How to Evaluate Investment Real Estate Risk with a Scenario Analysis

The scenario analysis method provides a good measurement of real estate investment risk regularly used and favored by real estate analysts and individual investors.

What Scenario Analysis Is

Scenario analysis 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 with typically three scenarios: worst-case, most likely and best-case scenario.

Rental income, for instance, is subjected to scenario analysis because the real estate analyst wants to see the outcome on cash flow, rates of return, and profitability for various income scenarios as a gauge to measure the potential investment property performance.

For example, say you're looking at an apartment complex selling at a 6.23% cap rate and a gross scheduled income of $54,000 generated from five units each renting for $900 per month. But it's your opinion that the cap rate is too low (meaning the price is too high) and you have been told that the seller will not budge on the price. So you are faced with a dilemma: to either pay the price for the apartment complex (against your better judgment) or walk away.

Okay, this is where a rent scenario analysis can help you make your investment decision.

The analysis will allow you to explore the influence that various changes to rent have upon property performance. In other words, you can see what cash flows and rates of return result from a change in rents and at the same time discover what rents are required to achieve your cap rate; therein highlighting the risk you might be taking if you purchase the property at the asking price and later hope to achieve your desired rate by raising the rents.

How It's Done

First, you would create a real estate analysis based upon the property's income and expenses and your projected financing plan. This gives you a starting point. With quality real estate investment software you should then get a calculation for the cash flow, cap rate and cash on cash return based on that property data. If you don't use investment software and instead are using a homemade spreadsheet, be sure to include those calculations in an easy-to-read table format so you can quickly compare all the scenarios side by side.

Next, you want to consider three rent scenarios: worst-case, most likely, and best case, or "no change to rents", "realistic increased rents", and "rents beyond your wildest dreams". Here's the idea: you want to enter those three separate rents into your software program or spreadsheet so you can what the cash flow, capitalization rate and cash on cash return becomes for each scenario as a result.

Finally, examine the results. If your desired cap rate is attainable, but only if rents increase beyond your wildest dreams, you might consider the risk too high and walk away. Whereas, if you determine that your desired cap rate can be achieved with a more realistic rent increase, you might hang in there and dig deeper into the property.

Why It's Popular

Scenario analysis has become popular because easy-to-use real estate investment software programs can calculate and recalculate a range of variables quickly. What would have taken hours before, now with the computer and template-based spreadsheet software for the computer, takes just minutes. Moreover, good real estate investment software solutions create printable tables and reports.

Of course, no investment decision should be made solely on one analysis, but scenario analysis has provided real estate agents and investors with valuable information that later proved invaluable.

If you're serious about investment property be sure to take advantage of a scenario analysis the next time you need to make an investment decision. It has proven to be an excellent way (thanks to computers and software) to examine variables quickly, and not surprisingly has played a significant part in real estate investing selling and buying decisions.