On so many levels exposure to the risk of poor Investment can bring even the wisest Investor to their knees.
Offices bursting at the seems with financial analysts lay testament to the fact that constant monitoring cushions Corporate Investors from poorly performing investments; even so, they don’t always get it right.
As a non Corporate investor, you don’t necessarily have the same sort of analytical resource,but that shouldn’t mean you don’t analyse the proposition.
So what do you do?
Many claim they have a gut feeling about their deals feeling confident to rely on fag packet calculations to support their decision making. In a rising market this philosophy may have been supportable, despite it being just a tad unscientific. The credit crunch has brought with it fresh challenges and even if you are happy with the fag packet calcs., the financiers won’t be.
Financial modelling employs a variety of scenarios all of which may or may not happen. It’s a common sense approach to developing decision making tools that anyone can use.
1. Start with research; pick your property, shares or uncut diamonds whatever it is that floats your boat. Determine the value at today’s cost.
2. Consider additional costs; refurbishment costs, development costs, acquisition costs and legal costs, everything you can think of that will make your asset rentable, sellable or storable.
3. Consider ongoing costs; insurance, maintenance & overheads.
4. Then look at the income; it may be dividends, rent or interest.
[ Remember for property always factor in void periods, the shorter the lease the longer the void periods are likely to be. For example it might be prudent to only include 40% of city letting income; where accommodation is let daily, unless you have proof that you can do better than this. For a 6 month shorthold tenancy, assume at least one month a year will be void. With commercial property the lease may be longer but don’t assume you will let straight away especially in today’s market. A prudent investor would establish this type of tenancy before buying the investment.]
That’s the straightforward part ‘Income and Expenditure’ cash flow.
If you can imagine these figures in a spreadsheet you could handsomely demonstrate that your proposal stood a chance of making you money or conversely not; at least in this case it gives you the option to walk away before it’s too late.
Now we have to consider different scenarios.
The easiest to envisage at the moment is an increase in interest rate.
It’s reasonable to assume that interest rates will rise in the next 2 years however, it’s anybody’s guess by how much and when.
It could however, firmly put the scuppers on your plans.
A rise in interest will change the ongoing costs of borrowing. Therefore build in a rate rise of varying degrees and see what happens to your cash flow analysis.
What if a commercial tenant were to exercise a break at year 5 in your plan, how long would you be without rent, what if this scenario coincided with your worst expectation of interest rate rise.
What if a major employer in the city suddenly went bust leaving your buy to let investments unoccupied for long periods, a flood, a fire maybe; the list goes on?
Some of the mentioned events are possible, but unlikely. These types of occurrences can usually be insured against and let’s face it, insurance makes sense; you can’t think of everything.
Whether it’s a £50,000 or £50,000,000 investment, financial modelling will help you demonstrate to lenders that you have considered the possibility of change into the model. If your cash flow remains good despite worst case scenario then it’s a goer.
Once you are happy with a workable budget you can then concentrate on the actual value of your proposition, factoring in growth on the plus side and inflation on the negative you can work this back to a Net Present Value (NPV)
What Does Net Present Value – NPV mean?
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Investopedia goes on to explain that
NPV compares the value of a pound today to the value of that same pound in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.
You might not be able to go all the way with this, but at the very least you should attempt the first part, it’s a common sense fairly straightforward way to assess whether your next big deal really represents ‘Value for Money’.