Overview of Risk Analysis in Underwriting

Sensitivity analysis tests how changes in a single variable affect investment returns while holding all other variables constant. The most impactful variables for multifamily investments are: vacancy rate (each 1% increase reduces NOI by approximately 1.5-2%), rent growth rate (each 1% change in annual rent growth compounds significantly over a 5-year hold), exit cap rate (each 25bp increase in exit cap rate reduces the exit value by 3-5%), operating expense growth (each 1% above projection erodes NOI), and interest rate (each 25bp increase in debt rate reduces cash-on-cash return by 0.3-0.5%). Build a sensitivity table showing returns (IRR, cash-on-cash, equity multiple) at three levels for each variable: base case, adverse case, and severe case.

Scenario modeling combines multiple variable changes simultaneously to reflect realistic conditions. Base Case: the most likely outcome using validated market data and reasonable assumptions. Upside Case: favorable conditions—lower vacancy, higher rent growth, cap rate compression. Probability weight: 20-25%. Downside Case: adverse conditions—higher vacancy, lower rent growth, cap rate expansion. Probability weight: 25-30%. Stress Case: severe conditions—recession-level vacancy, negative rent growth, significant cap rate expansion, rate increases. Probability weight: 5-10%. The probability-weighted expected return is: (Base × 45%) + (Upside × 25%) + (Downside × 25%) + (Stress × 5%). This gives a single expected return that accounts for the range of possible outcomes.

Break-even analysis identifies the point at which the investment fails to meet minimum return thresholds. Key break-even calculations: (1) Occupancy break-even: the minimum occupancy required to cover debt service and operating expenses. Formula: (Operating Expenses + Debt Service) / (GPR + Other Income). Typical target: below 85%. (2) Interest rate break-even: the maximum interest rate the investment can absorb and still produce positive cash flow. (3) Cap rate break-even: the maximum exit cap rate at which the investment still achieves the minimum target IRR. (4) Rent growth break-even: the minimum annual rent growth required to achieve the target IRR. Each break-even metric provides a clear threshold—if conditions deteriorate beyond this point, the investment underperforms. Wider margins between current conditions and break-even points indicate more resilient investments.