The scenario analysis method is favored amongst real estate
investors and investment property specialists because it
provides a good way to measure risk during the process of
evaluating real estate investments.

What Scenario Analysis Is

Scenario analysis 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 with typically three scenarios: worst-case,
most likely and best-case scenario.

Rental income, for instance, is subjected to scenario
analysis because the real estate analyst wants to see the
outcome on cash flow, rates of return, and profitability
for various income scenarios as a gauge to measure the
potential investment property performance.

For example, say you're looking at an apartment complex
selling at a 6.23% cap rate and a gross scheduled income of
$54,000 generated from five units each renting for $900 per
month. But it's your opinion that the cap rate is too low
(meaning the price is too high) and you have been told that
the seller will not budge on the price. So you are faced
with a dilemma: to either pay the price for the apartment
complex (against your better judgment) or walk away.

Okay, this is where a rent scenario analysis can help you
make your investment decision.

The analysis will allow you to explore the influence that
various changes to rent have upon property performance. In
other words, you can see what cash flows and rates of
return result from a change in rents and at the same time
discover what rents are required to achieve your cap rate;
therein highlighting the risk you might be taking if you
purchase the property at the asking price and later hope to
achieve your desired rate by raising the rents.

How It's Done

First, you would create a real estate analysis based upon
the property's income and expenses and your projected
financing plan. This gives you a starting point. With
quality real estate investment software you should then get
a calculation for the cash flow, cap rate and cash on cash
return based on that property data. If you don't use
investment software and instead are using a homemade
spreadsheet, be sure to include those calculations in an
easy-to-read table format so you can quickly compare all
the scenarios side by side.

Next, you want to consider three rent scenarios:
worst-case, most likely, and best case, or "no change to
rents", "realistic increased rents", and "rents beyond your
wildest dreams". Here's the idea: you want to enter those
three separate rents into your software program or
spreadsheet so you can what the cash flow, capitalization
rate and cash on cash return becomes for each scenario as a
result.

Finally, examine the results. If rents would have to
increase to a level beyond your wildest dreams for you to
attain your desired cap rate, you might consider the
investment too risky and walk away. Whereas, if you
determine that your desired cap rate can be achieved with a
more realistic rent increase, you might hang in there and
dig deeper into the property.

Why It's Popular

Scenario analysis has become popular because easy-to-use
real estate investment software programs can calculate and
recalculate a range of variables quickly. What would have
taken hours before takes just minutes with the computer and
template-based spreadsheet software for the computer.
Moreover, good real estate investment software solutions
create printable tables and reports.

Of course, no investment decision should be made solely on
one analysis, but scenario analysis has provided real
estate agents and investors with valuable information that
later proved invaluable.

If you're serious about investment property be sure to take
advantage of a scenario analysis the next time you need to
make an investment decision. It has proven to be an
excellent way (thanks to computers and software) to examine
variables quickly, and not surprisingly has played a
significant part in real estate investing selling and
buying decisions.

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James Kobzeff is the developer of ProAPOD - leading rental
property real estate software since 2000. Create cash flow,
rates of return, and other real estate analysis
presentations in minutes! Includes scenario and sensitivity
analysis. Learn more at => http://www.proapod.com

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