How do you generate real estate financial models? In many cases, the real estate financial model that works best depends on the specifics of the transaction. For example, if you are concerned about interest rate risks, you might run a sensitivity analysis to identify the most influential variables. On the contrary, if you are looking to see how multiple factors mesh together and impact an outcome, you might utilize scenario analysis.
There’s no one-size-fits-all approach to building a comprehensive and useful financial model; however, there are two strategies that are widely used. In this article, we’ll dive into the details of sensitivity analysis and scenario analysis, giving you the ability to determine when to use each in a real estate deal.
What is Sensitivity Analysis?
Sensitivity analysis is a financial modeling method that tests the impact of changing a variable. This could be anything, such as the upfront purchase price, the sale price, operating costs, capital expenditures, or financing costs. Let’s say that you have identified a deal and want to know the most favorable purchase price. In this situation, you would run models based on different purchase prices to determine the best price.
Moreover, sensitivity analysis is commonly used to determine which variables have the most influence on a model’s results and to evaluate the likelihood of a deal succeeding under different conditions. Each sensitivity analysis financial model will include a base-case, best-case, and worst-case scenario, giving you transparency in expectations.
Example: Sensitivity Analysis
Let’s say that you have entered into a contract to purchase a residential apartment building. Since the deal doesn’t close for six months, you aren’t able to lock in the interest rate for another five months. You decide to run a sensitivity analysis and receive the following results:
- Base-Case – Interest rated are currently 6%. If they remain steady, the deal will produce a 10% profit margin.
- Best-Case – Interest rates decrease to 5%, making financing more affordable. If this happens, your profit margin will increase to 12%.
- Worst-Case – Interest rates increase to 7%. If this occurs, your profit margin drops to 8%, and you need to find alternative options to reduce costs.
By putting together a sensitivity analysis financial model that dives into interest rates, you can better plan. For example, as a proactive approach, you might look into alternative ways to lower costs, such as raising equity capital instead of financing the entire project or cutting out certain renovations.
What is Scenario Analysis?
While sensitivity analysis only focuses on one factor, scenario analysis examines the impact of multiple variables. For example, in your financial model, you might create a model with a 5% interest rate and a $500,000 purchase price and a model with a 7% rate and a $400,000 purchase price. With this information, you can then evaluate the impact on operating expenses and overall profitability. By testing multiple variables at once, you can refine your model to meet your goals.
Furthermore, scenario analysis is also commonly used to project future cash flows. Let’s say that you are closing on a commercial building and want to maximize rent revenue. Using scenario analysis, you can run a projection on the increase in cash flow from adding units versus the cash flow with no renovations. This insight allows you to make an informed decision that aligns with your goals.
Example: Scenario Analysis
Bouncing off our above example, let’s add some numbers. The current rental income is $50,000. You have two options to increase rent: rehab existing units or construct units from the ground up. It’s estimated that rehabbing existing units would cost $20,000 and result in a 5% increase in rent while building units from the ground up will cost $45,000 and generate a 12% increase in rent. You use scenario analysis to evaluate the return on investment:
- Rehab of Existing Units
- $50,000 x 5% = $2,500 Added Rental Income
- $2,500 / $20,000 = 12.5% Return on Investment
- Ground-Up Construction
- $50,000 x 12% = $6,000 Added Rental Income
- $6,000 / $45,000 = 13.3% Return on Investment
Based on this example, you would choose the ground-up construction because it offers a higher return on investment. However, your scenario analysis would take this a step further, evaluating the impact of financing costs and future rent prices before making your decision. If you’ll be able to increase rents on the rehabbed units by 7% next year but only 2% on the ground-up units, your decision might change.
The Role of Each in Real Estate Financial Modeling
Both sensitivity analysis and scenario analysis play an important role when evaluating real estate deals and decisions. For one, you might want to understand the impact of changing one detail, like the interest rate, financing method, or operating expenses. On the other hand, it can be helpful to look at the big picture and how different variables are dependent on each other, like the purchase price and financing costs.
Moreover, sensitivity analysis provides a quick and focused analysis of one factor. This is a great option for last-minute changes and fast data. Scenario analysis is better leveraged when managing complex situations and strategic planning. Taking the time to look at the relationship and outcomes of different variables can be a time-consuming and tedious process.
As a result, sensitivity analysis is used to pinpoint specific risks, while scenario analysis is beneficial for broader potential outcomes. Working both types of financial models into your deal analysis and decision-making process will generate the best outcomes. You will be able to recognize granular risks from changing variables while understanding the influence of different variables on your goals.
The Perfect Pair: Combining Sensitivity and Scenario Analysis
Both Scenario analysis and sensitivity analysis have advantages and use cases. Leveraging both of these real estate financial models gives you the information to make well-rounded decisions. After all, the more insights you have into potential risks and outcomes, the more agile and prepared you can be.