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How scenario analysis helps measure risk when investing in real estate

Real estate investors and investment property specialists use scenario analysis because it provides a good way to measure risk when evaluating real estate investments.

What is scenario analysis? It is about estimating a range of variables that will have the greatest impact on the probability that an investment will perform according to an investor’s minimum expectations. 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 hold up should rents go down or up?

Scenario analysis typically considers three scenarios. In this case, we will assume that our scenario analysis is intended to explore what influence changes in rents would have on property performance.

  1. Worst case: If rents go down or don’t change at all
  2. Most likely case: the most realistic rents that can be obtained
  3. At Best: Rentals Beyond Our Wildest Dreams

Assume, for example, that you are evaluating a rental property consisting of five units rented at $900, producing an annual rental income of $54,000, and resulting in a capitalization rate of 6.23%. Although he is interested, he believes the cap rate is too low (he prefers a 7.0% cap rate). The seller will not lower the price (which would raise the cap rate), so he is faced with the dilemma of paying the price (against his better judgment) or walking away.

This is where a rental scenario analysis can help. Instead of blindly making a decision, you can explore the influence that various rent changes would have on performance. In other words, at least you can see what rents would have to be charged to reach your cap rate and whether they are likely or unusual.

In this case, you would consider all three scenarios: worst case, most likely case, and best case. If your desired cap rate were achievable within the first two scenarios, it would indicate current property rents are low and offer some “upside potential.” Therefore, you may want to pay the asking price confident that it can increase rents and therefore improve the performance of the property. Otherwise, if rents had to rise beyond your wildest dreams to reach your cap rate, you might want to walk.

How do you build a rental scenario analysis? You can use a spreadsheet or buy a real estate investment software program. Just remember what it is you want to achieve. You want to see the outcome of essentials like cash flow and rates of return based on a variety of rental scenarios. You may be surprised at what you discover about the property.

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