What is the expected return on investment for a project? What risks are the most prevalent in a deal? How much cash flow will the investment generate? Answering these key questions relies on refining the deal’s assumptions.
How do you pinpoint your assumptions? After all, it’s difficult to know for certain where closing costs will fall or the actual amount of capex until the deal closes. This is where sensitivity analysis comes into play, helping you build a robust and accurate financial model.
In this article, we’ll cover ten key assumptions that you should be testing in your sensitivity analysis. Pinpointing the most likely results gives you the ability to hone in on your financial model to answer key questions, like profitability and investment return.
Purchase Price
The first assumption your sensitivity analysis should cover is the purchase price. Utilizing sensitivity analysis is beneficial, even if you have already put in an offer. Most deals are contingent on a variety of factors, such as inspections and appraisals. This gives you the ability to adjust the purchase price. Test different purchase prices to see where your final numbers fall. This helps you determine a fair price to pay for the purchase. Maybe you find that reducing the purchase price by $50,000 allows you to reach your return on investment goals or that you can pay $25,000 over asking for a property. Whatever the case, sensitivity analysis plays an important role.
Closing Costs
Just like purchase price is an important assumption, so are closing costs. Closing costs can include legal fees, accounting fees, due diligence expenses, and commissions. These upfront costs can erode your profitability if not properly factored into the transaction. Figuring out your expected range for closing costs helps you choose the right professionals. Remember, you get what you pay for. This means you shouldn’t choose the cheapest professionals just because they generate stronger financial results.
Rental Rates
Another key assumption in your sensitivity analysis will be rental rates. How much is each unit renting for? What is the impact of a 10% increase in base rental prices? Will increasing rents impact your vacancy rates? These questions are answered by testing different rental rates. Pulling market data for your location and considering the impact of renovations and capex will also be important. Be realistic about rental rates. Although an increase of 20% would be ideal, this might not be attainable when considering the impact on your vacancy rates.
Operating Expenses
Operating expenses directly impact your profitability and cash flow. When conducting your sensitivity analysis, you want to consider the impact of changes in operating expenses. What happens if pest control increases by 50% once an existing contract expires? How does the cost of hiring in-house maintenance staff impact profitability compared to outsourcing? Testing different levels of operating expenses helps you figure out your margins and back into other factors like the purchase price or capex budgets. Operating expenses might include insurance, property taxes, salaries, interest expense, repairs, and maintenance.
Capex Costs
Capital expenditures are costs outside of normal repairs and maintenance, such as remodeling the property or adding amenities. If your team frequently targets distressed properties, testing the sensitivity of capex costs in your financial projections will be crucial. You might choose to look at the impact of capex on your taxable income, rent rates, and overall profitability. For example, you might find that investing $50,000 to put in a new pool gives you the ability to increase rents by 3%. Knowing this information helps you maximize profitability and plan resources.
Vacancy Rates
How does your profitability change with a vacancy rate of 20% versus 10%? With any real estate deal, vacancy rates play a crucial role. Understanding where your vacancy rates need to be to hit your strategic goals is done through sensitivity analysis. By keeping other factors the same, such as operating expenses and rental rates, you can back into your ideal vacancy rate. Knowing this information helps you plan capex projects and what your team needs to do to fill units.
Interest Rates
Interest rate volatility can cause your real estate deal to go from a positive cash flow to a negative one. Testing different interest rates in a sensitivity analysis gives you insights to pinpoint your ideal rate range. Then, you can find lenders that offer those rates. For example, let’s say your sensitivity analysis projects that an interest rate of 5% results in a 10% return on investment. Your team can then look for lenders with loan products that have a 5% rate. If you are unable to find a lender that offers a 5% rate, you may need to adjust the sources of financing or other criteria in your deal, like the purchase price.
Financing Sources
Financing sources are another important assumption to test. What is the impact of using 40% equity and 60% debt financing versus 75% equity and 25% debt? How do changes in the debt financing amount impact your interest rate and overall profitability? For growing real estate organizations, using a combination of financing sources is common. Utilizing a financing source sensitivity analysis model allows you to determine the best way to deploy capital into a deal.
Rent Growth Percentage
Sensitivity analysis models are not only beneficial to understand the current terms of a deal, but they also help you project future cash flow and profit. How much does your return on investment increase with a 3% rent growth rate compared to a 5% rate? In many cases, it can take a few years to stabilize a deal. You want to understand reasonable rent growth rates to identify the length of time it takes to meet your strategic objectives.
Summary
Are you already testing for these ten key assumptions in your sensitivity analysis? If not, now is the time to start. The more insight you can derive from these assumptions, the better you can plan resources, reach your strategic goals, and reduce risks.
