How do you use sensitivity analysis in your valuation models?

1 What is sensitivity analysis?

Sensitivity analysis is a method of analyzing how the value of a commercial real estate property changes when one or more inputs or variables are altered. For example, you can change the rent, vacancy, cap rate, discount rate, or growth rate, and see how they affect the net operating income (NOI), cash flow, and property value. Sensitivity analysis can be performed using spreadsheets, software, or online tools, and it can be presented using tables, charts, or graphs.

2 Why is sensitivity analysis important?

Sensitivity analysis is important for several reasons. First, it helps you understand how sensitive your property's value is to different factors, and which ones have the most impact. This can help you prioritize your due diligence, negotiate better terms, and optimize your investment strategy. Second, it helps you evaluate the uncertainty and risk of your valuation, and how it compares to the market expectations and benchmarks. This can help you adjust your assumptions, identify potential upsides or downsides, and justify your valuation to lenders, investors, or appraisers. Third, it helps you communicate your valuation to your audience, and show them how you arrived at your conclusions. This can help you build trust, credibility, and confidence in your analysis.

3 How to perform sensitivity analysis?

In order to perform sensitivity analysis, you must first define a clear and consistent valuation model that calculates your property's value based on the income approach, the sales comparison approach, or the cost approach. Additionally, you need reliable and realistic inputs for your model, such as rent, vacancy, expenses, cap rate, discount rate, growth rate, etc. Afterwards, you must select the variables to be tested and how much they should vary. You can then calculate how your valuation model's outputs and results change when the variables are varied. Finally, you must present and interpret your findings in a clear and concise way. You can use tables, charts, or graphs to show the changes in your outputs and results while also using indicators such as sensitivity coefficients to measure the degree of sensitivity of each variable. This will help you understand how your property's value varies across different cap rates and rent growth rates.

4 What are some best practices for sensitivity analysis?

To perform effective and reliable sensitivity analysis, you should follow some best practices. You should base your assumptions and inputs on market data, comparable transactions, historical trends, and expert opinions, rather than arbitrary or unrealistic values. Additionally, you should focus on the variables that have the most impact on your property's value, and that are most likely to change or vary. Furthermore, you should vary your variables by reasonable and realistic ranges and scenarios that reflect the possible outcomes and variations. Finally, you should present your findings in a simple and understandable way that shows the main effects and impacts of your sensitivity analysis. Moreover, you should interpret your findings objectively and critically, acknowledging the limitations and assumptions of your sensitivity analysis, and how they affect your conclusions.

5 What are some common pitfalls to avoid in sensitivity analysis?

To avoid errors and biases in your sensitivity analysis, you should be aware of some common pitfalls. Make sure to use the most recent and reliable data and inputs for your valuation model and sensitivity analysis, verifying and validating them for errors or inconsistencies. Additionally, do not test too many or too few variables as it can make your results confusing or misleading. Use ranges and scenarios that are relevant and plausible for your property and market, reflecting the potential variations and outcomes. Lastly, understand the assumptions and limitations of your sensitivity analysis, comparing and contrasting your results with other sources. Use your judgment and experience to evaluate your findings to avoid misinterpreting or overinterpreting them.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?