4 [Advanced] Real Estate Investment Analyses You Should Be Using

There are a lot of things that you can do to improve a real estate investment analysis, but if you really want to take things to the next level, there are a few extras that are definitely worth considering adding to a CRE pro forma.

These things can help you proactively address investor concerns, add an extra layer of assurance when underwriting your own deals, or just impress your boss if you’re working in the industry in an analytical role.

So in this post, we’ll cover four of the most helpful advanced analysis concepts that I’ve picked up from my 10+ years working in the industry alongside some of the biggest institutions in commercial real estate, and how each of these can be used within a real estate financial model.

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Analysis #1: Hold/Sell Analysis

The first type of analysis we’ll cover is applicable to any investor that’s focused most on maximizing the IRR of an investment, and this is a hold/sell analysis.

A hold/sell analysis allows an investor to look at a variety of different potential sale dates all at the same time, and then calculate returns for each of these scenarios.

When to Use This Analysis

You can run this at any point, but this can often be most helpful when you’re first acquiring a property and trying to plan your investment strategy.

Especially for private equity firms or general partners that are compensated based on exceeding certain IRR-based hurdle rates, figuring out the optimal sale year up front can be extremely beneficial.

Why It’s Not Always Obvious

While shorter hold periods will often maximize the IRR of an investment, this isn’t always the case, and this can vary based on strategy.

For example, on a value-add or opportunistic deal where you’re planning to increase NOI quickly through a projected renovation or re-leasing plan, you’ll usually see the IRR increase as you continue to hold the deal throughout that repositioning period, and this will typically end up peaking shortly after stabilization.

But for core and core-plus deals that might have more steady projected cash flows over time, this analysis might tell you that holding the property as long as you can is actually the best thing you can do to maximize the IRR.

Analysis #2: Partitioning the IRR

This next type of analysis can be a great way to understand the risk associated with a potential investment, and this is referred to as partitioning the IRR. To do this, investors will calculate the percentage of the IRR coming from cash flow from operations versus the percentage of the IRR coming from cash flow associated with sale proceeds.

Why This Matters

One of the biggest risks when investing in commercial real estate is relying too heavily on a speculative sale price in order to generate returns. In most cases, investors can reduce this risk by minimizing the portion of the IRR that’s dependent on hitting a projected valuation at sale, and relying more heavily on cash flow from operations (that have most likely already been proven out at the property).

How to Calculate This

The way this is typically done is by first separating out the projected cash flows on the deal between cash flow from ordinary operations and cash flow from net sale proceeds, and then taking the present value of each of these cash flows (discounted back at the project-level IRR).

And once we have our discounted cash flows, we can then divide the sum of our discounted cash flows from operations by the total discounted cash flows to find the percentage of the IRR coming from operations, and we can do the same thing with the sum of our discounted cash flows from sale proceeds.

Using This with Investors

If you’re a GP trying to pitch a deal to investors, this can be a great way to quantify how much (or how little) speculation around an ultimate sale price is driving your projected returns. This can help you either adjust your strategy to help reduce that exposure, or just provide some additional assurance to investors when these percentages are weighted more evenly.

Obviously, different business plans will call for different strategies, and deals like ground-up development projects or land banks will inherently generate much more of their IRR from sale proceeds. But in cases where you’re buying real estate that’s already operational, this type of analysis can provide a really helpful perspective.

Analysis #3: Next Buyer Analysis

The next type of analysis I want to cover can be a really useful tool to help dial in your sale value projections, and this is a next buyer analysis.

The Limitation of Standard Exit Cap Rate Approaches

In a typical real estate financial model, sale value projections are made by taking the next buyer’s first year of projected NOI and applying an assumed exit cap rate to that NOI, which makes the sale value of a property exclusively dependent on the first year of operations.

And while this is helpful for a quick estimated value calculation, a next buyer analysis allows you to take this a step further by factoring in the next buyer’s projected cash flows throughout their entire projected hold period, and then calculating their projected internal rate of return based on that sale price.

When This Analysis Is Most Valuable

A next buyer analysis can help provide a lot more clarity around whether your exit cap rate assumptions are realistic, based on what the next buyer’s returns might be at that valuation. This can be really beneficial in scenarios where the NOI of the property is projected to change significantly after the next buyer’s first year of ownership.

For example, if you’re selling a property with a major tenant that’s currently paying significantly below market rents, with a lease that’s expiring just two years after the sale, this wouldn’t be picked up in an exit cap rate valuation, but would be incorporated into a next buyer analysis.

This can also be really helpful in cases where things like affordable rent restrictions are scheduled to be lifted in the future, a significant increase in assessed property value is expected in the future, or any other scenario where the NOI of the property is expected to be significantly higher (or significantly lower) than the year immediately following the sale.

Even though the exit cap rate approach does tend to be the industry standard in commercial real estate, and this will be sufficient in the vast majority of cases, a next buyer analysis can be a great way to continue to dial in your exit cap rate assumptions. This ultimately provides an additional layer of assurance for investors, especially on deals with major fluctuations in cash flows.

Analysis #4: Best Case, Base Case, Weak Case Analysis

The last type of analysis that’s worth mentioning here is another way to analyze risk, and this is a best case/base case/weak case analysis.

The Problem with Data Tables

Many investors will use data tables in Excel to create a sensitivity analysis and calculate the impacts of changes to assumptions on returns. However, these can often slow down an Excel model pretty significantly, especially if you have multiple metrics that you’re trying to sensitize.

A More Efficient Alternative

A best case/base case/weak case analysis allows you to add any relevant assumptions you want to control all within one table across three different potential scenarios, and allows you to toggle back and forth between these in real time using a simple dropdown list.

This allows you to see the impacts of changes to multiple different assumptions that you think would realistically be correlated in upside, base case, and downside scenarios. And again, this can be really helpful to show investors both the results of a worst-case scenario that you could see materializing, but also an upside scenario if things go better than planned.

While a sensitivity analysis can be a helpful tool to accomplish a similar result, if you’re working in a huge, clunky model that tends to freeze a lot or already takes a while to recalculate, this can be another helpful way to analyze different scenarios in a much more efficient way.

Take Your Analysis Skills to the Next Level

If you want to learn more about how to build each of these analyses step by step in Excel, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.