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Learn About Sensitivity Analysis and Drive Your Real Estate Analysis

Learn About Sensitivity Analysis and Drive Your Real Estate Analysis

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Published by James R Kobzeff
Discover the meaning and usefulness of a sensitivity analysis to real estate investing and why it should be part of your real estate analysis.
Discover the meaning and usefulness of a sensitivity analysis to real estate investing and why it should be part of your real estate analysis.

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Published by: James R Kobzeff on Nov 19, 2008
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08/07/2011

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PROAPOD
®Real Estate Investment Softwarewww.proapod.com
Learn About Sensitivity Analysis and Drive Your Real Estate Analysis
 James R Kobzeff 
In this article, we'll discuss three ways you can incorporate sensitivity analysis into a real estateanalysis for smarter investment decisions. Before we get started, though, let's be sure weunderstand the basics of real estate investing.Real estate investing involves acquisition, holding, and sale of rights in real property with theexpectation of using cash inflows for potential future cash outflows in order to generate a favorablerate of return on that investment. The goal of real estate investing is to make a profit and acquirewealth. Therefore, real estate investing is all about the numbers—investment real estate stands or falls based on its numbers.Thus, prudent investors always concentrate on the bottom line when considering real estateinvestment opportunities. They "crunch the numbers" before making any decision to buy, sell, or hold real estate.The more data you obtain about an investment property, therefore, and the more you are able to digin to that data, the better chance you have of making a wise investment decision. That's wheresensitivity analysis comes in.
Sensitivity Analysis
Sensitivity analysis involves changing one variable at a time over a possible range of outcomes toevaluate the effect of that change; thus allowing real estate analysts to review each variable'simpact upon the investment property's present value.To do this, you would enter an amount to "step" the variable and the corresponding returns wouldin 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, $80,000and so on along with whatever returns are provided by the real estate investment software you'reusing for your real estate analysis.
Price Sensitivity
A price sensitivity analysis changes a property's sale price in increments over a range of outcomesso you can evaluate such things as the cash requirement, loan amount, mortgage payment, cashflow, cap rate, and cash on cash return (depending on the real estate investment software you're
©2008 James R Kobzeff. All rights reserved.
 
using) resulting from that change.For example, suppose the asking price for a property is $500,000 and you want to know what thecap 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 analysiswill display a range of prices in increments to that step, i.e., 505,000, 510,000, 515,000, etc. alongwith 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 paymentamounts. Let's say, for instance, an income property will produce a 5.5% cash-on-cash return witha down payment of $150,000, but you want to know how much of a down payment is required toachieve 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 beable 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.
Loan-to-Value Sensitivity
The loan to value sensitivity is a good way for you to determine the monthly loan payment basedupon 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 variousinterest 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 thosevariations.
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 havetaken hours before, now with the computer and template-based spreadsheet software for thecomputer, 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 sensitivityanalysis. It has proven to be an excellent way to examine variables quickly, and not surprisingly
©2008 James R Kobzeff. All rights reserved.

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