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How to Evaluate Rental Property Risk with a Scenario Analysis

By James Kobzeff

Republish: EasyPublish™ Published: 14Jul2009 Word count: 626 Viewed: 239 time(s) Get Free Content For Your Site

The scenario analysis method is favored amongst real estate investors and investment property specialists because it provides a good way to measure risk during the process of evaluating real estate investments.

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. However, you also feel that the cap rate is too low (meaning the price is too high in your opinion) and the seller will not drop 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. If you use a quality real estate investment software solution to do this you should see what the cash flow, cap rate and cash on cash return is based on that data. If you're using your own spreadsheet, be sure to include those calculations so you can quickly compare them to the scenarios.

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". In other words, you want to enter those three separate rents into your software solution or spreadsheet to see the resulting cash flow, cap rate and cash on cash for each scenario.

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 work with investment property (or intend to) be sure to take advantage of a scenario analysis. 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.

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