INTRODUCTION

For this edition of the White Paper, I sat down with Moyra Tran, our senior financial analyst here at 3E Management. We discussed her take on the topic of common financal modeling mistakes real estate developers make and if she has come across any in her time working for us.

"Over the years, I have built and reviewed hundreds of financial models. As a result, I have gained a detailed knowledge of how they work and the common mistakes developers make. I have created many financial models for various property types from scratch and audited a multitude of client models for private equity deals and was recently selected as one of the financial modelers of the year by the Financial Modelling Summit . Consequently, I see the same mistakes being made across the board whether the model is from a developer, investor, or lender. Above all else, in financial modeling it is important to make cashflows as accurate as possible. To create an accurate model that ensures correct results, these common mistakes should be avoided.

WHAT IS A FINANCIAL MODEL

Real estate financial modeling is a sophisticated form of financial analysis used by real estate developers, investors, and lenders. Financial models help one to get a sense of what returns should be expected from the deal by analyzing various metrics. Great financial models should be complex but simple to use. The formulas should be logically sound, but the model overall should be user friendly. A good real estate financial model can be the main decision-making tool in deciding whether a project should be developed or invested in. Financial models may include discounted cashflow analysis, sensitivity (or data) tables, and an in-depth evaluation. A real estate financial model can be the difference of valuing a project correctly and receiving a large return or incorrectly and losing money on a deal.

COMMON MISTAKES:

Treatment of Capital Expenditures

One of the most common mistakes that occur in real estate financial modeling occurs within the Net Operating Income (NOI). There is a longstanding debate about whether the capex reserves (funds set aside for future capital expenditures or long-term capital investments) should be included in the NOI or outside the NOI. In real estate financial modeling, the capex reserves should be included below the line or outside NOI because they are not related to daily operations. Not only does the seller profit more, but lenders are also more likely to give you better terms for your project. The NOI is important in real estate modeling because it is how you calculate the gross sales proceeds. To calculate the gross sales proceeds, one must sum the forward twelve NOI and then divide that sum by the cap rate. If the capex reserves are included in the line, the NOI is reduced. This in turn causes the gross sales proceeds to decrease. A lower gross sales proceed means a lower sale amount and a lower profit.

The NOI also impacts lender terms. Sometimes lenders calculate the amount of money they will lend you depending on the current value of your project. This is called the loan to value (LTV) method. The LTV method sums up the forward 12 NOI, caps the NOI, and then multiples it by the LTV percentage. By including the capex reserves in the NOI, the value of the project is lowered, in turn reducing the amount of proceeds you could receive from the lender.

Incorrect Lease-Up Schedules

Another common mistake that real estate developers make in financial modeling occur within the lease-up schedules. Often financial models never lease out all the units and never reach stabilization (one hundred percent occupancy). By not leasing out all the units, the revenues are being understated. To maintain a proper occupancy rate when developing a property, developers should check to be sure that all the units are leased.

In addition to not leasing all the units, I have also seen financial models not use a lease up schedule at all. Their models assume that one hundred percent of the units are leased up on day one of the project at delivery. It is extremely unlikely that all units will be leased up on the first day of leasing. Lease up schedules typically last anywhere from 6-12 months or even longer depending on the size of the project.

The third common mistake in real estate financial models within the lease up schedule is double counting vacancy. Sometimes financial models include vacancy in their lease up schedule. For example, if a project contains one hundred units and the vacancy is five percent, they will only lease ninety-five of the units. This method works but typically these types of models also include a vacancy line on top of the vacancy accounted in the lease up schedule. By adding an additional vacancy line, the model is now double counting vacancy and understating the revenues.

Waterfalls

Major mistakes in real estate financial modeling occur in waterfall calculations. These mistakes can lead to misinterpreted returns for investors as well as general partners. One should consider the legal documents to ensure that sponsor promotes are not miscalculated. When waterfalls are miscalculated, cashflows are over-distributed to one of the parties and under-distributed to others. Many finance professionals do not pay close attention to the agreements and make their interest compounding instead of non-compounding. Accruals can be calculated incorrectly by not cumulating or vice versa. Verbally communicating waterfall assumptions often leaves out the finer points and leads to miscommunication. If waterfall legal documents are readily available one should always refer to them for terms.

CONCLUSION

These are just a few of the most common mistakes in real estate modeling. These mistakes can be avoided (even simpler ones!) by double checking your work and reviewing the model. Implementing a process to review the final model can save millions of dollars lost or any headaches with investors and lenders. Consistency within financial models is key to producing an accurate model that is not only logically sound but can also easily answer any questions regarding the project. To make your financial model as accurate as possible, one should avoid these mistakes and apply best practices to their model".

Common Financial Modeling Mistakes Real Estate Developers Make