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How Scenario Analysis Helps Measure Risk When Real Estate Investing

How Scenario Analysis Helps Measure Risk When Real Estate Investing

By James Kobzeff

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 range of variables that will have the greatest impact upon the likelihood of an investment performing according to an investor’s minimum expectations. Rental income, for instance, is subjected to scenario analysis when the analyst wants to gauge investment property performance based on various rent scenarios. In other words, how well does the property perform in the event rents decline or increase?

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

Worst-case – if rents decline or do not change at all
Most-likely case – the most realistic rents that can be obtained
Best-case – rents beyond our wildest dreams

Assume, for example, you are evaluating a rental property consisting of five units rented at $900, producing $54,000 annual rental income, and resulting in a cap rate of 6.23%. Though you are interested, you feel that the cap rate is too low (you prefer a cap rate of 7.0%). The seller will not drop the price (which would raise the cap rate), so you are faced with a dilemma to either pay the price (against your better judgment) or walk away.

This is where a rent scenario analysis can help. Rather then making a decision blindly, you can explore the influence that various changes in rent would have upon performance. In other words, at the very least, you can see what rents would have to be collected to achieve your cap rate, and whether they are likely or pie-in-the-sky.

In this case, you would consider all three scenarios: worst-case, most likely case, and best case. If your desired cap rate were attainable within the first two scenarios, it would indicate that the property’s current rents are low and it does provide some “upside potential.” So you might want to pay the asking price confident that you can increase rents and thus improve the property’s performance. Otherwise, if rents would have to be raised beyond your wildest dreams to attain your cap rate, you might want to walk.

How do you construct a rent 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 outcome on essentials like cash flow and rates of return based upon a range of rent scenarios. You might be amazed what you uncover about the property.

You can see a sample Scenarios report at Just follow Reports.

About the Author

James R Kobzeff is the developer of ProAPOD Real Estate Investment Software – Rental property cash flow, rate of return, and profitability analysis. Sensitivity and scenario reports. Easy to use.

Real Estate Investor
– So those just starting to invest in real estate can determine whether the property makes money before invest. Dynamic reports. Easy to use. []Mortgage and Financial Calculator – Compute hundreds of mortgage, time value, and cash flow computations in seconds! Printable schedules and tables.

Article Source: How Scenario Analysis Helps Measure Risk When Real Estate Investing



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