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August 22, 2013

Risk and sensitivity are the most important attributes of an effective financial model.

Often times it seems as if CRE decisions come down to financial models that tell you what the best 10 year NPV is.  Well I’m here to tell you that most of those financial models are not worth the 1s and 0s the spreadsheet is written in.

Financial models are no better than the assumptions baked into them.  And we all know what assumptions mean.  Most models forget about the “what if” factor.  Yes, that scenario downtown may be 10% higher cost than midtown.  But what about the ability to sublease if the growth projections don’t work out as expected?  Suddenly it may be 5% better over 10 years given a set of 5 or 6 realistic scenarios.

Or you can have a lot of fun and run a Monte Carlo simulation of millions of possible scenarios and understand the true risks and opportunities that you have available.

The point is that a financial model that has a single value output for a scenario is not worth the paper it would be printed out on.  It only looks at 1 possible future instead of many of them.  You can make any scenario the best or worst by varying completely realistic assumptions that are baked into the model.

Don’t accept half-baked financial models.

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