The Importance of Stress Testing

So you found a great real estate deal and all the numbers look good to make this a profitable investment.  Should you go for it?  The answer to that question often becomes easier after a couple of simple stress tests to determine what happens if things turn bad.  Stress testing is one of the most important analysis tools when underwriting a deal but is often overlooked in favor of focusing on best case scenarios.  A good stress test model will show you what the downsides of the investment and how much stress your deal can take before you're reaching into your pocket to keep the property out of foreclosure.
There are various ways to stress test a deal and different types of properties as well as different business plans will determine the tests you should perform.  Here are a couple of common ones that apply to most deals and I recommend working them into your financial analysis of the deal before signing the purchase agreement.

• Breakeven Occupancy Test - This test is just as sounds; what is the occupancy rate that is needed to produce enough revenue to cover all debt service and operating expenses.  In simpler terms, how much vacancy can the property afford before it is losing money.  An easy calculation for this is:

          Total Expenses (including debt service)/total potential rent = Occupancy required for breakeven

• Refinance/Exit Test - This test looks at the forecasted unpaid principal balance of the loan compared to the forecasted property valuation.  In a commercial or multifamily asset, the valuation is forecasted using the projected Net Operating Income (NOI) and projected sales Cap Rate.  The obvious conclusion here is that the value of the property needs to be significantly more than the unpaid principal balance to perform a successful exit or refinance.  There are a couple of subsets of tests that go into this calculation:
  • Operational Shock Test - This is a test of what percentage decrease in effective gross income can the property withstand and still be able to exit or refinance as planned.
  • Capital Markets Shock Test -  This tests different scenarios regarding changes in interest rates or market cap rates (which would affect valuations)
  • Both Shock Test - The Both Shock Test compares different scenarios where both the effective gross income decreases and interest rates or cap rates increase (again lowering valuations).
• Rehab Overage Test - This test is more specific to a fix and flip property but can be useful for a long term hold too if there is significant rehab or "value-add" expenses in the business plan.  The test is simply to determine how far over the rehab estimate we can go and still have a profitable deal.  In most cases large scale rehabs run into issues and go over budget so I like to know how much cushion I have when that happens.

These are just a few of the more common and very important stress tests that should be used when evaluating a real estate deal.  There aren't any exact numbers that I can provide to say whether a deal is good or bad.  That is up to the individual investor's risk tolerance, business plan, and capital structure.  The important thing is to know these numbers and be able to look at them objectively to determine the possible scenarios.  For example; what are the chances that your property could see 10% vacancy compared to 30% vacancy?  Again, that depends on the specific property location, business plan (are you going to clear people out to renovate), and management style but if I have two deals and one needs 90% occupancy to break even and the other only needs 70%, all else equal, I am taking the 70% all day long.

To get more detailed information on stress testing and underwriting in general, I highly recommend reading the book:
The Definitive Guide to Underwriting Multifamily Acquisitions by Robert Beardsley

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