Are you using projection models? (Here's why you should)

[Leo R.]

Hey all,

Recently, I replied to a post asking folks whether they track their net worth. 

Personally, I do track my net worth. However, far more important to me are my financial projection models (which include projections about my net worth and many other variables over different time horizons). 

This got me wondering: how many BP folks are using projection models? If you're using projection models, what types of variables do you include? What types of time horizons do you cover? Why do you use projection models? What lessons have you learned from your projection models? How have projection models impacted your strategy?  Did you create your own projection models from the ground-up, or did you adapt someone else's existing models? Have your projections been accurate/inaccurate, and why?  ...if you're not using projection models, why not?

Here's a bit more info about my projection models, why they're so important, and why net worth (on its own) can be a completely misleading indicator of an investor's success:

Some of the main variables in my projection models include: expenses (broken down into various categories like personal expenses, capex, debt service, vacancy, etc.), income, cashflow, debt, DTI, equity, property appreciation, rent appreciation, mortgage paydown & amortization, rate of net worth growth, cost of living increases, hours worked per week, cash on hand, etc, etc.

I have short term (12-24 month), 5 year, 10 year, and 15 year projection models...sometimes I'll mess around with longer term (20+ years) projection models, but it's pretty difficult to project that far into the future, because there are so many unknown factors--so, the longer the projection model is, the less I tend to believe in its feasibility...

My projection models allow me to make more informed decisions about things like: whether to buy or sell a particular property, whether to refi a property, whether to rehab a property, whether to pursue or abandon a particular revenue stream, how to approach rent increases, how to manage risks, what debt to pay down first, whether a particular goal is worth the amount of hours I'll need to work to achieve the goal, what my goals should be, how to achieve various goals as efficiently as possible, etc., etc. 

In a nutshell, good projection models help you strategize. Sometimes the strategy the models reveal is to DO certain things (like rehab a property), but sometimes the strategy they reveal is to do nothing. Indeed, I recently ran some models that showed me that the best strategy for me, in certain areas of my portfolio, is to simply do nothing--don't make any big moves, just let things progress as they are...

A good projection model will show you not only how to reach various goals, but it also all sorts of potential roadblocks that could prevent you from reaching goals (as well as potential solutions to those problems). Projection models allow you to answer all sorts of "If I do X, what will happen in Y years?"-type questions.

I run projection models that include disaster scenarios (e.g.; a massive '08-style collapse in prices), as well as best-case dream scenarios...however, MOST of my projection models focus on fairly modest outcomes (such as 2-4% property appreciation, 2-4% rent growth, etc.). It's these more modest, relatively conservative models that are the "meat and potatoes" of my strategizing.

Although net worth is part of my models, and many investors love to brag on their net worths, net worth can be an incredibly misleading number. Consider two hypothetical investors:

Investor A tells you "my net worth is $10 mil". That may sound pretty good...until you discover that their net worth is decreasing at a rate of $2 million per year, and they've got $100 mil of adjustable rate debt on a portfolio of D class properties that forces them to work 80+ hours per week just to keep the whole thing afloat...

Investor B tells you "my net worth is $1 mil" --to many successful investors, that sounds like a relatively insignificant net worth...but, investor B owns a portfolio of A class properties with zero debt, professionally managed, their cashflow is $500k per year, their net worth is increasing at a rate of $1 mil per year, and they only have to work about 1-2 hours per week to keep their machine going.

Personally, I'd MUCH rather be investor B than investor A (even though investor A's net worth is 10x of investor B's).

So yeah, tracking net worth is advisable, but it's only a small part of what an investor should be tracking and modeling, and net worth alone might not be very indicative of an investor's success...

An effective investor creates models to help them strategize, and those models inevitably include net worth, but they include a LOT more than just net worth (and as a result, they can be quite time-intensive to create)...but, the things that are most worth doing usually ain't easy...

[Byron Valles]

Quote from @Leo R.:

Hey all,

Recently, I replied to a post asking folks whether they track their net worth. 

Personally, I do track my net worth. However, far more important to me are my financial projection models (which include projections about my net worth and many other variables over different time horizons). 

This got me wondering: how many BP folks are using projection models? If you're using projection models, what types of variables do you include? What types of time horizons do you cover? Why do you use projection models? What lessons have you learned from your projection models? How have projection models impacted your strategy?  Did you create your own projection models from the ground-up, or did you adapt someone else's existing models? Have your projections been accurate/inaccurate, and why?  ...if you're not using projection models, why not?

Here's a bit more info about my projection models, why they're so important, and why net worth (on its own) can be a completely misleading indicator of an investor's success:

Some of the main variables in my projection models include: expenses (broken down into various categories like personal expenses, capex, debt service, vacancy, etc.), income, cashflow, debt, DTI, equity, property appreciation, rent appreciation, mortgage paydown & amortization, rate of net worth growth, cost of living increases, hours worked per week, cash on hand, etc, etc.

I have short term (12-24 month), 5 year, 10 year, and 15 year projection models...sometimes I'll mess around with longer term (20+ years) projection models, but it's pretty difficult to project that far into the future, because there are so many unknown factors--so, the longer the projection model is, the less I tend to believe in its feasibility...

My projection models allow me to make more informed decisions about things like: whether to buy or sell a particular property, whether to refi a property, whether to rehab a property, whether to pursue or abandon a particular revenue stream, how to approach rent increases, how to manage risks, what debt to pay down first, whether a particular goal is worth the amount of hours I'll need to work to achieve the goal, what my goals should be, how to achieve various goals as efficiently as possible, etc., etc. 

In a nutshell, good projection models help you strategize. Sometimes the strategy the models reveal is to DO certain things (like rehab a property), but sometimes the strategy they reveal is to do nothing. Indeed, I recently ran some models that showed me that the best strategy for me, in certain areas of my portfolio, is to simply do nothing--don't make any big moves, just let things progress as they are...

A good projection model will show you not only how to reach various goals, but it also all sorts of potential roadblocks that could prevent you from reaching goals (as well as potential solutions to those problems). Projection models allow you to answer all sorts of "If I do X, what will happen in Y years?"-type questions.

I run projection models that include disaster scenarios (e.g.; a massive '08-style collapse in prices), as well as best-case dream scenarios...however, MOST of my projection models focus on fairly modest outcomes (such as 2-4% property appreciation, 2-4% rent growth, etc.). It's these more modest, relatively conservative models that are the "meat and potatoes" of my strategizing.

Although net worth is part of my models, and many investors love to brag on their net worths, net worth can be an incredibly misleading number. Consider two hypothetical investors:

Investor A tells you "my net worth is $10 mil". That may sound pretty good...until you discover that their net worth is decreasing at a rate of $2 million per year, and they've got $100 mil of adjustable rate debt on a portfolio of D class properties that forces them to work 80+ hours per week just to keep the whole thing afloat...

Investor B tells you "my net worth is $1 mil" --to many successful investors, that sounds like a relatively insignificant net worth...but, investor B owns a portfolio of A class properties with zero debt, professionally managed, their cashflow is $500k per year, their net worth is increasing at a rate of $1 mil per year, and they only have to work about 1-2 hours per week to keep their machine going.

Personally, I'd MUCH rather be investor B than investor A (even though investor A's net worth is 10x of investor B's).

So yeah, tracking net worth is advisable, but it's only a small part of what an investor should be tracking and modeling, and net worth alone might not be very indicative of an investor's success...

An effective investor creates models to help them strategize, and those models inevitably include net worth, but they include a LOT more than just net worth (and as a result, they can be quite time-intensive to create)...but, the things that are most worth doing usually ain't easy...

 Great post, Leo. I run financial projections for the families I serve using a planning software called eMoney. Some of the variables that go into the software include expenses broken down to as many details as they prefer, different types of income, assets, liabilities, different growth rates, etc. The software can produce many detailed reports but the ones I include for most families are cash flow, net worth, estate calculations, tax reports, etc. What I've found is that while the reports produced by the modeling software are helpful, they are not without limitations. 

As you mentioned, I've found that modeling projections for more than 15 years into the future is not as helpful. Especially for young folks. For those people, I've found that using software and presenting all kinds of different reports is overkill, it can frankly become confusing and overwhelming (imagine having a conversation with a 30-year-old about their estate calculation 40+ years into the future). Instead, I built a simpler Excel model with variables like their asset balances, any contributions/debt paydown, growth rates, and future value calculations for different time frames not exceeding 15 years. I use this simpler model to supplement the educational conversations we have about good financial habits. 

The other limitation I've found with eMoney (and many other professional software) is that they do handle basic real estate projections like depreciation, amortization schedules, income/expenses, net equity, etc. However, the software is designed to produce reports and projections from property already owned. In other words, you can't use it to analyze potential deals. So I build an Excel model for that. 

Lastly, I couldn't agree more with you regarding some of the drawbacks of models. They take a long time to build and refine if built by hand and you have to understand the calculations and assumptions behind them.