2. Define the Model Structure
In this lesson, we'll create a structure for the valuation model, defining the critical variables that will determine internal rate of return (IRR).
- Our model output will be the investment IRR, which needs to be greater than 15%
- The IRR will be determined by the investments cash flows
- The cash flows will depend on the following components:
1 Investment holding period
2 Purchase Price
3 Revenues (Rental income)
5 Mortgage (or loan)
6 Income and capital gains taxes
7 Final asset sale price
Modelling the 7 components
- Most of these components are mini-models, not inputs
- Using our diagram as a guide, we'll arrange our overall model into several mini-models
- This will make our progress and model structure much easier to understand
In the previous lesson we found a problem statement that read, “Will the asset yield an IRR of greater than 15% if we buy for $1.4 million and sell in the next six to nine years?” Using this problem statement, we can now structure our model with a lot less ambiguity.
And we’re going to do this by first drawing a diagram of the problem.
Let’s start with our output which is going to be IRR.
The IRR must be greater than the minimum threshold of 15%.
IRR is determined by the annual cash flows of the project from year zero when the asset is purchased, to the year in which the asset is eventually sold.
There are seven major factors that will affect the cash flows of the asset.
The first of these is the Holding period, how long we hold the asset before we sell.
Next up is the Purchase Price or the cost of acquiring the asset, and this affects cash flows in year zero or before operation.
Next up are the Revenues generated by the asset, and this is simply the rental income that Joe receives from tenants.
Expenses such as Insurance and Management fees will also affect cash flows during this time period.
Joe also hopes to take out a Mortgage on the asset.
The Mortgage will contain Interest and a Principal.
It will affect the initial amount of cash that Joe pays for the investment and also require annual Interest repayments.
In addition to the Mortgage, Joe will also need to pay a variety of Taxes.
The Taxes paid on acquiring assets can vary a lot by Country and by the type of structure you use.
In this case, Joe will pay Income tax for each year of operation provided that he makes a profit.
And he will also pay tax on the Capital gain when he eventually sells the asset.
We’ll be covering Tax liability in much more detail in a later lesson. But for now, we’ll just acknowledge its presence.
The last variable that will affect the annual Cash flows is obviously the final selling price.
Once you have the components of your annual cash flow identified, you can target each as an individual mini model.
In the next lesson we’ll begin by building the Revenue projections for our Real Estate asset.