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 Realestate investment. In other words, the goal of realestate investing is to make a profit and acquire wealth and therefore is all about the numbers investment real estate stands or falls based on its numbers.
Consequently, prudent 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 Property Laws.
It stands to reason therefore that the more data you obtain about an investment property and the more you are able to dig in to that data, the better chance you have of making a wise investment decision. That’s where sensitivity analysis comes in.
Okay, let’s get started and consider what sensitivity is along with three ways you can use it in your real estate analysis.
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.
An analysis of price sensitivity involves changing 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. Say, for instance, that an apartment complex produces 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 table, just input an amount to “step” the variable, which in this case is 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.