Does determining risk in your real estate investments make you queasy? It might be time to get that stochastic feeling and roll the dice with a Monte Carlo simulation.
By definition, stochastic means using random variables. The Monte Carlo reference is about how six-sided dice yield an equal chance for any number to come face up when rolled, and then asking, for example, what the chances are of two dice coming up with a winning number, like seven.
Monte Carlo simulations are used in diverse industries and businesses to help assess risk and uncertainty by running models that include multiple variables in as many combinations as you care to see.
Contending with cycles, lack of performance data
A 2018 blog post from RCLCO Real Estate Advisors explains how Monte Carlo simulations can help investors despite the inherent drawbacks of cycles and a lack of performance data in the pursuit of profits: "Due in large part to its illiquidity and the resulting limitations on performance data, the real estate industry has historically lacked quantifiable assessments of risk as a tool to improve investment decision-making."
Due to its already cyclical nature, and conventional wisdom now challenged by a pandemic, real estate investing can benefit from the running of thousands of potential outcomes "based on the expected probability distributions for each variable," the RCLCO post says.
Providers cite growing usefulness
planEASe, a provider of commercial real estate (CRE) analysis software, says this: "Perform Monte Carlo risk analysis with any assumptions you choose versus any measure, such as rate of return, net present value, etc. Risk analysis allows you to investigate how these measures vary with a change in assumptions like holding period, cap rate at sale, renewal probability, vacancy, etc."
planEASe's products are examples of software that takes those variables, crunches them, and spits out tables and graphs that show "the probability of achieving any level for the chosen measure."
RCLCO also offers that type of analysis and says Monte Carlo simulations are getting better as data and analytical tools progress.
"With the prospect of further improvements in the future, the accuracy of the analysis will only continue to improve, along with its usefulness in real estate investment decision-making," the RCLCO post says.
There are multiple providers of Monte Carlo-type simulation software and services, but the ambitious can go it alone, too.
Monte Carlo simulations, DIY-style
Here are some YouTube videos that show the Monte Carlo simulation method in action:
And, it can be done in one of the most common pieces of software out there -- Microsoft (NASDAQ: MSFT) Excel.
"So, you want to run Monte Carlo simulations in Excel, but your project isn't large enough or you don't to do this type of probabilistic analysis enough to warrant buying an expensive add-in," writes Spencer Burton of Stablewood Properties in a blog post on Adventures in CRE titled "How to Run Monte Carlo Simulations in Excel." "Well, you've come to the right place."
Burton then shows step by step how to use Excel's built-in stochastic modeling abilities, "including running as many simulations as your computer's processing power will support."
Might be a good way to develop your Excel muscles while gaining some insight into how your current and future investments might fare amidst all this new complexity.