The importance of financial modeling for real estate funds

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The recent credit crunch and slow subsequent economic recovery have highlighted the increasing need for effective back and middle office monitoring processes for real estate funds in order to improve their overall management efficiency, as well as risk management and compliance functions. Examples include tax authorities enforcing more strictly transfer pricing/thin capitalization rules and debt covenant compliance issues triggered by depressed property values as well as declining leasing conditions. In addition, future regulations (e.g. the AIFMD and Solvency II) will require more sophisticated and accurate modeling of liquidity and risk sensitivities. A key element of a real estate fund’s monitoring process is its financial or cash-flow modeling – but what does this entail and how useful can it be in practice?

In this context, a sound generic knowledge of modeling techniques is invaluable. A high-quality financial model should have a robust structure (allowing for safe, trackable changes throughout its life), embedded integrity checks as well as flexibility to allow for sensitivity analysis on the major inputs and scenarios. A robust, flexible, customized and easy-to-use financial provides an efficient day-to-day management and compliance tool, as well as supporting management’s analysis of key investment decisions.

Day-to-day management tool

Depressed overall returns over the last three years, volatile real estate asset values and increasing risk management concerns have lead investors to request additional qualitative and quantitative performance and risk information from fund promoters, often in a highly customized format. This is also consistent with the development of industry guidelines (for both the listed and unlisted sectors) in respect of standardized historical and forward-looking performance metrics. This facilitates benchmarking with other asset classes and, crucially, allows more meaningful comparability of the performance of different real estate funds.

The embedding of appropriate functionality within the design of a fund’s financial model will allow the effective benchmarking and management of fund expenses and, in particular, facilitate the routine calculation of key metrics (both historical and forward looking) such as Total Expense Ratio (TER), Real Estate Expense Ratio (REER) and Return Reduction Metric (RRM) as recommended by INREV guidelines. Using both actual and estimated forecast metrics allows investors to see how closely a fund tracks its objectives and to follow management’s analysis and explanations regarding performance.

Tax planning is another area where budgeting, and hence modeling, is of paramount importance. In particular predicting trapped cash within a fund structure is a critical issue as it directly impacts income yields and overall fund returns. If trapped cash can be predicted early enough, appropriate measures can be taken to mitigate its adverse consequences. An appropriately sophisticated model can be also be used to monitor other tax risks such as thin capitalization requirements, transfer pricing rules and other relevant structuring matters.

Additionally, a flexible financial model is a potentially powerful risk management tool as it allows management to carry out sensitivity and scenario analysis in order to measure the impact of changes in major variables such as interest rates, foreign exchange rates, yields and letting assumptions on performance measures and financing covenants. A well-designed model should provide both a sound picture of how resilient the current structure is in the event of adverse changes in the above variables and also reveal areas of potential improvement (refinancing, hedging, etc ...) indicated by the results. On a shorter-term perspective, the model can be used as a day-to-day tool to manage liquidity risk and ensure ongoing compliance with covenants such as Loan-To-Value (LTV) Ratios or Interest Coverage Ratios (ICR).

Support for key investment decisions
A model may be used not only in the context of ongoing operational activities but also to provide valuable insight and support for decision-makers in the context of transactions such as acquisitions, disposals and letting. A sound financial model can also aid management in negotiations regarding the structuring of new finance, especially if sensitivity analysis can be carried out to highlight risks related in respect of covenants or provide assurance to counterparties. Transactions such as sale and leaseback arrangements or vendor due diligence related to the sale of portfolio assets also benefit from a well-designed model.

In conclusion, as the real estate industry has moved through the end of the last economic cycle, the importance and benefits of robust financial models have been recognized. A robust and flexible financial model has multiple outputs and users spanning front, middle and back office functions. This supports investor reporting, risk and liquidity management, transactions and tax operations. It is the right time for asset managers to assess their capabilities in this area before we move into the next economic cycle.