Scenario Planning for Acquiring Commercial Real Estate
Create a best, likely and worst-case scenario for your investments
The word "scenario" comes from Latin origins meaning the "sketch of a plot of a play." While the operatic meaning has changed slightly over the years, it has relevance to sound investment strategy.
When looking at investment property, we often look at the bright side and imagine how this nicely fits into our portfolio and how it will kick out sweet cashflows until the end of time. Yet sometimes there are bumps along the road that could derail even the best laid plans, so it's important to go into an investment with your eyes wide open and understand best-, likely- and worst-case scenarios.
Let's say for example you are looking at a retail grocery-anchored shopping center and doing a 10-year cashflow analysis. The grocery store has been there for many years and has 7 years left on its current lease with an option to extend another 10 years after the initial term at 95% of market rents. You spoke with the manager of the store and they have indicated that they have an established brand within the community and have no plans on leaving after the initial term. The local economic area has seen steady rent growth over the past decade and tends to increase at around 5% annually on average. Can we craft a best, likely and worst case? Absolutely!
Best Case: Let's imagine that in 7 years, the grocery store exercises their option and extends the lease, but instead of rental growth at 5%, it goes up by 7% because we're bullish on the area and think there's a possibility it could outperform. This could be a best-case scenario.
Likely Case: The most likely scenario shows the established neighborhood grocer extending the lease and rental growth staying about the same as it has been historically.
Worst Case: In this scenario, the grocer decides to not extend the lease. This means quite a few costs that you will need to anticipate, including construction costs, marketing and brokerage fees to get it leased up. In addition, you will need to budget 6-9 months of no income on the space.
You can even analyze these scenarios in terms of IRR (Internal Rate of Return) showing weighted averages for each case.
Obviously you can play around with these numbers and determine the likelihood of each scenario and the IRR's associated with them. You can even add in other scenarios and calculate those. For example, what if the grocer stayed, but rents didn't increase at the average rate? You can do this for days, so remember not to get analysis-paralysis!
The bottom line is that you want to have a clear picture in the sketch of your investment play. Do the scenarios and the calculated returns justify the potential risk you are making? Have a clear picture of the play before the opening scene, because no one likes unforeseen drama, especially in real estate.
About the author:
Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty specializing in portfolio and asset management for high net worth clients and institutions, with a strong focus on market, financial and risk analysis. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.
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