As a commercial real estate investor, property profitability depends on many factors that can be calculated in any number of ways using different methods. So, how do you know which calculation or measurement to use to determine if an investment property will be profitable and fit your financial goals?
One commonly used method is a commercial real estate sensitivity analysis.
What is a Sensitivity Analysis?
A sensitivity analysis is a useful method of assumption, one that many investors use before they purchase a property to determine if a commercial property is likely to meet their investment goals. It is a visual what-if analysis of the unknown variables and how they can change throughout the life of the investment. These variables can include but are not limited to the price of the property, holding period, cap rate at sale, lease renewal probability, vacancy rates, interest rate, debt yield, and more.
The purpose of a sensitivity analysis is to investigate how any two measures vary with a change in one of the assumptions. Any measure or variable may be chosen for the sensitivity analysis, just as any assumption may be chosen. For example, you could look at the after-tax rate of return versus the vacancy factor.
The analysis is useful because these are factors beyond your control – like the inflation rate or selling price – which allow you to figure out the worst-case scenario.
A sensitivity analysis will help you answer questions like:
- What would my net operating income (NOI) be if I bought the property for $X and charged $Y for rent?
- What is the lowest rent can I charge and still turn a profit?
- 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?
- How does my down payment affect my return?
A sensitivity analysis is a method that takes into account several factors that impact an investment property’s return and helps you calculates how a change in each factor would affect profits.
Examine the Size of Your Down Payment as Part of the Sensitivity Analysis
The amount you put down on a property will, of course, affect the property’s profit potential. So knowing beforehand the minimum down payment you need to make a profit allows you to estimate how much leverage you’ll need to rely on.
Use a sensitivity analysis to estimate the cash-on-cash (CoC) return, the annual loan payment, and the debt coverage ratio. Each one will provide a different angle on the property’s potential, which is important when deciding how a particular property fits in with other investments in your portfolio.
Another variable combination to explore is the loan amount versus the interest rate. Comparing these two 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 and the best ROI.
How Does a Sensitivity Analysis Work?
Running a real estate investment sensitivity analysis can be quite complicated. You can use a template-based program like Microsoft Excel or specific third-party software, or better still, engage a buyer’s advisor to do it for you. At Westwood Net Lease Advisors, we have the latest technology and tools that make calculating your return on investment much easier, freeing up your time and reducing the stress of uncertainty.
If you choose to do a sensitivity analysis on your own, here’s how it works.
First, decide which variables you’d like to test out. To choose the most important ones for your investment goals, ask yourself a few questions:
- What result do you want to discover from this analysis? Some examples include NOI, cap rate, IRR, or purchase price.
- Variable #1: Which variable would you like to test out? Some examples include vacancy rate, interest rate, or cap rate.
- Variable #2: Choose the 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, 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, to make sure your numbers are clean, stick to one variable at a time.
Sensitivity Analysis for NNN Investments
When performing a sensitivity analysis for NNN lease investments, it much easier to predict your potential profitability. Because NNN properties are typically tenanted by major brands with long-term, corporate-guaranteed leases and few, if any, landlord expenses, there are fewer variables – most often the tenant will not vacate early, and the rent is paid no matter what. With absolute NNNs, there are no landlord expenses, so that variable goes away. Basically, in most cases, the rent received is the NOI, and the asset holds it resale value.
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.
To Wrap it Up – Why a CRE Sensitivity Analysis is Useful
When you invest in any commercial real estate, there’s no way to know exactly how a potential property will perform, but a sensitivity analysis can provide an in-depth look at different profitability scenarios. It is good practice to understand how this analysis works before you purchase, and why estimations of variables that are out of your control are important.
If you choose to purchase a NNN lease property investment, the sensitivity analysis becomes much more straightforward, as does your overall investment property ownership. Additionally, if you engage a Westwood Net Lease Advisor to help you with your purchase, he will do it for you.
Our team has decades of experience in helping new and seasoned investors alike with the commercial real estate buying process. We specialize in NNN lease investments and 1031 exchanges, and guide buyers through the process with ease, starting with education and advocacy, all the way through closing, at no cost. Contact us today if we can help! Our no-obligation conversations are free – we look forward to meeting you! 314-997-5227
