Understanding the fundamental principles of real estate development and acquisition is paramount. All real estate models encompass general concepts, but certain underwriting models also have unique elements. For instance, the approach to residential real estate differs from self-storage, and mixed-use acquisition / development and rent varies from build and sell condo development at a granular level. However, they all share certain common features. Once you grasp these foundational pillars, a myriad of creative strategies can be devised, scrutinized, and assessed. An effective model aims to be versatile, minimizing the need for tailored logic with each transaction.
Along the way of building custom real estate models for many clients (large and small) here are the real estate models I've come up with.
Key Concepts
Understand the general deal structures. You will have to figure out how the deal is getting financed (debt vs equity), timing of investments, debt usage, and advanced financing structures like preferred return vehicles. To get an idea of what much financing is required, you must model the core business activity so that the final result shows periodic cash flow / cash requirements.
Core business activity. Are you modeling a construction project or an acquisition?
If it is a construction project, is it build and sell or build and rent?
For build and sell real estate modeling, you are going to focus on the timing of construction costs (all up front, evenly spread over the construction period, or hard coded costs that are defined on a monthly basis). This will depend on the type of equity backers as well as the general contractor terms. You are going to want to separate out key line items for all hard and soft costs.
Hard costs are things like construction materials, land acquisition, equipment rental, labor, and anything that can be directly attributed to constructing the building / structure.
Soft costs include things like architectural and design fees, Legal fees and permits, Inspection and surveying costs, Insurance and bond premiums, Financing (interest) and loan fees, Administrative and overhead, Marketing and sales expenses.
Next up within a build and sell construction project model, you need to figure out how much to sell the units for or building, the timing of those cash inflows / any related fees, and how the returns of the project compare to the initial investment (with things like cash-on-cash return, MOIC, IRR).
Note, this structure could include all kinds of financing structures layered on top of it as well. You could have a fund, LP/GP structure, or it could be a single operator that is funding all costs. It could just be a simple construction loan that covers 80% of the estimated costs (this is why you need to create a budget) and then the other 20% comes from investors / operators. You pay the loan back when you sell the units or building and whatever is left is profit. The idea being that you can sell what you have just constructed for a healthy markup on the costs.
Let's jump into build and rent real estate modeling now. This could be for mixed-use, residential, self-storage, mobile home parks, short-term rentals, multi-family, hotels, or what have you. Most of the models I've built for this are usable for both new construction or acquisition because of how I structured the assumptions for initial purchase / construction cost schedule inputs. I've got a pretty clever structure for debt and REFI flows as well that I use in many of the above models.
For build and rent, you need to know the timing of cash requirements. Are you raising all the money up front or in tranches as you need it? This will affect the IRR of investors if you are displaying that metric. If you are not, then a total cash-on-cash return doesn't care about the timing, but rather the total costs vs total return.
The build and rent model is often done on a monthly basis so you can properly delay when rent starts vs the construction period. For example, if it is an 18-month construction period where units are finished throughout that entire time, then it is important to understand when the first rents start coming in and returns can be tracked. It won't matter much in year 5 or 6, but for the first 36 months this is important so you can plan out working capital flows between construction costs and rents.
Generally, for this kind of a project you will get a construction loan and/or preferred equity financing. The construction loan will often be interest only (possibly accrued interest or paid) and then once the construction period is over and rents are stabilized, you would REFI that to a regular principal and interest loan that can be paid off as rents are collected. Note, this is where occupancy assumptions and interest rates are important to sensitize. It is vital to know at what point you can no longer service the debt (use the debt service coverage ratio).
For build and rent models, the timing is typically 10 to 20 years. In that time, there could be multiple REFIs as well as a potential exit. On these, you want to use a cap rate for the exit valuation (less any selling fees). So, if your exit cap is 6%, then you take the annualized net operating income on the exit year (or trailing 12 months if it is not a fiscal year you end on) and divide that by the cap rate. I like this method rather than estimating an annual appreciation of the property, but you can do it either way.
Operating Assumptions
For build and rent, you need to have a pro forma that shows your gross rental income, operating expenses, debt service, depreciation, and cash flow. The depreciation is a non-cash item and often will be complex (especially if you are doing a cost segregation study) but it will help determine tax liabilities. I include it in the more advanced real estate underwriting models. Net Operating Income (NOI) is equal to the gross rental income less operating expenses. Cash flow is then based on Net Operating Income less interest and principal payments. Sometimes there may be expenses such as GP management fees and those will hit below the NOI line and be considered an expense of the project. GP fees are income to the GP and expenses of the project.
Usually, the operating expense assumptions will be fixed per month and possibly increase over time. You may also want to account for property management fees and those are one of the only variable expenses, often being based on a percentage of rent. Property management fees (hit the pro forma before NOI) are different from GP management fees.
Rent Forecasting
I am kind of working backwards here, but the next thing you need to know how to model is how much rent is expected to be collected over the holding period. This is going to vary depending on the type of real estate. Generally, you have an initial expected occupancy rate, an improvement in occupancy, and a stabilized occupancy rate. That rate is applied to the maximum potential rent. It may vary depending on unit types or square footage, depending on how rental income is being denominated. Also, the rent may increase at different rates in the initial few years compared to the stabilization years. That is more likely to happen in acquisitions, but every situation is a little different. The key is to have assumptions that are dynamic enough to handle any rent increase scheme.
Often there may be other income sources. This can be modeled as 'other ancillary income', or you can break it down into specific buckets depending on the source. It may be pet rental fees, parking fees, pool pass fees, laundromat income, or all sorts of different small revenue streams.
Acquisition and rent real estate modeling is very similar to build and rent. The main differences are that instead of an initial construction period, you often have an option for renovations (value-add). Also, there may be GP acquisition fees if a joint venture is being used. The other major difference is that for acquisition modeling, you want to have a good grasp on the existing rent roll (not relevant for new constructions). The existing rent roll will be used to forecast future rents, occupancy rates, and improvement in occupancy as well as renovation costs per unit types.
Also, existing operating expenses are used to estimate future operating expenses. Often, you will base all of this off a T-12 (trailing 12-month pro forma of the acquired building).
After doing this kind of financial modeling for many years, I personally find the most difficult pieces of the model to build are debt / leverage assumptions, the joint venture waterfall distribution schedule (varies from deal to deal) and GP fee implementation.
Article found in Real Estate.
