1. TOPIC
WELCOME TO FINANCIAL MODELLING
OF REAL ESTATE INVESTMENT ASSETS :
AN INTRODUCTION TO THE BASICS
Before going on to do some financial modelling of potential real etate asset
acquisitions, you might want to go through this basic introduction to the investment
appraisal process.
FYI: This presentation is not meant to be printed out. You’ll get more out of it if you
click through it.
Press F5 and Page Down

2. Topics covered
•
•
•
•
•
Rationale, required knowledge and rough approach
A hypothetical example
The hypothetical cash flow
The missing detail
The Key Inputs
–
–
–
–
–
Forecasting rents
Forecasting sale prices
Forecasting depreciation
Forecasting void costs
Setting the target rate of return
• Uncertainty

3. RATIONALE, REQUIRED KNOWLEDGE
AND ROUGH APPROACH

4. What is the point of this stuff?
• BECAUSE MOST MAJOR INVESTORS
UNDERTAKE FINANCIAL MODELLING OF REAL
ESTATE ASSETS IN ORDER TO
– TO WORK OUT HOW MUCH THEY CAN
PAY FOR AN ASSET THAT THEY ARE
CONSIDERING BUYING
– TO WORK OUT WHETHER AN ASSET THAT THEY
OWN WILL DELIVER THEIR REQUIRED
RETURNS

5. Do I need to know anything first?
• Yes - I’m afraid so
• You need to know about basic financial maths
– About discounting and compounding
– About discounted cash
–
flows
About Net Present Value and Internal Rate of
Return
• If in doubt, go over the Introduction to Financial Mathematics for
Real Estate Appraisal
• You need to know some basic things about real estate e.g. how
leases work and the meaning of some terms. It’s often difficult to
know which terms need to be explained and which don’t. For
instance, most people know what a lease is, but they may not
necessarily know what a schedule of dilapidations involves.

6. Some basic concepts
•
AN ASSET’S VALUE IS TAKEN AS THE PRESENT VALUE OF ITS FUTURE
REVENUE STREAMS.
•
THIS IS A FUNCTION OF THREE THINGS
– THE REVENUE STREAM
– THE TARGET RATE OF RETURN
– TIME
•
“INVESTMENT VALUE” IS THE WORTH
OF AN ASSET TO AN
INVESTOR OR A CLASS OF INVESTORS
•
You can think of Investment Value as similar to equity analysts trying to establish
whether companies’ share prices are overvalued or undervalued. Equity analysts
often estimate the future cash flows of the companies to estimate the present
value of the dividend flows. You see phrases like “intrinsic”, “fundamental” or
“fair” value being used to mean the same thing as IV. They then compare this
estimate of value to the actual price at which companies’ shares are trading .

7. A common approach is to
• Set out on an annual (but could be quarterly or
monthly) basis
–
–
–
–
How much cash (do we estimate) will be paid out?
When (do we estimate that) it will be paid out?
How much cash (do we estimate) will be received?
When (do we estimate that) it will be received?
• You need to estimate a target rate of return
• Then estimate the Gross Present Value of the net
cash flow produced by the asset

8. 2.
A HYPOTHETICAL EXAMPLE

9. Enough concepts, how about an example? Er, please.
• OK - let’s take a hypothetical example – and strip
out some of the detail for now
• Where? A real estate asset in London’s West End
• What? 10,000 sq m of office space
• Who? It was let three years ago to a tenant on a
15 year lease with rent reviews to Market Rent
every five years.
• How long? The investor has a seven year
holding horizon

10. How much? Just the basic inputs for now
•
How much (1)? The tenant is paying £6,500,000 rent per annum
•
How much (2)? Recent deals suggest that if let today the Market
•
•
•
Rent is £7,500,000
How much (3)? The research department estimate that Market Rents will grow at
3.5% per annum for the next seven years.
How much (4)? The research department also estimate that offices experience rental
depreciation at 1% per annum – i.e. loses value
How much (5)? The research department also think that the asset will sell for 20 times its rent in
seven year’s time –
•
that’s an (exit) yield or cap rate of 5%
How much (6)? The investor has a target rate of return of 7.5% per annum
•
How much (7)? The existing owner wants
£150,000,000 for it.
 We’re placing a lot of faith in our researchers!

11. 3.
THE CASH FLOW

12. Here goes
Year
Year 0
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
£0
Rental income
Year 1
£6,500,000
£6,500,000
£7,879,688
£7,879,688
£7,879,688
£7,879,688
£7,879,688
This is the rent review five years into the lease. The lease started three years ago. The Market Rent is currently
£7,500,000. However, the research department are forecasting Market Rents to grow at 3.5% per annum.
However, this asset is also expected to depreciate at 1% per annum. £7,879,688 represents £7,500,000 grown at
2.5% per annum for two years. This stays fixed for five years until the next rent review.
Sale Price
£178,302,863
The sale price is a product of the rent at sale and the rental multiplier
(exit yield at sale). The rent at sale is expected to be £7,500,000 grown at
2.5% per annum for seven years. This is £8,915,143. The expected exit
yield is 5% or the multiplier is 20. This gives £178,302,863.
Net cash flow
£0
£6,500,000
£6,500,000
£7,879,688
£7,879,688
£7,879,688
£7,879,688 £186,182,551
Total revenues from rental income and sale price
PV @ 7.5%
1.0000
0.9302
0.8653
0.8050
0.7488
0.6966
0.6480
0.6028
£0
£6,046,512
£5,624,662
£6,342,838
£5,900,314
£5,488,664
£5,105,734
£112,222,445
(1+i)-n
DCF
PV factor * Net Cash Flow
GPV
£146,731,169
This the sum of the discounted cash
flows.
It is how much the investor should pay
if they require a 7.5% return

13. As you should realise, if they pay the £150 million, they
won’t receive their target rate of return of 7.5% per
annum.
Cost
-£150,000,000
Rental income
£0
Sale receipts
£0
£0
£6,500,000
£0
£0
£6,500,000
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£0
£0
£7,879,688
£178,302,863
Net cash flow
-£150,000,000
£6,500,000
£6,500,000
£7,879,688
£7,879,688
£7,879,688
£7,879,688
£186,182,551
DCF
-£150,000,000
£6,046,512
£5,624,662
£6,342,838
£5,900,314
£5,488,664
£5,105,734
£112,222,445
NPV at 7.5%
IRR
-£3,268,831
7.12%
The IRR is below the target
rate of return and the NPV
is negative

14. Alternatively, if they are trying to work out how much
to pay, there is no initial cost – and the surplus is what
the asset is worth to them
Year
0
1
2
3
4
5
6
7
Rental income
Sale receipts
£0
£0
£6,500,000
£0
£6,500,000
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£0
£7,879,688
£178,302,863
Net cash flow
£0
£6,500,000
£6,500,000
£7,879,688
£7,879,688
£7,879,688
£7,879,688
£186,182,551
NPV at 7.5%
£146,731,169

15. 4.
THE MISSING DETAIL

16. What detail was left out?
Mainly costs and fees
Management costs
Letting agents fees
Capital expenditure Selling agents fees
Void costs
Buying agents fees
Rent review fees
Legal fees
Stamp Duty (buying
and selling)
For a large assets such as a shopping centre, the cash flow could contain
dozens of rows. One for each individual tenant. I’ll expand the cash flow
later in order to illustrate some of the issues.

17. THAT’S ALL THERE IS TO IT! I COULD
HAVE ADDED A LOT OF IMPORTANT
‘CLUTTER’ BUT THE ESSENTIAL
PRINCIPLES ARE HERE. SO, THE
TECHNIQUE IS STRAIGHTFORWARD.
IT IS THE INPUTS THAT ARE CRITICAL.
LET’S LOOK THEM IN MORE DETAIL.

18. 5.
THE KEY INPUTS

19. 5.1 FORECASTING RENTS

20. OK then, could you start with rental growth forecasts?
•
•
•
•
•
•
•
•
•
•
•
•
•
•
What do you want to know?
How are they produced? By who? What is being forecasted? How reliable are they?
You don’t ask for much. Well, the UK real estate market is one of the most forecasted real estate markets in the
world. Forecasts are usually produced by specialist forecasters who use econometric (look it up!) models to
predict future rents. They tend to be produced by
– major investors e.g. Prudential, Aviva, Standard Life etc. themselves,
– or by research departments of real estate services firms (JLL, DTZ, CBRE etc.),
– by some of the large investment banks (UBS, Morgan Stanley etc.)
– and by some specialist firms (e.g. PMA, IPD).
The Investment Property Forum take a quarterly survey of their forecasts of rental and capital growth in the IPD
index.
So the IPF do a survey of forecasts of IPD! Are the forecasts any good?
Depends on what you mean by ‘good’? Not surprisingly, they disagree. If you take average of their forecasts,
they tend to get the direction of rental growth right. If they think rents will rise, they do tend to rise and similarly
with falling…
Hmmm – so the numbers may not be reliable?
Nope – afraid not. Forecasters tend to claim that their main contribution is get the relativities right. Which
sectors/cities will perform best etc. it’s pretty impossible to get the numbers right.
But it seems to be locations not buildings that they’re forecasting?
Yes – they could be forecasting the rent of the average building in the average location or the best building in the
best location or the typical IPD building in a typical IPD location. It’s a bit like forecasting the weather. When the
weather person predicts that it will be 10 degrees celsius in London, they’re not saying that every part of London
will be that temperature. It could vary a lot according to local conditions.
But they’re not forecasting the actual building being appraised?
Unlikely – they will leave it to the analyst to focus on the buildings and, possibly, to tweak the forecasts according
to whether they think that the building might be better or worse.
How do analysts or appraisers do that?
No idea!

21. 5.2 FORECASTING SALE PRICES

22. Getting the future sale price must be even harder!
•
•
•
•
•
•
•
•
•
•
•
Yep. Their forecasts of capital growth are really not good. Often, they get the
direction of growth wrong?
How do they manage that when they get the direction right with rents?
The real problem is forecasting yields. One forecaster said to me “To be able to forecast
property yields, I need to be able to forecast bond yields. If I could forecast bond yields, I
wouldn’t be even trying to forecast property yields”
You think that yields are inherently unforecastable?
Is that an actual word? Anyway, yes - it is difficult, er, extremely challenging.
But there’s lots of people forecasting share and bond markets
If someone’s prepared to pay for a forecast of something, then someone else will usually step
forward to sell them a forecast of something.
Cynical – even for one so old. I suppose that they’re not actually forecasting yields in the
building being appraised?
Right again. To be fair, real estate forecasters are happy to acknowledge the difficulty of
forecasting yields but, if you’re doing cash flow analyses, it has to be done because the
forecasted sale price for commercial assets is a function of the forecasted rent and the
forecasted yield at sale.
What would you do?
Pardon

23. What would you do about the yield forecasting
problem?
•
•
•
•
•
•
•
•
•
I’m not a forecaster.
That’s not what I asked.
Well, ok, I’d look at where yields were in terms of their long term average. Let’s say London WE office
yields have averaged around 5% and rarely gone further below 4% or above 6% in the last two decades
(which they haven’t). I’d anchor around that 5% if looking five years ahead to provide an indicator of the
yield on the best/average office.
But the office being appraised may have changed?
We can be pretty sure of two things about any property in, say, five years. Firstly, it will be five years older.
Thanks for that
You’re welcome…and, secondly, the unexpired lease term will very likely have changed for the worse. I
might then ‘tweak’ the yield to try to take this into account possibly in consultation with some of the
investment agents who understand how buyers are, albeit currently, pricing these differences.
Actually , it sounds fairly sensible.
It makes me nervous. It’s a bit ad hoc and atheoretical. The implied forecast is reversion to the mean for
the location yield and some tweaking to take into account changes to the building. I suppose that it is wellknown that very simple forecasting models e.g. no change often beat sophisticated techniques in
forecasting competitions. So- maybe there is some merit in a fairly simple approach. In a five year cash
flow analysis, the exit yield is likely to be the most important single assumption. It is prone to a lot of
uncertainty. This variable should really be subject to intense discussion and debate if it is the basis for
bidding.

24. 5.3 FORECASTING DEPRECIATION

25. What about depreciation? Where does that come from?
•
•
•
•
•
•
•
•
•
Well, we know surprisingly little about it. We can be pretty sure that buildings lose value as
they get older. This may be remedied by some regular or ‘lumpy’ capital expenditure to improve
the asset.
So it can involve some blend of spending money and losing value?
Yes. This needs to be incorporated into the cash flow. There’s some studies that suggest that rental
depreciation is about 1-2% per annum in offices, a bit higher for industrial and a bit lower for retail.
I would have thought that it is a bit like cars. You lose a lot of initially and then it starts to slow. You
probably only need to start spending money on the asset after five or six years as well.
I suspect that you’re right – but it doesn’t seem to have been really nailed by
researchers. In my experience, some analysts or appraisers just ignore it. I’m not sure but I don’t
think that Argus (standard industry software for doing investment appraisals) has a field for it.
It can’t be that important then.
Well, in a low growth era, it might be really important. If rents are growing at 20% on average, then
1% or 2% depreciation is probably trivial but if rents are growing at 1% or 2% per annum, then
depreciation wipes it out.
How would I find out about what is likely to be needed to be spent on a building and when?
This is probably within the domain of the asset and/or building managers. They tend
to have the most experience in maintaining, repairing and refurbishing assets.

26. 5.4 FORECASTING VOID COSTS

27. What about things like voids?
•
•
•
•
•
•
•
•
•
•
•
•
•
Well, tenants do vacate at the end of their leases, become insolvent and go out of business etc. If a
building becomes empty, you could end up with a negative cash flow!
What kind costs are there?
You end up with no income and having to pay to insure, secure, maintain and market the asset. You also
become responsible for the property taxes. If there’s a service charge for common areas…
How often do tenants leave? How long does it take to find a new one? What are the costs?
Don’t sound so stressed. I suspect that it varies a lot. IPD produce a lease events survey that tries to
monitor these types of things. JLL produce a measure of service charge costs (OSCAR). It tends to cover
insurance, utilities, cleaning etc.
What do I do in the cash flow when leases end? Tenants can either stay or go. I have to assume one or the
other?
Well, you could do a number of things. If you have 10 leases expiring during the period of the investment
appraisal, then you could assume that some will stay and some will go. You can’t have much idea about
which ones – they might not even know it themselves yet. But you can be pretty sure that some will go
and that some will stay. Just pick some. Alternatively, you could incorporate some expected losses.
How do I do that?
Well, it’s the estimated costs of vacation (lost income and costs) adjusted for the probability of incurring
them. You also have to make assumptions about the new lease and, albeit implicitly, the new tenants
This all sounds worryingly like shooting from the hip to me. The assumed numbers will never be accurate.
True. Neither will estimated rental growth, depreciation, exit yield, capex….
What’s the point then?
Pardon

28. 5.4 SETTING THE TARGET RATE OF
RETURN

29. I’ve often wondered how investors set a target rate of return for assets?
•
Funny that – so have I. I think that it really depends on the investor and their particular targets and
constraints.
–
–
–
–
•
•
•
•
•
•
•
•
Some investors are being benchmarked against an (IPD) index. They tend to set their target rate of return
above the forecasted (IPD) index returns.
Other investors may be focussed on absolute return – they’ll pick a number (albeit with reasons).
Others may try to build a risk premium (to add to bond yields with similar time horizons) for the asset
looking at its tenants, location, leases, construction etc.
Companies and REITs may be linking required returns to their weighted average cost of capital.
So it’s kind of horses for courses?
Afraid so. It’s not really a precision science. There are too many data uncertainties. The
assumptions embedded in standard finance pricing models such as the Capital Asset Pricing Model
tend to be so divorced from real estate market reality that they are not capable of being applied.
I’ve heard that there may be problems applying them to shares?
Yes – target rates of return…a bit like laws and sausages, you tend to lose respect for them when
you see how they’re made.
You could say the same thing about forecasts?
Indeed, you could
…and investment appraisals?
I’m not arguing

30. 6
UNCERTAINTY

31. Why bother with this stuff at all?
•
•
•
•
•
•
•
•
My take on it is that it’s bit like what Churchill said about democracy being the worst possible
system of government…
Except for all the others.
There must be an alternative.
I’m struggling. You need a way of deciding whether you think a building will give you the
returns that – you estimate – you’ll need. These returns are in the future and the future has
lots of Rumsfeldian known unknowns.
You could rely some qualitative evaluation, intuition or gut feeling.
You could but intuition usually contains implied forecasts. You tend to end up putting
numbers on things eventually. It’s probably best to regard the cash flow analysis as an arena
to provide a framework for decision-making. As long as users are aware that the numbers
are uncertain, then it provides an imperfect but probably optimal basis for allocating capital.
We tend to like everything to be neat and exact. We want to get ‘the answer’ and to avoid
ambiguity. I think that you simply have to live with the ambiguity.
What are the most important assumptions then?
I think that it’s depends on the combination of how much they affect the appraisal and how
uncertain they are. Some variables are really important but you can be pretty sure of getting
close to the right answer Rent paid is clearly a fact. Market Rent - you should get close.
Some are really uncertain but not really that important e.g. future sale costs but they’re only
uncertain because future sale price is so uncertain. Go on - you guess.

32. How would you classify the following assumptions or
variables?
•
•
•
•
•
•
•
Rental growth?
Rent passing?
Depreciation?
Exit yield?
Target rate of return?
Void costs?
Market Rent?
High or Low Importance?
High or Low Importance?
High or Low Importance?
High or Low Importance?
High or Low Importance?
High or Low Importance?
High or Low Importance?
High or Low Certainty?
High or Low Certainty?
High or Low Certainty?
High or Low Certainty?
High or Low Certainty?
High or Low Certainty?
High or Low Certainty?
In hindsight, it was a badly worded question. Arguably all the variables are important
but some are more difficult to estimate than others. You can be really sure about what
the rent passing is and the target rate of return. You can be fairly sure about the level
of Market Rent. But you can’t be sure about rental growth in the future and the yield it
will sell for. The success of this appraisal depends on getting the latter right and these
high importance/low certainty variables are then, arguably, the most important
variables

33. OK. Let’s leave it there. We’ve
covered a lot of ground. I’ll make a
more detailed spreadsheet available
so that you can see how these things
are done in Excel.