Building financial models is an art. The only way to improve your craft is to build a variety of financial models across a number of industries. Let’s try a model for an investment that is not beyond the reach of most individuals – an investment property.
Before we jump into building a financial model, we should ask ourselves what drives the business that we are exploring. The answer will have significant implications for how we construct the model.
Who Will Use It?
Who will be using this model and what will they be using it for? A company may have a new product for which they need to calculate an optimal price. Or an investor may want to map out a project to see what kind of investment return he or she can expect.
Depending on these scenarios, the end result of what the model will calculate may be very different. Unless you know exactly what decision the user of your model needs to make, you may find yourself starting over several times until you find an approach that uses the right inputs to find the appropriate outputs.
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On to Real Estate
In our scenario, we want to find out what kind of financial return we can expect from an investment property given certain information about the investment. This information would include variables such as the purchase price, rate of appreciation, the price at which we can rent it out, the financing terms available fore the property, etc.
Our return on this investment will be driven by two primary factors: our rental income and the appreciation of the property value. Therefore, we should begin by forecasting rental income and the appreciation of the property in consideration.
Once we have built out that portion of the model, we can use the information we have calculated to figure out how we will finance the purchase of the property and what financial expenses we can expect to incur as a result.
Next we tackle the property management expenses. We will need to use the property value that we forecasted in order to be able to calculate property taxes, so it is important that we build the model in a certain order.
With these projections in place, we can begin to piece together the income statement and the balance sheet. As we put these in place, we may spot items that we haven’t yet calculated and we may have to go back and add them in the appropriate places.
Finally, we can use these financials to project the cash flow to the investor and calculate our return on investment.
Laying Out the Model
We should also think about how we want to lay it out so we keep our workspace clean. In Excel, one of the best ways to organize financial models is to separate certain sections of the model on different worksheets.
We can give each tab a name that describes the information contained in it. This way, other users of the model can better understand where data is calculated in the model and how it flows.
In our investment property model, let’s use four tabs: property, financing, expenses and financials. Property, financing and expenses will be the tabs on which we input assumption and make projections for our model. The financials tab will be our results page where we will display the output of our model in a way that’s easily understood.
Let’s start with the property tab by renaming the tab “Property” and adding this title in cell A1 of the worksheet. By taking care of some of these formatting issuing on the front end, we’ll have an easier time keeping the model clean.
Next, let’s set up our assumptions box. A few rows below the title, type “Assumptions” and make a vertical list of the following inputs:
Initial Monthly Rent
Annual Rent Increase
In the cells to the right of each input label, we’ll set up an input field by adding a realistic placeholder for each value. We will format each of these values to be blue in color. This is a common modeling convention to indicate that these are input values. This formatting will make it easier for us and others to understand how the model flows. Here are some corresponding values to start with:
The purchase price will be the price we expect to pay for a particular property. The initial monthly rent will be the price for which we expect to rent out the property. The occupancy rate will measure how well we keep the property rented out (95% occupancy will mean that there will only be about 18 days that the property will go un-rented between tenants each year).
Annual appreciation will determine the rate that the value of our property increases (or decreases) each year. Annual rent increase will determine how much we will increase the rent each year. The broker fee measures what percentage of the sale price of the property we will have to pay a broker when we sell the property.
The investment period is how long we will hold the property for before we sell it. Now that we have a good set of property assumptions down, we can begin to make calculations based on these assumptions.
A Note on Time Periods
There are many ways to begin forecasting out values across time. You could project financials monthly, quarterly, annually or some combination of the three. For most models, you should consider forecasting the financials monthly during the first couple years.
By doing so, you allow users of the model to see some of the cyclicality of the business (if there is any). It also allows you to spot certain problems with the business model that may not show up in annual projections (such as cash balance deficiencies). After the first couple of years, you can then forecast the financials on an annual basis.
For our purposes, annual projections will cut down on the complexity of the model. One side effect of this choice is that when we begin amortizing mortgages later, we will wind up incurring more interest expense than we would if we were making monthly principal payments (which is what happens in reality).
Another modeling choice you may want to consider is whether to use actual date headings for your projection columns (12/31/2010, 12/31/2011,…). Doing so can help with performing more complex function later, but again, for our purposes, we will simply use 1, 2, 3, etc. to measure out our years. In Excel, we can play with the formatting of these numbers a bit to read:
Year 1 Year 2 Year 3 Year 4…
These numbers should be entered below our assumptions box with the first year starting in at least column B. We will carry these values out to year ten. Projections made beyond ten years do not have much credibility so most financial models do not exceed ten years.
On to the Projections
Now that we have set up our time labels on the “Property” worksheet, we are ready to begin our projections. Here are the initial values we want to project for the next ten years in our model:
Equity Line Bal.
Owned Property Value
Add these line items in column A just below and to the left of where we added the year labels.
The property value line will simply project the value of the property over time. The value in year one will be equal to our purchase price assumption and the formula for it will simply reference that assumption. The formula for each year to the right of the first year will be as follows:
Where B14 is the cell directly to the left of the year in which we are currently calculating the property value and $B$7 is an absolute reference to our “Annual Appreciation” assumption. This formula can be dragged across the row to calculate the remaining years for the property value.
The annual rent line will calculate the annual rental income from the property each year. The formula for the first year appears as follows:
B12 should be the “1” in the year labels we created. $B$10 should be an absolute reference to our investment period assumption (the data in our assumption cell should be an integer even if it is formatted to read “years,” otherwise the formula will not work). B5 should be a reference to our monthly rent assumption, and $B$6 should be an absolute reference to the occupancy rate.
What this function says is that if our investment period is less than the year in which this value is to be calculated, then the result must be zero (we will no longer own the property after it is sold, so we can’t collect rent). Otherwise, the formula will calculate the annual rent, which is the monthly rent multiplied by twelve and then multiplied by the occupancy rate.
For subsequent years, the formula will look similar to:
Again, if the investment period is less than the year in which this value is to be calculated, then the result will be zero. Otherwise we simply take the value of last years rental income and increase it by our annual rent increase assumption in cell $B$8.
Time to Exit
Now that we have forecasted property values and rental income, we can now forecast the proceeds from the eventual sale of the property. In order to calculate the net proceeds from the sale of our property, we will need to forecast the values mentioned above: property sale price, broker fee, mortgage balance and equity line balance.
The formula for forecasting the sale price is as follows:
This formula states that if the current year (B12) is equal to our investment period ($B$10) then our sale price will be equal to our projected property value in that particular year (B14). Otherwise, if the year is not the year we’re planning to sell the property, then there is no sale and the sale price is zero.
The formula to calculate broker fees takes a similar approach:
This formula states that if the sale price for a particular year (B18) is equal to zero, then broker fees are zero. If there’s no sale, there’s no broker fees. If there is a sale then broker fees are equal to the sale price (B18) multiplied by our assumption for broker fees ($B$9).
Our mortgage balance and our equity line balance we will calculate on the next worksheet, so for now we will leave two blank lines as placeholders for these values. Our net proceeds from the property sale will simply be the sale price less broker fees less the mortgage balance, less the home equity line balance.
Let’s add one more line called “Owned Property Value.” This line will show the value of the property we own, so it will reflect a value of zero once we have sold it. The formula will simply be:
B12 refers to the current year in our year label row. $B$10 refers to our investment period assumption, and B14 refers to the current years value in the property value line we calculated. All this line does is represent our property value line, but it will show zero for the property value after we sell the property.
On to the Financing
Now let’s model how we will finance the property acquisition. Let’s name a new tab “Financing” and add the title “Financing” at the top of the worksheet. The first thing we need to know is how much we need to finance.
To start, let’s type “Purchase Price” a few lines below the title. To the right of this cell make a reference to our purchase price assumption from the “Property” tab (=Property!B4). We will format the text of this cell to be green because we are linking to information on a different worksheet. Formatting text in green is a common financial modeling convention to help keep track of where information is flowing from.
Below this line, let’s type “Working Capital.” To the right of this cell, let’s enter an assumption of $5,000.00 (formatted in blue text to indicate an input). Our working capital assumption represents additional capital we think we’ll need in order to cover the day-to-day management of the investment property. We may have certain expenses that aren’t fully covered by our rental income and our working capital will help make sure we don’t run into cash flow problems.
Below the working capital line, let’s type “Total Capital Needed” and to the right of this cell sum the values of our purchase price and working capital assumption. This sum will be the total amount of capital we will need to raise.
A couple lines below our “Total Capital Needed,” let’s create a capital sources box. This box will have six columns with the headings: source, amount, % purchase price, rate, term and annual payment. Two typical sources of capital for acquiring a property are a mortgage and an equity line of credit (or loan). Our final source of capital (for this model anyway) will be our own cash or equity.
In the sources column, let’s add “First Mortgage,” “Equity Line of Credit,” and “Equity” in the three cells below our sources heading. For a typical mortgage, a bank will usually lend up to 80% of the value of the property on a first mortgage, so let’s enter 80% on the line for the first mortgage under the % purchase price heading (again, formatted in blue to indicate an input value).
We can now calculate the amount of our first mortgage in the amount column with the following formula:
B5 is a reference to our purchase price and C11 is a reference to our % purchase price assumption.
In the current market, banks are reluctant to offer equity lines of credit if there is less than 25% equity invested in the property, but let’s pretend that they are willing to lend a bit. Let’s assume that they will lend us another 5% of the property value in the form of an equity line. Enter 5% (in blue) in the equity line of credit line under the % purchase price heading.
We can use a similar formula to calculate the equity line amount in the amount column:
Now that we have the amount of bank financing available for our purchase, we can calculate how much equity we will need. Under the amount heading in the row for equity, enter the following formula:
B7 is our total financing needed. B11 is the financing available from the first mortgage and B12 is the financing available from the equity line of credit. Again, we’re assuming that we’ll have to cough up the cash for anything we cannot finance through the bank.