Commercial real estate (CRE) is in the midst of an ongoing correction. Valuations are already down about 15% to 20% for multifamily assets, and it’s unclear when the market will bottom out. Credit risk, slowing rent growth, and high interest rates are still taking their toll.
Due to this ongoing uncertainty, most multifamily investors I know have slowed their acquisitions or even stopped completely. Many players want to wait to see what happens. Ideally, they can perfectly time the bottom of the market and jump back in. The problem is that no one knows exactly when the market will bottom out.
So, how does an investor get into this market? How do you take advantage of the opportunities that will exist in commercial real estate in the coming years without taking on excessive risk? A sensitivity analysis could help.
A sensitivity analysis is a simple step in your due diligence and underwriting that can help you test your underwriting assumptions and evaluate risk and reward during this uncertain time. I’ll explain how it works and how you can create one for yourself.
Commercial Valuations
Before we get to sensitivity analyses, I need to briefly explain how most commercial assets are valued using cap rates and net operating income (NOI).
A capitalization rate (cap rate) is a measurement of market sentiment used to benchmark income-producing properties. Or, in plain English, cap rates reflect how much investors are willing to pay, as a percentage of the property’s income, to buy a property. Generally speaking, buyers want high cap rates (lower valuations), and sellers generally want low cap rates (higher valuations).
Cap rates are relative to specific areas and asset classes and are influenced by investor demand. So, the cap rate an office building in Cleveland trades for will be different from a multifamily complex in Orlando. If there is low demand for a particular asset type, cap rates will rise. If there is strong demand, cap rates fall.
To estimate values in CRE, you can use cap rates and NOI. NOI is a measure of profitability calculated by subtracting a property’s operating expenses from the gross income. When you know a property’s cap rate and NOI, you can estimate valuation.
Valuation = NOI/Cap Rate
As an example, if you have a property with an NOI of $200,000 and the cap rate is 5%, the valuation will be about $4 million.
Sensitivity Analysis
The challenge with using cap rates for valuation is that the market cap rate can change. You may buy an asset at one cap rate, and then over the course of your hold period, market sentiment shifts, and you are selling at a very different cap rate.
And this really matters. If cap rates stay steady or fall over the course of your hold period, great! That will help your returns. But if cap rates rise, that could damage your valuation.
The same thing goes for NOI. Most CRE business plans count on income growing over the course of the hold period, but things don’t always go according to plan. What happens if rent growth stalls and your NOI stagnates? Or, what if NOI skyrockets—how big is the upside?
To evaluate potential risk and reward in CRE, particularly during uncertain and correcting markets like the one we’re in today, you need to account for potential changes in cap rates and your NOI. You do this by completing a sensitivity analysis.
A sensitivity analysis is a simple idea. You start with your base assumptions about the deal, such as:
- How long will you hold it?
- How much will your NOI grow?
- How will cap rates change over the course of the investment?
This is what you’re shooting for, but as we all know, assumptions are usually wrong.
A sensitivity analysis allows you to evaluate potential returns for scenarios where your assumptions are wrong. What happens if cap rates rise or fall? What if you miss your NOI budget? A sensitivity analysis lets you visualize this in one simple chart.
Example Property
Let’s imagine I’m looking to buy a multifamily property with a purchase price of $3 million and an NOI of $180,000 (cap rate of 6%). In this scenario, I’d be borrowing 60% of the purchase price, and my partners and I are going to put in $1.2 million—of which I am contributing just 5% ($60,000).
The plan for this property is to hold it for seven years, during which time we’ll grow the NOI to $250,000. About seven years from now, we plan to sell the property at a similar cap rate to what we bought it for, 6%.
If my assumptions are right, the property will be worth about $4,166,667 at the point of sale, and I would earn about an 11% compound annual growth rate, which I am happy with.
Note: In this simplified example, I am not accounting for any cash flow distributions—I am basing returns solely on appreciation. When you do this for yourself, make sure to include cash flow in your return calculations using internal rate of return (IRR).
But what if my assumptions are wrong? I spend a lot of time analyzing deals, and I think I’m pretty good at it—but I am still wrong all the time. So, instead of hoping my assumptions are right, I conduct a sensitivity analysis.
As we learned, we can estimate valuations if we know our NOI and cap rate. In the table, I can see my projected exit valuation with different cap rates and NOIs.
On the vertical axis, I have cap rates that range from 4% to 8%—a solid range, given I am buying at 6%. On the horizontal axis, I look at what happens if my NOI only reaches 70% of my target, and I can see different outcomes all the way to my NOI reaching 130% of my goal.
Then, using some additional information (like sales costs and my loan balance), I can look at my possible rates of return.
Right in the middle, you can see what I will earn (as measured by compound annual growth rate) if my assumptions are correct: $250,000 in NOI and a 6% cap rate at exit. I can also see many different scenarios.
In a particularly great scenario for me, if cap rates fall and I exceed my NOI targets, I would earn a CAGR above 20%—amazing! However, I also can see my downside risk. If I miss my NOI targets and cap rates rise more than 1%, I will probably take a loss.
By looking at this, I can get a clear picture of the potential risks and returns for this investment. If cap rates rise, I can still make a modest return if I hit my NOI targets. If rates fall, I will make double-digit returns, even if I miss my NOI by 30%. But if cap rates rise and I miss my NOI target, I will probably take a principal loss.
Using a sensitivity analysis allows me to admit that I don’t know exactly what will happen with my investment—and evaluate the potential of my deal anyway.
The Bottom Line
Conducting a sensitivity analysis should be a part of every due diligence process. This is especially true in the market conditions we’re in right now.
The direction cap rates will go in the coming years is very unclear. Rent growth is slowing, and NOI growth should also stagnate. It’s important to be conservative with your estimates and understand what will happen if your assumptions are wrong.
If you’re investing in CRE as an operator, I encourage you to learn to do this type of analysis for yourself. There are good tools on the internet like this, or you can just do an internet search. If you’re investing as a limited partner in a syndication or a fund, you should ask anyone you invest with for a sensitivity analysis so you can test their assumptions.
Once you have a sensitivity analysis, what you decide to do is a matter of personal choice. You need to decide for yourself what level of risk you’re comfortable with in order to earn a potential level of return. You should also be doing other due diligence other than this analysis, like vetting operators, understanding your market, etc.
In the coming years, there will be good deals, but there will also be risks. A sensitivity analysis is one tool that can help you evaluate the potential risks and rewards of a deal, even in an uncertain market.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
