Why Real Estate Investors Use Sensitivity Analysis for Investment Decisions
Real estate investors typically do an investment analysis to examine a specific rental property's financial and operational performance based upon unique requirements of the investor in order to make the most prudent real estate investment decision.
One such method is known as a sensitivity analysis. The idea is that a variety of outcomes could result from variables beyond the investor's control (e.g., the selling price) and the sensitivity analysis would enable investors to review the impact a change in any particular variable would have upon the investment property's bottom-line numbers and at minimum provides for the most likely, worst case, and best case scenarios.
Here's how it works.
Sensitivity analysis involves changing one variable at a time over a possible range of outcomes to evaluate the effect of that change. For example, the sensitivity analysis would illuminate for the investor the possible range of resulting cap rates based on changes to property price (say) in increments of $10,000.
The thought that real estate investors could routinely use a sensitivity model as part of their investment analysis process was once thought unrealistic given the amount of computations the model requires. But with the onset of personal computers along with template-based spreadsheet programs like Microsoft Excel and other third-party real estate investment software solutions, the process is now effortless for investors.
Therefore it seemed needful to illustrate three financial variables that real estate investors might consider examining with the sensitivity model. Click the link provided for each illustration to preview a sample report.
1. Price Sensitivity
The price real estate investors wind up paying for the investment, of course, is paramount to an investment decision because it affects the cash flows, rates of return and profitability the investor will get as a result of the property acquisition.
During the evaluation period, therefore, it just makes sense that the investor would be interested in knowing how well the rental property would financially perform based upon a series of possible purchase prices.
In our sample, the investor was primarily interested in knowing how a price change would affect the annual cash flow, cap rate, and cash-on-cash rate of return. The price is stepped in increments of $10,000 but it should be noted that that amount can be adjusted to any amount the investor wants.
2. Down Payment Sensitivity
How much cash down the investors are willing to fork over to make the acquisition is also a good variable worth analyzing because the amount will impact the investor's bottom line numbers outcome.
Our model, for instance, reflects both annual cash flow and cash on cash return as well as the investors cash requirement, annual loan payment and debt coverage ratio.
This model steps two variables: loan amount and interest rate. So investors can evaluate what to expect as a monthly mortgage payment in the event he or she obtains one particular loan amount at some given interest rate.
The benefit here, of course, is that the analysis results in hundreds of variations which enable the investor to examine in order to determine which combination yields the lowest possible monthly payment.
So You Know
ProAPOD provides a printable sensitivity analysis report in both it's Agent 6 and Executive 10 real estate investing software solutions.