Financial Model

A comprehensive, quantitative tool that combines various financial and operational inputs to forecast and predict the financial performance, value, and viability of a commercial real estate investment or project.

A financial model enables investors, developers, and other stakeholders to evaluate potential risks and returns, assess financing and leasing structures, and make informed decisions regarding property acquisition, development, or disposition. By incorporating assumptions such as rental income, vacancy rates, property expenses, market trends, and capitalization rates, financial models help provide a robust and dynamic analysis of a property’s potential performance over a specified time horizon.

Putting ‘Financial Model’ in Context

An A.CRE Accelerator graduate, Jake Peterson, is preparing for a technical interview at Lone Star Equity Partners, a private equity firm based in Austin, Texas. As part of the interview process, he is given a case study where he must build a financial model for the acquisition of a suburban office property, Vista Oaks Business Park.

The Property: Vista Oaks Business Park

Vista Oaks is a 150,000 square-foot, three-building office complex located in a growing suburban area just north of Austin. The property, built in 2008, has a current occupancy rate of 85% with 5% of the leases expiring within the next 12 months. The asking price for the property is $42 million, and it generates an annual Net Operating Income (NOI) of $2.8 million.

The Task

Jake is tasked with building a financial model to assess whether Lone Star Equity should pursue the acquisition. His model needs to evaluate the following:

• Rental Income Projections: Vista Oaks currently leases space at an average rate of $26 per square foot. Jake needs to forecast future rent growth based on market trends, factoring in lease escalations of 2% annually and the potential for lease-up of vacant space over the next 18 months.
• Vacancy and Leasing Assumptions: The financial model should incorporate a conservative vacancy rate of 10%, to account for market uncertainties and lease expirations, as well as the expected leasing commissions and tenant improvement (TI) costs for upcoming renewals and new leases. TI costs are estimated at $25 per square foot for new leases and $10 per square foot for renewals.
• Operating Expenses: Current property expenses, including maintenance, management fees, and taxes, total $800,000 annually. Jake will apply a 2.5% annual growth rate for expenses.
• Financing Structure: Lone Star plans to finance the acquisition with 65% debt at an interest rate of 4.25%, amortizing over 30 years. Jake needs to model the impact of this debt service on cash flows and ensure that the project meets Lone Star’s cash-on-cash return target of at least 8% in the first year.

Financial Model Outputs

Jake’s financial model will use these assumptions to project the property’s cash flow over a 10-year hold period. Key outputs of the model include:

• NOI Projections: The model will forecast the Net Operating Income based on rental income, vacancy assumptions, and expense growth. For instance, assuming Jake manages to lease the vacant space, the NOI could increase from $2.8 million to over $3.1 million in the first 24 months.
• Debt Service Coverage Ratio (DSCR): Jake calculates the DSCR to ensure that the property’s income is sufficient to cover the annual debt payments. With debt service costs of approximately $1.47 million annually, the DSCR in year one would be roughly 1.9x, which is considered healthy.
• Exit Strategy: In his model, Jake also estimates an exit cap rate of 6.25% based on market conditions at the end of the 10-year hold. Using this cap rate, the terminal value of the property is projected to be approximately $50 million.
• Internal Rate of Return (IRR) and Equity Multiple: Jake’s financial model will calculate the projected IRR and equity multiple for the investors. Based on his assumptions, the model predicts an IRR of 11.2% and an equity multiple of 1.7x, indicating a potentially solid return for Lone Star Equity’s investors.

Conclusion

Jake’s financial model demonstrates the importance of forecasting and analyzing key property and market assumptions to determine whether the investment meets the firm’s objectives. His ability to incorporate multiple variables—such as rental income growth, vacancy rates, debt service, and exit value—allows him to paint a comprehensive picture of Vista Oaks’ potential performance over the investment horizon. After presenting his model to the interview panel, Jake feels confident that he has showcased his analytical skills and real estate acumen.