What is a financial model?
In short, a financial model is a mathematical abstraction of how a company works. In our case, our company is an investment property and the financial model is an excel spreadsheet with inputs that are linked through mathematical formulas to the outputs. The inputs are the assumptions that drive the financial model, things like, rent per square foot, acquisition/disposition cap rate, operating expenses, etc. The outputs are the income projections the model produces if the assumptions are true: return on investment (ROI), internal rate of return (IRR), and return on cost (ROC), etc.
Financial models are used to make investment decisions and to understand the financial significance of changing the assumptions in the property’s business plan. We use financial models to analyze every investment’s overall returns, and to answer specific questions such as, “what impact does raising rents by $0.25 per sq. ft. have on investor’s returns?”. If we change the input variable “rent per sq. ft.” the model will automatically calculate and provide the output to answer our question.
Why investors should care about financial models?
Investors should care about financial models because they are the primary tool used to evaluate an investment opportunity. Both active and passive investors should take the time to understand how to properly underwrite a property in order it mitigate investment risk. The first step to mitigating risk when underwriting a property is verifying the quality of the assumptions that are used in your underwriting model.
Garbage in, garbage out refers to the computer science concept that flawed or nonsense input data produces flawed/nonsense output data and the same holds true when underwriting an investment property. It is the investor’s responsibility to verify the assumptions that are driving the outputs of the financial model. If similar two-bedroom / one-bathroom units in the a 2-mile radius of the property are renting for $1.50 per sq. ft. and the financial model assumes a rental rate of $2.50 per sq. ft. that should raise a major concern about the quality of the financial projects that the model is producing. All of the financial model’s assumptions should be anchored to a reliable datapoint to ensure that the financial projections are as accurate as possible. Income assumptions (rent per sq. ft.) should be anchored to comparable properties in the surrounding area and expense assumptions should be anchored to trailing-12 month profit and loss statement for the property. If there is a large variance between the anchors and the financial model’s assumptions, make sure you understand why. A best practice as a passive investor is to independently verify the key assumptions in the financial model and to schedule a meeting with the general partner specifically to review the property’s financial model and their justification for the assumptions driving the model.
What are the parts of a financial model?
Every financial model should include the following tabs: assumptions tab, calculation tab, waterfall tab, and a summary tab. The assumptions tab contains all of the inputs that the underwriter hardcodes. These inputs will have a blue font color. Blue is the industry standard color for cells containing assumptions, this is derived Wall Street professionals who use a color coding system to easily identify which cells contain hardcoded inputs. The inputs on the assumptions tab should be linked through mathematical formulas to the cashflow tab where the property’s profitability is calculated. If the property is producing profit then those cashflows will be sent to the waterfall tab where the Limited Partner’s preferred return is calculated and the profitability of the project is split according to the waterfall schedule. Finally the information on the waterfall tab will flow through to the summary tab where investors can see a high level overview of the profitability of the investment.
Final thoughts
“All models are wrong, but some are useful – British statistician George E. P. Box”
Similar to a model airplane or car, our financial models are an abstraction of reality. The financial model will never be 100% accurate considering that it is based on assumptions which may or may not be correct but at the very least they should be as close as possible. However, financial models are the best tool we have for making projections about investment opportunities and are used to evaluate the risks and rewards of an investment. Although financial projections will never be 100% correct it is our responsibility as investors to verify and anchor the assumptions in the financial model to reliable datapoints to make our projections as accurate as possible.