How Scenario examination Helps Measure Risk When Real Estate Investing

Scenario examination is used by real estate investors and investment character specialists because it provides a good way to measure risk when evaluating real estate investments.

What is scenario examination? It involves estimating a range of variables that will have the greatest impact upon the likelihood of an investment performing according to an investor’s minimum expectations. Rental income, for example, is placed under scenario examination when the analyst wants to gauge investment character performance based on various rent scenarios. In other words, how well does the character perform in the event rents decline or increase?

Scenario examination typically considers three scenarios. In this case, we will assume that our scenario examination is intended to analyze what influence changes to rents would have on character performance.

  1. Worst-case – if rents decline or do not change at all
  2. Most-likely case – the most realistic rents that can be obtained
  3. Best-case – rents beyond our wildest dreams

Assume, for example, you are evaluating a rental character consisting of five units rented at $900, producing $54,000 annual rental income, and resulting in a cap rate of 6.23%. Though you are interested, you feel that the cap rate is too low (you prefer a cap rate of 7.0%). The seller will not drop the price (which would raise the cap rate), so you are faced with a dilemma to either pay the price (against your better judgment) or walk away.

This is where a rent scenario examination can help. Rather then making a decision blindly, you can analyze the influence that various changes in rent would have upon performance. In other words, at the very least, you can see what rents would have to be collected to unprotected to your cap rate, and whether they are likely or pie-in-the-sky.

In this case, you would consider all three scenarios: worst-case, most likely case, and best case. If your desired cap rate were attainable within the first two scenarios, it would indicate that the character’s current rents are low and it does provide some “upside possible.” So you might want to pay the asking price confident that you can increase rents and consequently enhance the character’s performance. Otherwise, if rents would have to be raised beyond your wildest dreams to reach your cap rate, you might want to walk.

How do you construct a rent scenario examination? You can use a spreadsheet or buy a real estate investment software program. Just remember what it is you want to unprotected to. You want to see the outcome on essentials like cash flow and rates of return based upon a range of rent scenarios. You might be amazed what you uncover about the character.

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