In my nearly 30 years of providing analysis software to real estate investors, and almost a decade of writing books and teaching real estate finance at Columbia University, I’ve had the opportunity to talk with thousands of people who were analyzing potential real estate investments. Some of these people were seasoned professionals, many were beginners or students, but just about all were highly motivated to analyze their deals to gain the maximum advantage.
I’ve seen some tremendous creativity in their analyses, but I’ve also seen some huge missteps. Here are some of the pitfalls you will want to be sure to avoid.
1. The Formula That Doesn’t Compute
If you are attempting any kind of financial analysis, then a full-featured spreadsheet program like Excel is almost certainly your tool of choice. You might opt for professionally built models, like my company’s RealData software, or you could attempt to construct your own.
- One of the most common problems I see in do-it-yourself models is the basic formula error. A robust financial analysis involves the interaction of many elements, and it is really easy to make any of several errors that are hard to detect. The simplest of these is an incorrect reference. You entered your purchase price in cell C12 and meant to refer to it in a formula, but you typed C11 in that formula by mistake. You may (or perhaps may not) notice that your evaluation of the property doesn’t look right, but it can be difficult for you to find the source of the problem.
- You used to have a formula in a particular cell, but you accidentally overwrote that formula by typing a number in its place. The calculation is gone from the current analysis, and if you re-use the model, you’ll always be using that number you typed in, not the calculated value you expect.
- Cutting and pasting numbers seems innocent enough, but it can scramble your model’s logic by displacing references. Simple rule: Never cut and paste in a spreadsheet.
- Perhaps the most insidious is the formula that doesn’t do what you thought it did. Let’s say you have three values that you enter in cells A1, B1, and C1. You want to write a formula that adds the first two numbers and divides the result by the third. It’s easy to say this in plain English: “I want A1 plus B1, divided by C1.” So you write the formula as =A1+B1/C1. Wrong. Division and multiplication take precedence, so the division happens first and that result gets added to A1. Not what you expected. The formula that does what you intended would be =(A1+B1)/C1, where the sum of A1 and B1 is treated as a single value, divided by C1.
2. The Modern Art Syndrome
Even if you get all of your formulas correct, your job is only half done. I harangue my grad students constantly with this pearl of wisdom: Sometimes you create a pro forma analysis of a property strictly for your own interest. You will never show it to anyone else. Most of the time, however, successful completion of a real estate investment deal means you have to “sell” your point of view to one or more third parties:
- You may be the buyer, trying to convince the seller that your offer is reasonable;
- You may need to convince the lender that the deal should be financed; or
- You may need to show an equity partner that his or her participation would be profitable.
Most of the homebrew presentations that I see look to me like a Jackson Pollock painting with numbers superimposed. The layout usually has a logic that I can’t discern, and I find myself hunting for the key pieces of information that the presenter should have designed to jump off the page.
The layout needs to be orderly and logical: revenue before expenses and both before debt service.
Labels need to be unambiguous:
- If you mention capital expenditures, are they actual costs or reserves for replacement?
- Is the debt service amortized or interest only?
- When you label a number as “Price,” are you talking about the stated asking price, or your presumed offer? Be clear.
Lenders and experienced equity investors will be looking for several key pieces of information before they scrutinize the entire pro forma, items like Net Operating Income, Debt Coverage Ratio, Cash Flow and Internal Rate of Return. If these items don’t stand out, or if the presentation is disorganized, you might as well add a cover page that says, “ I’m Just an Amateur Who Probably Can’t Pull This Deal Off.”
3. Errors, We Get Errors, Stack and Stacks of Errors
You may be too young to know Perry Como’s theme song (by the way, it was “letters,” not “errors”), but the tune goes through my head when I look at some investors’ spreadsheets.
- The #NUM error can appear when you try to perform a mathematically impossible calculation, like division by zero, or also when attempting an IRR calculation that can’t resolve.
- #VALUE usually occurs when you type something non-numeric (and that can include a blank space, letters, punctuation, etc.) into a numeric data-entry cell. If there are formulas in your model that are trying to perform some kind of math using the contents of that cell, those formulas will fail. In other words, if you try to multiply a number times a plain-text word, you’re violating a law of nature and Excel is going to call down a serious punishment on your head, a sort of high-tech scarlet letter.
It can get really ugly really fast because every calculation that refers to the cell with the first #NUM or #VALUE will also display the error message, so the problem tends to cascade throughout the entire model. Unfortunately, I often see investors who then go right ahead and print out their reports with these errors displayed and deliver the reports to clients or lenders.
Your objective in giving a report to a third party is typically to try to convince the recipient to accept your point of view. You will not accomplish that if your report has uncorrected errors.
4. What’s Wrong with This Picture?
It’s the errors you overlook – the ones that don’t have nice, big, upper-case alerts like #VALUE – that can cause the greatest mischief of all; and these can be troublesome even if the analysis is for your eyes only.
It may be an unwanted and unintended side effect of the computer age that we tend to accept calculated reports at face value. Be honest: How often do you sit at a restaurant with a calculator and verify the addition on your dinner check?
This presumption of accuracy can be dangerous when you are evaluating a big-ticket item like a potential real estate investment. As I discussed earlier, you could have bogus formulas that give you inaccurate results. But even if you use a professionally created tool like RealData’s Real Estate Investment Analysis software, you are still not immune to the classic “garbage in, garbage out” syndrome.
The mistake that I see far too often is a failure to apply common sense. For example:
- “Gee, this investment looks like it will have a 175% Internal Rate of Return. Looks good to me.” (Reality: You entered the purchase price as $1,000,000 instead of $10,000,000. You should have been saying to yourself, 175% can’t be right; what did I do wrong?)
- “Wow, this property shows a terrific cash flow.” (Reality: You entered the mortgage interest rate as 0.07% instead of 7%.) Again, results outside the norm, either much better or much worse than you would reasonably expect, are your tip-off that a mistake is lurking somewhere. It is essential that you develop the habit of examining every financial work-up – those you create, and also those that are presented to you – very closely to see if the calculations appear reasonable.
5. What You Don’t Know CAN Hurt You
The final item in our list of big-time mistakes goes beyond the mechanics of spreadsheets and formulas and into the realm of fundamentals. You can be the most proficient creator of spreadsheet models on the planet, but if you don’t really understand the essential financial concepts that underlie real estate investment analysis, then you will neither be able to create nor interpret an analysis of such property.
The examples that I’ve seen are numerous – I can’t possibly list more than a few here – but they all revolve around the same issue: A lack of understanding of basic financial concepts as they apply to real estate. Some of the most important:
- Net Operating Income – This is a key real estate metric, and calculating it incorrectly can play havoc with your estimation of a property’s value. Basically, NOI is Gross Operating Income less the sum of all operating expenses, but I have frequently seen all kinds of things subtracted when they should not be. These have included mortgage interest or the entire annual debt service, depreciation, loan points, closing costs, capital improvements, reserves for replacement, and leasing commissions. None of these items belongs in the NOI calculation.
- Cash flow – I have seen NOI incorrectly labeled as “cash flow,” and have seen cash flow miscalculated with depreciation, a non-cash item, subtracted.
- Capitalization rate – Cap rate is another key real estate metric and is the ratio of NOI to value. Unfortunately, I’ve encountered some folks who have used cash flow instead of NOI when attempting to figure the cap rate and have ended up with a completely erroneous result – not only for the cap rate itself, but then also for the value of the property.
Clearly, there are two vital problems with these kinds of basic errors. First, is that they completely derail any meaningful analysis. If your NOI is not really the correct NOI and your cap rate is not really the correct cap rate, then nothing else about your evaluation of the property can possibly be correct. And second, if you give this misinformation to a well-informed investor or lender, your credibility will evaporate.
The Bottom Line
What is our take-away from these five disasters waiting to happen? You could avoid many of these errors by using the best, professionally developed analysis models – but then, of course, you would expect me to say that because that’s what we do for a living.
Let me suggest three other important steps you can take:
- Understand that there is no substitute for careful scrutiny of any financial presentation, whether it is someone else’s or your own. Be diligent always and apply the test of reasonableness.
- Recognize that any real estate analysis you create is likely to be a representation to a third party of the quality of your thinking and professional competence. You wouldn’t be careless or casual with a resume; you should give the same care to your real estate presentations.
- Finally, recognize that you need to make a commitment to mastering the fundamental concepts and vocabulary of real estate investing. There is no substitute for knowledge.
Want to learn more?
- Read What Every Real Estate Investor Needs to Know About Cash Flow… and 36 Other Key Financial Measures and Mastering Real Estate Investment
- Visit the “Blog” page at www.realdata.com
- Finally, check out RealData’s real estate investment and development analysis software.