This informal CPD article, ‘Best Practices in Modelling Real Estate Transactions,’ was provided by Farley Cove who have built investment and development models for a range of real estate investments and operational businesses, including start-ups, and can provide ongoing analyst support.
In the world of financial modelling, achieving accuracy, flexibility, and ease of use is paramount. Whether you're building models for real estate investments or other financial analyses, here's a list of essential do's and don'ts to ensure that your models meet these objectives.
Essential do's and don'ts
1. Thorough Due Diligence Matters: Neglecting comprehensive due diligence is a fundamental mistake when modelling real estate assets. Accurate data is the foundation of sound financial projections. Always gather precise and up-to-date information on property expenses, rental income, market trends, and potential risks before you start your financial model.
2. Refined Rental Income Assumptions: Overestimating rental income is a common pitfall in real estate financial modelling. To avoid this, conduct thorough research on local market conditions, consider historical rental trends, and consult with local real estate experts for realistic rent estimates.
3. Consider Vacancy and Turnover Rates: Properties are rarely occupied 100% of the time, especially multi-tenanted ones. Therefore, it's essential to incorporate reasonable vacancy rates and turnover costs based on historical data and local market conditions. A conservative approach might include a general vacancy allowance.
4. Accurate Operating Expense Projections: Underestimating operating expenses can significantly impact your financial model. Ensure you include maintenance costs, property management fees, insurance premiums, and property taxes in your analysis. Don't forget to account for inflation and unforeseen expenses in your service charge budget.
5. Factor in Financing Costs: Financing is a critical aspect of real estate investments. Precise calculations of loan interest rates, SONIA, closing costs, and any associated loan fees are essential. Consider different financing scenarios to understand their impact on investment returns.
6. Don't Forget Tax Implications: Taxes can significantly affect the profitability of real estate investments. Avoid overlooking property taxes, income taxes, and potential tax incentives by consulting with tax professionals for accurate tax calculations.
7. Embrace Sensitivity Analysis: Building a financial model based on a single set of assumptions can be risky. Neglecting sensitivity analysis, which assesses how changes in variables (such as rent, expenses, interest rates, and yields) impact investment performance, is a common oversight. Create multiple scenarios and stress-test your model for more informed decision-making.
Excel Modelling
In the realm of Excel modelling, adhering to best practices is crucial for creating robust and user-friendly models. Here are six tips that help us produce high-quality models:
1. Simplicity and Transparency: Keep your model simple and transparent. Avoid unnecessary complexity and use straightforward formulas and assumptions. Document your assumptions, formulas, and methodology clearly for easy understanding and auditability.
2. Consistent Formatting: Maintain a consistent format and structure throughout the model, including fonts, cell colours, and naming conventions. This ensures ease of use for third parties or clients.
3. Separate Inputs and Outputs: Clearly differentiate between input assumptions and calculated outputs. Inputs should be easily adjustable without altering the core model. You can use color-coding to distinguish input and output tabs.
4. Prioritise Sensitivity Analysis: Perform sensitivity analysis to assess how changes in key assumptions affect your model's results. This helps identify potential risks and opportunities, ensuring the model's robustness.
5. Error Checking and Validation: Implement error-checking mechanisms and validation checks to catch data input errors and ensure data integrity. Use 'evaluate cell' functions to trace and check formulas.
6. Named Ranges and Cell References: Use named ranges for important variables and avoid hardcoding values directly into formulas. This makes the model more flexible and easier to update.
By adhering to these financial modelling best practices, you can create models that are not only accurate and reliable but also user-friendly and adaptable to changing circumstances.
We hope this article was helpful. For more information from Farley Cove, please visit their CPD Member Directory page. Alternatively, you can go to the CPD Industry Hubs for more articles, courses and events relevant to your Continuing Professional Development requirements.
