How Scenario Analysis Helps Measure Risk When Investing in Real Estate
Scenario analysis is used by real estate investors and investment property specialists because it provides a good way to measure risk when evaluating real estate investments.
What is scenario analysis? It involves estimating a series of variables that will have the greatest impact on the probability that an investment will be made in accordance with the minimum expectations of an investor. Rental income, for example, is subjected to scenario analysis when the analyst wants to measure the performance of investment properties based on various rental scenarios. In other words, how well does the property perform in the event that rents go down or up?
Scenario analysis generally considers three scenarios. In this case, we will assume that our scenario analysis aims to explore what influence changes in rents would have on property performance.
- Worst case: if rents go down or don’t change at all
- Most likely case: the most realistic income that can be obtained
- At its best: rentals beyond our wildest dreams
Suppose, for example, you are evaluating a rental property that consists of five units rented at $ 900, which produces an annual rental income of $ 54,000 and results in a capitalization rate of 6.23%. Although you are interested, you think the capitalization rate is too low (you prefer a 7.0% capitalization rate). The seller will not lower the price (which would increase the capitalization rate), so you are faced with the dilemma of paying the price (against your best judgment) or walking away.
This is where a rental scenario analysis can help. Rather than making a decision blindly, you can explore the influence various rent changes would have on your performance. In other words, at a minimum, you can see what rents should be charged to achieve your capitalization rate, and whether they are probable or false.
In this case, you would consider all three scenarios: worst case, most likely, and best case. If your desired capitalization rate were achievable within the first two scenarios, it would indicate that current property rents are low and provides some “upside potential.” Therefore, you may want to pay the sales price with the confidence that you can increase rents and therefore improve the performance of the property. Otherwise, if rents had to increase beyond your wildest dreams to reach your capitalization rate, you might want to walk.
How do you build a rental scenario analysis? You can use a spreadsheet or purchase a real estate investment software program. Just remember what it is you want to achieve. You want to see the bottom line in things like cash flow and rates of return based on a variety of rental scenarios. You may be surprised what you find out about the property.