If you’re an investor, then you know that whether a particular property is profitable depends not only on the property, but on how the property fits in with your investment goals.
If you’d like to determine whether or not a property meets your investment goals, then one of the best ways to do that is to do a sensitivity analysis.
What is a Sensitivity Analysis?
A sensitivity analysis takes into account several factors that might impact the property’s returns and computes how a change in each factor would affect profits.
This is useful because it takes into account factors that are beyond the investor’s control – like the selling price – allowing you to figure out the worst case scenario.
A sensitivity analysis will help you answer questions like:
- What is the lowest rent can I charge and still turn a profit?
- What would my NOI be if I bought the property for $X and charged $Y for rent?
- At what vacancy rate will I start losing money?
- I want to buy the property for not more than $X; what would the cap rate and NOI be in such a case?
- What is my debt service likely to be if I paid $X for the property with $Y interest?
- Will I have enough to pay my debt service if my vacancy rate is $X?
- At what point will the property start losing money?
Another important factor to examine is the size of the down payment.
The amount you put down on a property will of course affect the property’s profit potential. So knowing beforehand the minimum you need to put down in order to make a profit allows you to estimate how much leverage you’ll need to rely on.
But don’t just figure the NOI. Use a sensitivity analysis to estimate the cash on cash return, the annual loan payment and debt coverage ratio as well. Each one will give a different angle on the property’s potential, which is important when deciding how a particular property fits in with the other investments in your portfolio.
Another variable combination to explore: loan amount vs interest rate. Comparing these two variable will help you figure out what your monthly mortgage rate will be if you get a loan of $X at a particular interest rate. This makes it much easier to compare lenders to see which offer will give you the lowest possible monthly payment.
How a Sensitivity Analysis Works
Running a sensitivity analysis can be quite complicated, which is why you’ll do one either through Excel or third-party software.
Here’s how it works.
First, decide what variables you’d like to test out. In order to choose the most important ones for your investment goals, ask yourself a few questions:
1) What result do you want to discover from this analysis? Some examples include: NOI, cap rate, IRR, or purchase price.
2)Variable #1: What variable would you like to test out? Some examples include: vacancy rate, interest rate, or cap rate.
3)Variable #2: Choose a second variable.
Now open a spreadsheet; variable one will occupy the column and variable two the row. The output, or result of the two variables will populate the table.
Remember, in order to obtain accurate data, you should change only one variable at a time. Keep in mind that with some variables, changing one will naturally affect another variable, but regardless, in order to make sure your numbers are clean, you should stick to one variable at a time.
Of course there’s no way to know exactly how a potential property will perform, but the sensitivity analysis is a good way to get clear on the risks (and benefits) of investing in a particular property – before you sign on the dotted line.