In this article, we’ll discuss three ways you can incorporate sensitivity analysis into a real estate analysis to make smarter investment decisions. Before we get started, though, let’s understand the basics of real estate investing.
Real estate investing involves acquisition, holding, and sale of rights in real property with the expectation of using cash inflows for potential future cash outflows in order to generate a favorable rate of return on that investment. The goal of real estate investing is to make a profit and acquire wealth. Therefore, it’s all about the numbers–investment real estate stands or falls based on its numbers.
As a result, successful real estate investors always pay attention to the bottom line when evaluating real estate investment opportunities. That is, they “crunch the numbers” as much as possible before making any decision to buy, sell, or hold real estate.
It makes sense therefore that the more data you obtain about an investment property and the more ways you can evaluate that data, the better chance you have of making a wise investment decision. That’s where sensitivity analysis comes in.
What Sensitivity Is
Sensitivity analysis involves changing one variable at a time over a possible range of outcomes to evaluate the effect of that change; thus allowing real estate analysts to review each variable’s impact upon the investment property’s present value.
To do this, you would enter an amount to “step” the variable and the corresponding returns would in turn reflect that amount.
For example, if the variable amount was $100,000 and you step it $10,000, you create a range of amounts both higher and lower than the variable such as $120,000, $110,000, $90,000, $80,000 and so on along with whatever returns are provided by the real estate investment software you’re using for your real estate analysis.
A price sensitivity analysis changes a property’s sale price in increments over a range of outcomes so you can evaluate such things as the cash requirement, loan amount, mortgage payment, cash flow, cap rate, and cash on cash return (depending on the real estate investment software you’re using) resulting from that change.
For example, suppose the asking price for a property is $500,000 and you want to know what the cap rate becomes if the price were reduced (or raised) in increments of maybe $1,000, $5,000, or $10,000. Simply input an amount to “step” the sale price (say, $5,000), and the sensitivity analysis will display a range of prices in increments to that step, i.e., 505,000, 510,000, 515,000, etc. along with the resulting cap rate for each one of those sale prices.
Down Payment Sensitivity
Suppose you want to determine the cash on cash return based upon a range of down payment amounts. Let’s say, for instance, an income property will produce a 5.5% cash-on-cash return with a down payment of $150,000, but you want to know how much of a down payment is required to achieve a 6.5% cash-on-cash return.
As before, to create the sensitivity analysis table, you simply input an amount to “step” the down payment. Depending on what real estate investment software program you’re using, you should be able to determine the results for the cash on cash return along with your cash requirement, mortgage payment, debt coverage ratio, and annual cash flow for each down payment amount.
The loan to value sensitivity is a good way for you to determine the monthly loan payment based upon a range of loan amounts and interest rates. It’s the same procedure as before but in this case, to create the sensitivity analysis, you want to step the loan amount and the interest rate.
Let’s say you want to evaluate the monthly loan payment for a range of loan amounts at various interest rates such as $300,000, 310,000, and 320,000 at 6.0%, 6.125%, and 6.25%. In this case, you input a dollar amount to step the loan and then a percentage to step the interest rate, and Viola! Your sensitivity analysis table is created with numerous monthly loan payments based on those variations.
Why It’s Popular
Sensitivity analysis has become popular because easy-to-use real estate investment software programs can calculate and recalculate a range of variables quickly.
Moreover, real estate investment software solutions create tables and reports. What would have taken hours before, now with the computer and template-based spreadsheet software for the computer, takes just minutes. So you’re without an excuse.
If you work with investment property (or intend to), be sure to take advantage of a sensitivity analysis. It has proven to be an excellent way to examine variables quickly, and not surprisingly has played a significant part in real estate investing selling and buying decisions.
James R Kobzeff is the developer of ProAPOD® – leading real estate investment software solutions. Create cash flow analysis presentations plus all three sensitivity analysis options in minutes! See how at www.proapod.com
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