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 in accordance with 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 perform if 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.
- Worst case scenario: if rents go down or don’t change at all
- Most likely case: the most realistic rents that can be obtained
- Best Case Scenario Rentals Beyond Our Wildest Dreams
Assume, for example, that you are evaluating a rental property consisting of five units rented at $900, which produces an annual rental income of $54,000 and results in a cap 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 making a blind decision, you can explore the influence that various rent changes would have on performance. In other words, at the very least, you can see what rents would have to be collected to reach your capitalization 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 that current property rents are low and offer some “upside potential.” Therefore, you may want to pay the sales price confident that you can increase rents and therefore improve the performance of the property. Otherwise, if rents were to increase 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 purchase a real estate investing 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.