Building financial models is an art. The only way to improve your craft is to build a variety of financial models across a number of industries. Let's try a model for an investment that is not beyond the reach of most individuals - an investment property. property heat map for investors Before we jump into building a financial model, we should ask ourselves what drives the business that we are exploring. The answer will have significant implications for how we construct the model. Who Will Use It? Who will be using this model and what will they be using it for? A company may have a new product for which they need to calculate an optimal price. Or an investor may want to map out a project to see what kind of investment return he or she can expect. Depending on these scenarios, the end result of what the model will calculate may be very different. Unless you know exactly what decision the user of your model needs to make, you may find yourself starting over several times until you find an approach that uses the right inputs to find the appropriate outputs. On to Real Estate In our scenario, we want to find out what kind of financial return we can expect from an investment property given certain information about the investment. This information would include variables such as the purchase price, rate of appreciation, the price at which we can rent it out, the financing terms available fore the property, etc. Our return on this investment will be driven by two primary factors: our rental income and the appreciation of the property value. Therefore, we should begin by forecasting rental income and the appreciation of the property in consideration. Once we have built out that portion of the model, we can use the information we have calculated to figure out how we will finance the purchase of the property and what financial expenses we can expect to incur as a result. Next we tackle the property management expenses. We will need to use the property value that we forecasted in order to be able to calculate property taxes, so it is important that we build the model in a certain order. With these projections in place, we can begin to piece together the income statement and the balance sheet. As we put these in place, we may spot items that we haven't yet calculated and we may have to go back and add them in the appropriate places. Finally, we can use these financials to project the cash flow to the investor and calculate our return on investment.