like mentioned in previous blogs, including parking.

Expense Assumptions 

This is where you estimate the amount of expenses your property will have. This is a little easier than income assumptions because data can be used from previous developed properties. Starting out with inflation, 3% is a safe number. The expense categories will grow at the rate of inflation.

The following assumptions are yearly figures and mainly based on comparable data from existing assets. Administration and General includes legal counsel, accounting work, insurance, office supplies, etc. Grounds refers to landscaping and keeping up the property in good shape. Management fee is how much the property management company charges you to run the apartment community from leasing to maintenance and everything in between. 3-4% is a normal rate for property management. Maintenance and marketing are self-explanatory; there are going to be maintenance issues with units over time and through use, and the apartments must pay for marketing to make customers aware of the property. Redecoration includes costs after a tenant moves out and is a mixture of the turnover rate—what percentage of tenants leave after their lease expires—and the cost per unit of redecoration. Utilities are mainly based off of historical data in a similar market. The same is true for insurance, and taxes. Replacement reserves run similarly to previous properties and act as an “savings account” in case something does not go as planned.

Unit Mix Assumptions

This is a major aspect of a development because it helps decide how many units you will have in the property and how many bedrooms the units will have. This can change how big the building is and how much rent it brings in. One bedroom units tend to be the most desirable to build, with two bedrooms behind ones, and three bedrooms behind twos. Deciding on the size of the apartments (Square footage) and the rent depends on market research. Looking at what comparable apartments charge and what their unit mix and sizes are will inform the decisions made in this section. This is an estimate and will be continually refined up until construction.

Payroll Assumptions

Payroll assumptions are the last piece of the puzzle. The rule of thumb is that there will be one in, one out for every 100 units. One in means a property manager or leasing agent who works in the leasing office, and one out means a maintenance employee. The salaries for these positions are generally taken from looking at market rates for these positions.

Summary:

·       Operating Assumptions: How you expect the property to operate once construction is finished

·       Income Assumptions: Higher level estimates of aspects that affect a property’s income

·       Expense Assumptions: Deal mainly with the ground-level assumptions of expenses necessarily to running an apartment complex

·       Unit Mix Assumptions: How many units of each floor-plan do you expect to have

o   Important to pay attention to Square Footage and Rents!

·       Payroll Assumptions: 1 in 1 out for every 100 units; how much are you going to spend on the people needed to make the property run smoothly

My next blog will cover the Development Budget, the final assumptions section of the model. I had no clue about any costs pertaining to construction of commercial properties before going into this learning goal experience, so it was very interesting learning about this part of the development process.

Investment Assumptions: The Starting Block

Welcome back. It's finally time to open Excel!!

One more thing to note, before beginning. There are three font colors used in financial models: blue, black, and green. Blue numbers are hard-coded, meaning the user types the number into the cell. Black numbers are calculated based on numbers in the same sheet in which the calculation is taking place. Green numbers are calculated based on numbers in other sheets in the workbook. This is important to note so the calculations and assumptions are made clear for the user and other viewers of the model.

For the multifamily development model I have been working with, there are seven main sections: investment assumptions, operations assumptions, budget, cash flow waterfall, stabilized cash flows, draw schedule, and amortization schedule. The tabs that include assumptions are the two assumptions sections and the budget; the other components take the information in the first three sections and calculate the necessary information. For the purposes of my blog, I will focus on the sections containing assumptions, and briefly overview the other sections which are calculated based off of the assumptions. *Any dollar figures here are made up purely as an example*

Investment Assumptions

This section deals with the high-level investment, from a 10,000-foot view as opposed to a ground level view. It is broken up into financing, project costs, equity, disposition, construction, and other assumptions. The financing tab is extremely important, because it deals with where the majority of funding—the debt—is coming from and how much it costs. However, the inputs on this section mostly come from recently completed deals or the source of debt funding, and is therefore a section that is very realistic and does not require much deep thought. It is the first aspect of the model that I learned to complete, and serves as the basis for the rest of the underwriting process.

The Project Costs section feeds in from the budget and encompasses all of the costs necessary for the project. The Equity section is calculated from the investment assumptions tab. The total equity is the total uses minus the loan amount, minus any other aspects that do not require equity, like: a land contribution made by a partner in exchange for equity, or reserves that the lender might require you to keep.  The “Preferred” and “Promote” cells deal with a common private equity investment structure. Preferred returns, if present, are paid out to the investors of the deal, while the promote is paid out to the “sponsor” of the deal, the person or entity who puts it together and pretty much does all of the work. These factors play into the cash flow waterfall which will be discussed later.

Other Assumptions are generally on a case-by-case basis and not a major component of the model. The Disposition section is important for to arrive at the final return. The “Exit Cap” is the cap rate at which the property will be sold, and is generally assumed to be a little higher than current cap rates for similar deals, to be conservative. This assumption can drive returns if changed even by a quarter of a percentage point.

Lastly, the Construction section plays a big part into a multifamily development deal because buildings can be leased while other buildings are still under construction. Because the timing of cash flows affects return metrics like IRR, this is an important component. In this model, about 5% of the construction is projected to be completed per month. This can change deal to deal, depending on density of the development and any special circumstances associated with site development or permitting. The first move in month and leases per month determine how quickly the project will be “stabilized” or operating at peak occupancy. These numbers are generally gleaned from previous developments to try to garner as realistic a number as possible. The months to stabilization cell is calculated based on the first move in month, leases per month, and the vacancy loss which is part of the operations assumptions tab.

Overview of the remaining components:

• Budget: Development budget encompassing every aspect of constructing the buildings
• Waterfall: A statement which shows cash flows to the partners in the deal each year and after the property is sold, and shows the return rates for the deal
• Stabilized Cash Flows: The statement which shows every line-item that has to do with the property after it is constructed and concludes with the Net Operating Income.
• Draw Schedule: Deals with the construction of the property and where the money is coming from
• Amortization: Shows how the loan is being paid off every month.

Summary:

• Color code your financial model to be clear!
• Investment Assumptions are high-level factors in a project
• Key drivers include:
• Financing—where the money is coming from
• Disposition—how much the development can be sold for in the future
• Construction—when will the project start delivering units and reach stabilization

For my next blog post, I will discuss the Operations Assumptions and Budget components of the model.

Two Real Estate Terms you MUST Know (and an overview of underwriting)

The most important figure needed to value commercial real estate is NOI—Net Operating Income. I mentioned this concept in my last blog post, but I want to add a little detail. It is a real estate specific metric because, when calculated, it exhibits a property’s money-making ability which is what investors, lenders, and other professionals care about. Real estate is a highly leveraged and depreciated asset class, so other financial metrics do not accurately capture the revenue potential of real estate investments like NOI does.

NOI is equal to all property revenues minus operating expenses. Revenues are mainly from rents which tenants pay, but can also include income from late fees, charging for parking in a parking garage, renting out the roof to a cellular company to place a cell tower, or even from a vending machine. These line items are considered “Other Income”, and can add—sometimes significantly—to the value of a property. Operating expenses include anything that is necessary to run and maintain the entire property: property management fees, insurance, utilities, property taxes, maintenance, etc. Depreciation, amortization, debt payments, and capital expenditures are not included in operating expenses.

Maclennan Investment Group

Once NOI is calculated, the next step is determining a capitalization rate for the property. A cap rate, as it is referred to in the industry, is simply the NOI divided by the value of the asset. If the NOI for a property is $6 and the property is worth $100, then the cap rate is 6, or 6%. Often times, cap rates are used to determine the value of property as opposed to vice versa. Based on comparable properties, and properties types (office, retail, multifamily, etc.), cap rates can be determined to use as a basis for imputing value. If we know that the cap rate for a multifamily property is 6, and the NOI is $6, then we divide $6 by 0.06 to calculate a value of $100 for the property. The lower the cap rate is for a property, the higher the value will be. Multifamily properties tend to have lower cap rates than property types like office and retail because apartments are viewed as a safer investment. Back to finance: the riskier the investment, the higher the return, or the higher the cap rate.

Forbes

Underwriting (!!)

We are finally to the fun part, the actual practice of underwriting a real estate property.

First off, a disclaimer: all financial models are different (and not created equally). Each person in my office has a different way of underwriting deals, but they all boil down to the financial return metrics which is what investors and developers care about. Some are more advanced and polished than others, but if correctly built, should have the same outputs. Secondly, a financial model is simply a set of assumptions that flow through a framework, to spit out return metrics and show you how a property could potentially perform.

FINANCIAL MODELS ARE ALWAYS WRONG. Always. There is probably a greater chance of winning the lottery as correctly predicting the future performance of a real estate asset. Knowing that a model is always wrong, the goal is to refine your underwriting to get as close as possible to the most likely scenario. It is a process, and continues until a building is purchased or a development is completed. In my next blog, I am going to give an overview of the various aspects of a model, delving into the specifics of the assumptions part of the underwriting process.

DO NOT READ If You Are a Real Estate or Econ/Finance Major!, Part II

The last piece of the puzzle is the underwriting.

What is underwriting? Investors, sales brokers, lenders, appraisers, and other real estate professionals underwrite, or value, potential deals to determine an estimated value for the property or portfolio of properties. Every entity involved in a real estate transaction will underwrite the asset to figure out what they think it is worth so sound business decisions can be made. 

How do we value commercial real estate? Whereas residential real estate is mostly valued based off of the price of recently sold comparable properties, Commercial Real Estate is generally valued based off its future cash flows and the assumed value of the property when sold at a future date. To value something based on future cash inflows, you must discount those values to give you a figure that works in today’s dollars. What do I mean by today’s dollars? This is where the finance comes in...

I promise, it's not that bad. The saying is: a dollar today is worth more than a dollar one year from today. Let that marinate. A dollar today is worth more than a dollar one year from today.

This is called the Time Value of Money and is an economic principle that has to do with inflation—a general increase in prices and fall in the purchasing power of money—and opportunity cost—the loss of potential gain from other options when one alternative is chosen.  

Over time, money buys less and less. For example, our parents could go to the movies for around $2 in the 1970s and now it costs an average of $9, due to prices inflating. Vanderbilt tuition in 1960 cost about $400 per semester but over time prices have increased (in addition to a plethora of other factors) and now a semester of tuition costs more than 60 times the 1960 value. There are two types of inflation, cost-push and demand-pull, but you can explore those on your own if you're interested.

Skye Gould/Tech Insider

Opportunity cost relates to this because there are ways to make money by using your money. You can do this by generating interest, money paid at predetermined intervals at a specific rate in exchange for the use of money lent, or investing in something that generates a return. 

If you sign up to receive $1 a year from now, you are missing out on the multitude of investment opportunities available to you today that could increase the value of that dollar. Those investments could result in more than $1 a year from now: this is why, all else equal, I might pay less than a dollar today instead of waiting a year to get that same dollar. The present value (PV) of the dollar should be less than the future value (FV) of the dollar because of the time value of money. The formula for PV is below.

Let's say for sake of example that the rate of return is 3%, the FV is $1, and the period is 1. Plugging that in to our formula, the PV of that dollar one year from now is 97 cents. It might take a while to understand this concept, but it is foundational to being able to understand how to value real estate. This is what we call discounting cash flows. The cash flow of $1 in 365 days is discounted to today's dollars to a value of $0.97.

Using the cash flows we predict that a property will generate, minus reasonable expenses, will allow us to use a discounted cash flow model to predict what those future streams of cash flows are worth today. These are the basics of how you value Commercial Real Estate!

Summary:

• CRE professionals value properties through underwriting
• Cash flows are mainly used to value CRE
• A Dollar Today is Worth More than a Dollar One Year from Today!!
• Future cash flows must be discounted to today's dollars to determine a present value

This is a lot to digest, but without this knowledge, one cannot understand how to reach valuations for properties. The next blog post will cover the details of valuing real estate and an overview of the components of a CRE financial model. Each step of this process gets us closer and closer to the development process, and actually constructing a tangible building. Stay tuned, folks.