Planning to Purchase a Property Next Year? Conducting a Sensitivity Analysis Is Essential Before Investing

Commercial real estate (CRE) is currently experiencing an ongoing correction. Valuations has declined by 15%-20% for multifamily assets and it remains uncertain when the market will find stability again. Meanwhile, credit risk, slow rent growth, and rising interest rates continue to wreak havoc on property values.

As uncertainty remains high in the multifamily investment arena, most multifamily investors I know have either reduced or stopped entirely their acquisitions of multifamily properties. Some are waiting to see what unfolds and hoping they can time the bottom of the market so as to jump back in when necessary – however no one knows exactly when that might occur.

How can an investor enter this market, taking advantage of opportunities available in commercial real estate without taking on too much risk? A sensitivity analysis may offer assistance.

Sensitivity analysis is an integral component of due diligence and underwriting that allows you to test assumptions, assess risk and reward, and mitigate uncertainty during this uncertain time. I will explain its features and how you can create one yourself.

Before discussing sensitivity analyses, let me briefly review how most commercial assets are valued using cap rates and net operating income (NOI).

Capitalization Rate (cap rate) is a market sentiment measure used to evaluate income-producing properties. Simply stated, cap rates reflect investors’ willingness to pay as a percentage of an income-producing property’s annual earnings for its purchase; buyers generally prefer high cap rates (lower valuations) while sellers often desire lower valuations.

Cap rates can differ depending on where they’re being applied and which asset class it applies to, as well as investor demand. Thus, an office building in Cleveland will trade at a different cap rate than one located in Orlando; similarly, when demand drops for one type of property than it will cause its rates to increase while when demand grows again cap rates may go down again. If low demand occurs then rates tend to increase while when high demand exists then cap rates decrease again.

Estimating values in CRE requires using cap rates and net operating income (NOI). NOI measures profitability by deducting operating expenses from gross income to arrive at its estimate valuation. When you have these two figures at hand, valuation estimates become possible.

Valuation = NOI/Cap Rate. For example, if a property produces an NOI of $200,000 and a cap rate of 5%, its valuation would approximate $4 Million.

Sensitivity Analysis
One of the major difficulties of using capitalization rates as a valuation methodology is their variability: You may purchase an asset at one cap rate, only for market sentiment to shift dramatically during your hold period and ultimately result in you selling at a much different cap rate when selling off.

And this really matters – if cap rates remain steady or decline during your holding period, that will enhance returns while an increase could compromise valuation and diminish returns.

No Income Annuity. While most CRE business plans rely on income growing over the course of a hold period, things don’t always go according to plan. What will happen if rent growth stalls and your NOI stagnates or, conversely, skyrockets–how large could this potentially be?

To accurately evaluate potential risk and reward in CRE investments during uncertain and correcting markets like we currently experience, such as today’s, you should account for potential changes to cap rates and NOI through conducting a sensitivity analysis.

Conducting a sensitivity analysis is a straightforward concept. Start with your assumptions regarding a deal, such as:

How long will you hold it for, how much will your NOI increase and how will cap rates shift throughout your investment period? Its All these are assumptions which could prove incorrect.

A sensitivity analysis allows you to assess potential returns under scenarios where your assumptions are wrong, such as when capital rates rise or fall or you miss your NOI budget. A sensitivity analysis makes this easy with one chart showing all this data.