The Importance of Sensitivity Analysis in Property Investment
Sensitivity analysis is a standard feature for more advanced property development and property valuation software programs. At a general level, it refers to a statistical concept in which one variable is changed and other variables are held constant. This allows modellers, including developers and investors, to ascertain and review the effects of each variable being changed. Usually the analysis will be conduct to asset the net present value (or other key performance indicators) of the property and work out which are the best scenarios for buying or selling investment property.
The following are just four of the most common types of sensitivity analysis that can be performed on real estate development software, analysis which can significantly assist developers and investors with getting an accurate picture of the project at any time.
Changing the costs associated with the property or development project can be extremely valuable for obtaining budgetary and cash flow information. For example, the sale cost of the property will have an impact on the following:
- Cash requirement – how much cash the buyer will need to put down.
- Loan amount – how much will be borrowed.
- Mortgage repayments – monthly or fortnightly mortgage repayments can vary as the price changes.
- Performance indicators, such as the capitalisation rate – the ratio between operating income and capital cost.
- Net cash flow – how much the investor will have in their pocket or need to pay after all the costs are accounted for over the period of the loan.
Costs may include costs of borrowing, the sale amount, construction costs, tax, and other costs associated with purchase or development.
The deposit or down payment based sensitivity analysis is another common sensitivity analysis that’s very useful for investors. Some of the most useful figures a deposit amount sensitivity analysis can yield include:
- Loan repayment amounts – how much will monthly or annual repayment amounts need to be.
- Debt coverage ratio – a property’s annual net operating income divided by the property’s annual debt service requirements or total annual mortgage repayments. This gives an indication of how much the property can pay for itself.
- Cash flow – the size of the deposit will have an impact on net cash flow.
- Cash on cash return – the ratio of annual before-tax cash flow to the total amount of cash invested. This gives a quick idea of the cash flow potential of the property.
A loan-to-value sensitivity analysis allows the investor or developer to find out periodic loan payments for different interest rate and different loan amounts. This basic sensitivity analysis is very useful for budgeting, forecast, and other financial projection. Using this tool, the investor can get a preliminary idea on how to structure loan in order to, for example, pay loans off quickly or obtain the smallest monthly loan payments.
4. Construction Periods
For the real estate developer, construction period sensitivity analyses can be a very useful tool to manage timelines, costs, and budget projections. Developers can use this tool to create optimal construction period scenarios and to obtain a clear picture on how extending or shorten periods can affect cash flow and profits.