Sensitivity Analysis: How to Use for Real Estate Investing
The idea that real estate investors could routinely use a Sensitivity Analysis as part of their investment 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.
Okay, so what is it? Sensitivity analysis involves changing one variable at a time over a possible range of outcomes to evaluate the effect of that change.
For instance, consider the image above as a simple illustration. In this case, the variable changed is the price (i.e., in increments of $10,000) and the possible range of outcomes effected by that price is the cap [rate].
Thie benefit of a sensitivity analysis to real estate investors, of course, is that it enables them to review the impact a change in any particular variable would have upon the investment property's bottom-line numbers. In this article we'll consider three such variables along with a sample report you can preview for each to drive home the idea.
- Down Payment
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 what the financial outcome will be based upon a series of possible purchase prices and would benefit from a sensitivity analysis.
The model used in our sample reflects the investor's cash requirement (i.e., down payment and closing costs) and loan amount as well as the annual amount for cash flow, cap rate and cash-on-cash. But the analysis can reflect whatever amounts you prefer.
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 real estate investing software provides sensitivity analysis for all three models illustrated above with printable reports.