Are you trying to add transparency to your real estate deals? How about uncovering the impact of future events? Real estate financial modeling using scenario analysis helps investors solve these issues and enter deals with confidence and clarity. In this article, we’ll explore the fundamentals of real estate financial modeling using scenario analysis, including an example and common assumptions to test for.
What is Scenario Analysis in Real Estate Financial Modeling?
Scenario analysis is the process of testing different assumptions in real estate transactions to determine potential outcomes. This type of financial modeling is commonly used to estimate changes in a portfolio’s value based on different market conditions. Although it’s impossible to fully project outcomes, scenario analysis helps investors determine best-case and worst-case scenarios to guide decision-making.
Heads up: scenario analysis is not the same as sensitivity analysis. Scenario analysis is based on mathematical and statistical principles. For example, the likelihood of Situation A happening compared to Situation B. In addition, scenario analysis tests different scenarios, following the principles of what-if analysis, also known as sensitivity analysis. Sensitivity analysis evaluates the outcome of changing one variable in an equation. This helps you identify potential cash flow, revenue, and profitability.
Types of Assumptions Tested for in Real Estate Financial Models
Real estate financial models use scenario analysis to evaluate all factors that will impact a deal, project, or property. Let’s go through a few of the assumptions your models should cover:
Acquisition Costs
The first assumption in a real estate financial model is estimated acquisition costs. How much do you expect to pay professionals, like lawyers, attorneys, and lenders, to acquire the deal? Think of all the costs found in the due diligence phase. For large projects, these costs can quickly add up and erode profitability, making it important to identify how changing cost levels impact the deal.
Occupancy Rates
Occupancy rates are an important factor in the equation. An occupancy rate of 90% produces much more revenue compared to an occupancy rate of 50%. Scenario analysis in real estate financial modeling will test different occupancy rates to determine expected outcomes in revenue and profit. Identifying ideal occupancy rates will also help guide decisions when remodeling or developing a project.
Profitability
Profitability is one of the core assumptions tested in financial modeling. After all, if a project isn’t expected to generate profit, it shouldn’t be pursued in the first place. Real estate financial modeling will test different profitability levels by changing other factors, such as acquisition costs and operating expenses.
Operating Expenses
Operating expenses are another assumption that is found in real estate financial modeling. By projecting operating costs, including repairs, maintenance, and financing costs, you can project profitability and determine which projects are worth undertaking. Additionally, the impact of rising contractor costs will also be evaluated when testing this assumption.
How to Set Up Different Scenarios
When it comes time to put together your real estate scenario analysis, there are a few different steps you want to follow. Here’s a quick overview of how to create your scenario analysis:
- Define the Assumption – First, decide what you want to achieve with your scenario analysis. For example, you might want to determine the impact of unfavorable changes in market conditions.
- Gather Data – Next, you want to gather relevant data. This could be information on how interest rates or property prices are increasing.
- Separate Certainties and Uncertainties – Here, you will pinpoint which assumptions are certain and which are subject to change. For example, if you know the purchase price would be $500,000, that would be certain. However, you might now know if interest rates will be 5% or 6%.
- Develop Scenarios – Now, you will develop your scenarios. For each decision, you will have a base-case, best-case, and worst-case scenario with probabilities of each occurring.
- Analyze Results – Next, analyze the results you receive. This step might also entail getting feedback from your peers and investors.
- Refine Analysis – Based on the results, you will want to refine your analysis. If there is only a 5% probability of something happening, you might want to focus your attention elsewhere.
This step-by-step analysis is the starting point for setting up your real estate financial models. You may need to adjust the processes based on the deal and your specific goals.
Real Estate Scenario Analysis Example
Let’s go through an example of how scenario analysis is used in a real estate transaction. You are considering purchasing a residential apartment building for $750,000. Currently, you plan on financing 80% of the purchase price with a bank loan. Your investors require a 15% profit margin. Occupancy is $100,000 per year, with new leases just signed, and you estimate that general maintenance costs are 50% of gross rent.
With two months until you can lock in your bank interest rate, you are concerned about increasing rates. The current rate is 5%. Here’s how you would put together your scenario analysis:
- Base-Case = $600,000 x 6% = $36,000
- Best-Case = $600,000 x 5% = $30,000
- Worst-Case = $600,000 x 7% = $42,000
Since operating expenses are 50% of gross rent or $50,000, you would need to add the projected interest expense from each scenario to determine if investors' expectations are still met.
- Base-Case = ($100,000 – ($36,000 + $50,000)) / $100,000 = 14%
- Best-Case = ($100,000 – ($30,000 + $50,000)) / $100,000 = 20%
- Worst-Case = ($100,000 – ($42,000 + $50,000)) / $100,000 = 8%
Under this scenario analysis, we find that the deal only works if interest rates reach the best-case scenario. As a result, you might find ways to increase occupancy rates or lower operating expenses.
How Scenario Analysis Helps Investors Understand Risks and Returns
Scenario analysis helps investors understand potential risks and returns associated with a real estate deal or transaction. For one, it provides an in-depth examination of all possible outcomes. For example, investors gain insight into how the deal numbers change with interest rates at 7% versus 5% or how bringing on two additional investors changes cash flow and investment timeline.
Additionally, since scenario analysis tests all potential outcomes, you are able to understand the risks associated with the transaction. Let’s say your deal will most likely lose money during periods of rising interest rates. With this information in mind, you would evaluate the economic outlook and likelihood of rising interest rates. If rates are projected to decline, you might not take any other action. However, if rates are projected to increase, you might alter the terms of the deal or avoid the transaction altogether.
Summary
Scenario analysis is a fundamental component of analyzing real estate deals and infusing transparency into transactions. If you’re ready to learn more about financial modeling or real estate finance, head over to Wisdify to sign up for our CPE-eligible courses.