The risks involved in making big investments can be overwhelming. However, there are calculations and tools that can be used to understand these risks more intimately, as well as predict potential outcomes. When you’re looking to make an investment for the first time, it is in your best interest to complete a sensitivity analysis in order to calculate risks and understand your options. By conducting a sensitivity analysis, you won’t run into unexpected surprises down the road.
Essentially, a sensitivity analysis answers your “what if” questions, and in turn, can be called a “what-if analysis.” In a sense, one could say that there is a touch of fortune telling to this type of analysis—but the reality is that the potential results being analyzed allow for forecasting. By analyzing risks, your moves become less risky in general.
However, the details of sensitivity analysis can also seem a bit complicated.
Let’s break it down in the context of real estate investing.
- The sensitivity analysis starts by identifying a set of quantitative standards by which the investment will be assessed, which can also be established as the rate of return, or a net gain or loss of an investment over a certain period of time.
- Then, the independent variables most crucial to producing this ROR can be determined. For example, these variables could be loan amount, mortgage payments, cash flow, cash on cash return, and so on.
- Next, you’ll want to know what wiggle room you have with these investments. This can be determined by defining how much these variables can move over time. In addition, the absolute minimum and maximum values that these variables can fluctuate while still causing a positive ROR within should be determined as well.
- Finally, the results of those moving variables can be examined and clarified.
By knowing the entirety of the range of outcomes, an analyst can paint a comprehensive picture of all potential scenarios, as are determined by the variables applied. The complexity of the analysis will depend on the variables and their ROR effects.
For example, a real estate sensitivity analysis might foresee in lower number in occupancy at invested properties. If an analysis of sensitivity is completed in order to understand the downward trend in occupancy at those invested properties, investors can be aware of fluctuations and prepare to adjust accordingly.
There are a number of questions about real estate investing that can be answered throughout a sensitivity analysis:
- What risks do I run with specific investment models?
- What investment models should I use?
- What types of input variables should I assess?
- At what point will the property begin to gain money?
- At what point will the property begin to lose money?
Who can help me with my sensitivity analysis?
A sensitivity analysis can calculate predictions for different investments and understand the variable risks at hand. The benefit of a sensitivity analysis is that where one risk may dissuade you from investing, another can provide a positive scenario. It is less risky to make a risky move while having conducted a sensitivity analysis than it is to run that move without having attempted forecasting.
Though we specifically focus on markets with a potential for appreciation, we always conduct a sensitivity analysis. The majority of the scenarios we detail through sensitivity analysis actually allow for occupancy to rest at 75 percent to break even.
If you’re curious about how you can evaluate your own scenarios this way in order to make those important decisions on investments, feel free to get in touch.