How To Know If Your Financial Model is Accurate?
Welcome to the Real Estate Espresso Podcast, your morning shot on what’s new in the world of real estate investing. I’m your host, Victor Menasce. On today’s show we’re discussing about how to handle seemingly contradictory data in your financial model in situations where you’re faced with a constant influx of incoming data.
When we undertake an investment project assessment, we follow a set of guidelines. These guidelines are more related to our investment criteria than anything else. Let’s assume we’re creating a financial model for an apartment building. We will conduct an area survey to find the most comparable buildings, taking into consideration factors like location, size, amenities and market position. If there are no valid comparable points within the vicinity of your property, comparison becomes a complex task. You will experience incoming data from other properties which might be quite misleading.
Take for example the nearest properties are much older and their rent is significantly lower, from this you might draw the conclusion that there’s no market for your brand new building at a price point that makes your numbers add up. One could always manipulate an Excel spreadsheet or any financial model to present data as desired, but this doesn’t necessarily mean that it accurately reflects reality.
We always commission an independent market study from a reputable appraiser. Furthermore, to construct our financial model, we ask our property manager to build their own financial representation of the property. After performing comprehensive market research, the goal is to be confident in your understanding of the market and not merely speculating. Your lender may apply a pessimistic factor to the rents in their version of the financial model. You might question their data if it doesn’t reflect the reality that you reported both in the market study and in the appraisal.
Projecting into the future is another area of contention, particularly with debates over the use of trended or untrended analysis in your forecast. Over the past century, inflation has had a significant impact and it would be unwise to bet against inflation in the future. Most institutional quality investors advocate for using untrended analysis during the construction phase. We don’t set the rate of inflation to zero forever, just during the construction phase.
The next question is deciding what assumption to make in terms of market cap rate. To get data for this, you may want to look at a recent appraisal or market study.
Regardless of how your lender decides to model your project, the project’s performance that you and your investors experience is only connected to the reality and not the financial model. Therefore, the accuracy of your financial model is crucial for it to reflect reality.
So how do you know what’s going to be accurate? Well, you would want to take time to understand your local market dynamics. Visiting rental properties and creating your own database of rental properties can significantly help in today’s environment where many properties are offering leasing incentives. These leasing incentives are usually temporary and they do not reflect the long-term averages, so treating them as having a long term impact on your rents in the financial model is overly pessimistic.
The only way to counter the market data meaningfully is to know your numbers better than an appraiser. By doing a deep dive into market research you will be on the right track. As you think about that, have an amazing rest of your day and go make great things happen. We’ll talk to you again, tomorrow.
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