Long term financial modeling is essential in evaluating any income producing asset. Using the Cap Rate method, one is only looking at the current (or trailing) net operating income, which does not factor in all of the many things that could happen during the hold period. The IRR method (leveraged and unleveraged) is a much more valuable tool. By using IRR or discounted cash flow, one is able to factor in future impacts on cash flow such as rent growth, expense growth, vacancy, capital expenditures, leverage, future interest rates, and future sales price.
However the danger in using IRR, or any long range planning tool is being disciplined enough to not use the financial model to justify a current sales price. For example, if a property is selling at $10,000,000 and a company’s investment threshold is a 10% IRR, it could be very easy to increase the future rent growth to 3% vs. 2% to help justify a current sales price. In a financial model that I recently developed, the IRR went from 8% to 18% just by increasing the rent growth from 2% to 3% per year. While this may seem like a lot, the future rent growth compounds upon itself and the NOI increases much faster during the hold period resulting in a more cash flow, AND a higher sales price at the end of the hold period. Similarly, an expense increase of 2% instead of 3% resulted in an IRR of about 24% vs. 18% in the same model. These are just two of many examples of how changing a few “minor” details, can dramatically change the IRR and justify a given purchase price.
Another important item to consider is most models predict a straight line future. For example; rent growth will be 2% a year during the hold period (or expense growth, vacancy, etc). We all know that this simply won’t happen. There will be ups and downs based upon the economy, competitors, etc. If we predict a 2% rent growth each year and one year the rent growth is zero, and then resumes at 2%, not only did the property lose the 2% rent growth that year, but every subsequent year because financial models compound each year.
While long term financial models are very useful, and essential, in valuing a property, one must be very careful to take an unbiased, conservative approach as to not use the model to justify a sales price. Additionally, is it useful to run multiple financial models, or stress tests, to study how different financial scenarios effect the rate of return of a given property.
To learn more about how long term financial models effect the price of your senior living community, contact Jason Punzel at punzel@slibinc.com or 630-858-2501.
