From the startup of the investment process, there is a significant amount of due diligence that goes into the acquisition of a commercial property on behalf of our investors. We look at the property’s location, physical condition, ingress/egress, valuation, acquisition costs, required capital expenditures, and tenant mix to ensure these factors meet our investment criteria. More importantly, we also look at the property’s historic financial performance (Income Statement & Balance Sheet) and use this information to create a financial model or “proforma” to forecast cash flows over the course of the planned investment holding period, typically 5-10 years.
Because the length of time covered by the proforma is so long, forecasting cash flows to the penny is nearly impossible. However, using prior experience, it is possible for our financial analyst to create a model that is directionally accurate, whose output provides us with some idea of the property’s potential profitability.
Financial modeling and the associated cash flow analysis is more art than science, but there are a number of key steps that can be taken to ensure consistency and accuracy. In this article, we outline the steps to create an accurate financial model to calculate the potential profitability of a property.
Step 1: Obtain the Required Documents
The first step needed to create a financial model is to root it in the property’s prior performance. This means obtaining a number of key documents and statements that will assist in creating a baseline for the model:
Operating Statement
A property’s operating statement, sometimes referred to as a “Cash Flow Statement,” “T-12” or “Trailing 12 Months” is a financial statement that shows all of a property’s historical data for income and expenses in the previous 12 months. This statement is used to understand the “current” state of the property’s operations and how profitable it is.
Rent Roll
A property’s rent roll will list each of its tenants, what their monthly rental payment is, when their lease expires, and the total number of square feet they lease. This information should tick and tie to the income figure in the property’s operating statement and can be used as a basis for projecting future cash flows.
Bills
To verify line item expenses on the Operating Statement, it is important to ask for the property’s paper bills, including those for taxes, insurance, property management, payroll, landscaping, and maintenance. For example, if the property tax bill is $100,000, the line item expense on the income statement should also be $100,000. If it isn’t, it may be an indication that there could be an issue with the property’s recordkeeping.
Service Contracts
Many of a property’s expenses are contractual. For example, landscaping and maintenance expenses may be related to a contract. So, it is important to review the property’s existing contracts to understand what the expenses are going forward and when they change. These are important inputs into the model.
Leases
To verify income on the operating statement and to forecast future cash flows, all of a property’s leases should be obtained for existing tenants. They should be reviewed for key clauses like rental amount, expiration date, and payment escalations. The sum of lease payments should tie to the income shown in the Operating Statement.
With the documents in hand, the model construction process can begin.
Step 2: Creating the Model
Using the property’s documents as a guide, an analyst can begin constructing the financial model using the following steps:
1. Create the “Current” Scenario
As a first step, the analyst will create a current scenario, meaning they will model the property’s income and expenses based on the statements provided. When complete, it should match the trailing 12 months operating statement and each line item should be verified with supporting documentation.
2. Set Assumptions
This is where the art comes into the process of creating the model. Once the current scenario is complete, an analyst must decide on the assumptions that will be used to forecast future income and expenses. There are two major assumptions that must be made: the revenue growth rate and the rate of operating expense growth.
Revenue Growth Rate
With regard to income growth, many leases include built in “escalators” that are contractually mandated rent increases. This highlights the importance of understanding the terms of each lease, because these increases need to be modeled into future cash flow projections. When trying to do a quick assessment of a deal, an analyst may not have time to review every lease so, as an alternative, they may make a general assumption that income will grow a certain percentage each year. Usually, the percentage is meant to keep pace with or slightly exceed inflation so it may be in the 2% – 3% range.
Operating Expense Growth Rate
Regarding expense growth assumptions, they follow a similar logic pattern. For line item expenses that are governed by service contracts, there may be contractually mandated payment increases that must be built into the model. Or, in the absence of specific expense increases, a general assumption can be applied to all expenses, typically 1.5% – 2% annually.
3. Create the Model
With the current baseline established and the assumptions documented, the next step is to create the model itself. Typically this is done using a spreadsheet program like Microsoft Excel or, in more advanced shops, a real estate specific program like Argus. Each model is unique to the specifics of the property and the assumptions, but they generally contain the same line items so it is common for an analyst to work from a model template. When complete, it may look something like the table below (assuming a 5 year holding period):
Once complete, our financial analyst may perform something called “sensitivity analysis” on key model variables to determine how changes in one affect another. For example, they may run multiple scenarios with different vacancy levels to see how Net Operating Income changes. In some cases, they may also package the financial projections into a report, along with the key takeaways, to aid in the decision-making process.
Step 3: Calculate Potential Returns
The last line in the financial model is the key to calculating the potential return on the property relative to the initial investment. While each investor may have their own preferred return metrics, there are three that are commonly used:
Internal Rate of Return
IRR is the rate of return on each dollar invested, for each period of time it is invested in. It is often used as a proxy for the interest rate and mathematically, it is calculated as the discount rate that sets the Net Present Value of all future cash flows (positive or negative) equal to zero. In a model, the analyst will use the “IRR” spreadsheet function and the cash flows in the final line. It should be noted that some models may include a “Year 0” to reflect the initial investment, which is usually shown as a negative number.
Equity Multiple
An investment’s equity multiple is the sum of the cash flows received, divided by the cash invested. To calculate it from the table above, the Cash Available for Distribution columns are summed and divided by the value in the “Year 0” column. For example, if the sum is $100,000 and the initial investment was $50,000, the resulting equity multiple of 2.0x means that the original investment is doubled over the holding period.
Gross Rent Multiplier
The Gross Rent Multiplier is the ratio of a property’s purchase price to the income it produces (in year 1) and it is meant to indicate how long a property would take to pay for itself from its Gross Operating Income. The lower the number the better.
Discounted Cash Flow Analysis
In addition to the returns, the analyst may also perform a “discounted cash flow” or “dcf” analysis. Using the property’s free cash flow and a discount rate, they are about to discount the cash flows back to the current period to determine what price should be paid.
Setting Targets for Return Metrics
Each investor or investment firm has their own targets for the above return metrics and the purpose of calculating them is to see how they compare to the targets. If they aren’t close, the deal could be scrapped. If they are close, the analyst may go back to the model to see if there are line items that could be tweaked to reach the targets. If the metrics are met, the proforma can be used as a basis for the property’s budgeting process going forward.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating our own deals, we invest a significant amount of time and resources in the model creation and financial analysis for each potential investment. Through years of experience and dozens of deals, we have developed a repeatable, step-by-step process that we use to determine the most profitable deals for our investors. If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
