How Sensitivity Analysis Benefits Real Estate Investors

sensitivity-analysisSensitivity analysis has become a popular method of “number crunching” real estate investors more frequently benefit from during property valuation and the investment decision process.

This is mainly due to the advent of spreadsheets and real estate investment software. What would have taken hours before makes sensitivity analysis effortless now.

Many investors, of course, are generally aware of this and already include “sensitivity” models. After all, investment real estate stands or falls based on its numbers, so it’s not likely that any prudent investor would want to ignore any “number crunching” that might contribute to smarter real estate investing decisions.

In this article, we’ll discuss sensitivity analysis for those of you who are not aware of what it is or how it’s applied; including several illustrations of sample applications to give you the idea.

The Model

Sensitivity analysis involves changing one variable at a time over a possible range of outcomes to evaluate the effect of that change.

In other words, it takes a variable (e.g., property price) and runs a range of values for that variable in incrementally steps of some amount along with the corresponding returns and measures produced by those values.

For example, a rental income property priced at (say) $500,000 would generate a certain capitalization rate based upon that price. Likewise, a change in that price (say to $530,000) would also change the capitalization rate for that modified price as result.

This is the benefit of sensitivity analysis. It enables real estate investors to gauge a property’s performance, profitability, and rates of return based upon a range of variables.

There are no specific rules for the analysis. Other than correct calculations for “steps” in the variables and their outcomes, the final report is simply a table comprised of columns and rows. How many rows and columns is arbitrary; as is the variable you step and corresponding outcomes you are evaluating.

Sample Applications

Here are three samples where I use the sensitivity model in my real estate analysis presentations. They evolved over time from personal experience and customer suggestions, and have proven to be helpful to real estate investors. So I’m glad to share them with you.

1) Price Sensitivity

This concerns changes to property sale price (the variable). In this case, the outcome being evaluated are the investor’s cash requirement, loan amount, mortgage payment, cash flow, cap rate, and cash on cash return.

This is used for both rental property sellers and buyers. It helps sellers establish a more realistic asking price based upon returns in line with the local market; it helps buyers decide on a purchase price in line with their desired rates of return.

In this illustration I started with the variable amount of $4,500,000 (in bold) and “stepped” it up and down in increments of $10,000.

Illustration (click image to enlarge)
sensitivity-analysis-illustration


Source: ProAPOD Real Estate Investment Software

2) Down Payment Sensitivity

This is processed the same way. Except the objective here is to run a range of down payment amounts in order to examine the investor’s annual loan payment, debt coverage ratio (DCR), cash flow before tax, and cash-on-cash return (C-O-C).

In this illustration the variable amount is $1,200,000 and I “stepped” it up and down in increments of $5,000.

Illustration (click image to enlarge)
dp-sensitivity-analysis


Source: ProAPOD Real Estate Investment Software

3) Loan-to-Interest Table

This provides a good way for investors to determine monthly loan payment based upon a range of loan amounts and interest rates. The procedure is not unlike the previous two illustrations, but in this case you want to step the loan amount and the interest rate.

In this illustration I “stepped” the loan amount of $350,000 in increments of $5,000 and the interest rate of 6.00% in increments of 0.125%.

Illustration (click image to enlarge)
loan-to-interest-table


Source: ProAPOD Real Estate Investment Software

So You Know

ProAPOD Real Estate Investing Software solutions provide all three types of sensitivity analysis discussed in this article.