When you look at any prospective property for investment, a financial analysis might not be readily available. So, how can you analyze a deal before that?
There are times when even seasoned professionals in any field have doubts about the performance and growth prospects. Considering the pandemic that started in 2020 and is still widely prevalent in 2021, it has had fallouts on the investment market where a lot has changed. Investments in commercial real estate have been affected as well, primarily because real estate was also affected in terms of demand, supply, completions, and rising vacancy rates. One needs to analyze the market properly to understand which real estate deals will be beneficial to you as an investor.
So, what does this analysis involve? Even if you are familiar with terms like IRR, cap rate, and the like, this analysis is simple and straightforward, involving just plain old observation and categorizing opportunities into three buckets – worst, best, and realistic. Let us see how this process works.
Any deal or opportunity that you are considering for investment will have the worst factors added to it in this bucket. Understand that this is an assumption only, within the parameters mentioned in the opportunity.
Naturally, your evaluation will include large vacancy amounts and escalating costs. Imagine the worst market conditions – hold nothing back. The entire exercise is to find out exactly how bad things can get if you are stuck with the worst luck in investing ever. Then check if your finances can help you smooth it over. Let’s say you are looking at buying a standard residential house. With your average revenue across the last three years being close to INR 40,00,000 annually. With the pandemic still being around, you want to play it safe and predict the annual revenue at around INR 32,00,000 (a 20% reduction). Select the highest ever property tax you can find in India and the lowest ever insurance. That will force you to add on maintenance expenses worth at least a couple of lakhs. Taking all this into consideration, run the numbers and check if you can still make the mortgage payment. If not, well, then for how long can you handle the negative cash flow until things take a turn for the better?
Whatever you did in the scenario just above, switch to the opposite now. Suppose the property has no visibility online or any source of reference and that gives you an optimistic view of increasing the revenue by around 30% in the first year. Or you could find a way to streamline expenses by remodeling the place at a very low cost, increasing the tenancy limits. Consider a magical cure to pandemic being present right under our noses. The economy has stabilized and all the good things in the world are happening just for you, at the right time. Run the numbers again and check how much money you can make on holding the asset for a year.
This scenario makes it clear why an obscene amount of risk is needed to be taken in the worst-case scenario.
This situation calls for toeing the line between the worst and best scenarios. Consider risks that are unavoidable and chart out aspects that can be moderately beneficial to you. Consider all the developments around you, from the market and the government perspective to understand how your cash flow can be stabilized in the best way possible. Make sure that you don’t constrain your profits too much but allow sufficient breathing room for the occasional rainy day that comes across in any investment.
Tying it all together
If you think an investment can be done, with you surviving the worst, loving the best, and content with the realistic scenario, there’s no harm in going ahead with a deal. These types of imaginary scenarios will dispel a lot of doubts about your investment prospects and give you a lot to think about even on the front of managing daily finances.
This is an old method, but it works even today. Though simple, it considers all your worst fears and best hopes and charts out a future that you can be comfortable with. Let us know if you also approach investments in real estate in this manner before you approach a financial consultant.