Scenario Analysis – Measuring Property Investment Risk
Scenario analysis provides a good way for real estate investors to measure risk when evaluating real estate investments that involves estimating a range of variables that will have the greatest impact upon the likelihood of an investment performing according to an investor's minimum expectations.
Rental income, for instance, is subjected to scenario analysis when the investor wants to gauge property performance based on various rent scenarios. How well does the property perform in the event rents decline or increase? That's what a scenario analysis reveals to the investor.
Let's look at an illustration that assumes our scenario analysis is intended to explore what influence changes to rents would have on property performance. Scenario analysis typically uses three cases, which we will apply to our rent analysis.
- Worst-case – if rents decline or do not change at all
- Most-likely case – the most realistic rents that can be obtained
- Best-case – rents beyond our wildest dreams
For example, let's assume that we're evaluating a five-unit apartment complex each rented at $900 therein producing a $45,000 gross scheduled income, priced at 6.23% cap rate. But we feel that the cap rate should be no lower then 7.0%. Because the seller won't drop the price (which would raise the cap rate), we are faced with a dilemma of either paying the price and risk losing money on the investment or walk away from the deal.
In this case, rather then making a blind decision, we can generate a scenario analysis and explore the influence various changes in rent would have upon performance, thereby measuring our risk.
For our scenario analysis, we simply enter a rent amount in each rent category—worst-case, most likely case, and best-case scenario—then analyze the rates of return such as cap rate resulting for each of those rent amounts.
If our desired cap rate is attainable, at least in the most likely rent scenario, we can conclude by our scenario analysis that the property's current rents appear low with ample "upside potential", or, room for the rents to be increased. This means we might want to pay the price and then raise the rents immediately after we assume ownership.
If our desired cap rate is not met, even if rents were increased beyond our wildest dreams, we might want to walk away unless the owner reconsiders the asking price. Who knows, we might even present our scenario analysis to help persuade the seller; a well-structured scenario analysis has achieved that for others.
ProAPOD® Real Estate Investment Software provides scenario analysis with a printable rent scenarios report. Cash flow and rates of return such as cap rate are recalculated in real time each time you enter or change a rent variable. So you analyze the numbers as you enter the data.
About the Author
James Kobzeff is the developer of ProAPOD® - leading real
estate investment software for agents and investors. It's fast, easy, and concise. Create rental
property cash flow and rate of return presentations in minutes! Learn more at => http://www.proapod.com
