Does your real estate deal pass the stress test? Discover 4 ways to stress test your deals BEFORE you buy, to mitigate risks and ensure your property works today, tomorrow, and even when things take an unexpected turn.
Why Investors Skip Stress Testing
Smart investors stress test their deals before they buy, while others ignore potential problems and just hope for the best and end up losing money. Why would investors skip stress testing? There are two main reasons:
Lack of Knowledge: Many investors simply don’t know how to stress-test a deal. With 25 years of experience and a proven track record, I know how to put a deal through a stress test. Believe me, it’s essential.
Fear of Asking for Help: The typical investor is afraid to ask for help, but asking for help is a sign of strength, not weakness. It’s time to get over yourself and ask for help when you need it!
4 Metrics to Stress Test Your Deal
Here are 4 stress metrics that we apply to every deal. Whether you’re investing in apartments, self-storage units, or mobile home parks, these stress tests will help you safeguard your investments.
Stress Test #1: Economic Downturn
The first stress test is the most obvious: What happens in an economic downturn or market crash? Can your deal withstand economic volatility?
Metric #1: Rent Modeling
For this test, the metric we use is rent modeling. The premise is simple: Project a 10% decrease in rents for the year, or an increase in the vacancy rate of your multifamily property from 5% to 10%. You can factor in either one to stress test your deal. After adjusting the projected rent lower, ask yourself this question, “Does your deal still cashflow in a way where it still makes sense to buy?” This is a crucial question to answer.
Stress Test #2: Market Cap Rate Increases
The second stress metric tests your deal’s performance against fluctuating market trends. What happens if the market cap rate increases? How would that affect your deal? A cap rate is used to determine the value of your property. When a cap rate in a market goes up, that means property values go down. And accordingly, when a market cap rate goes down, like it is today in some markets, property values go up. Over the past decade, market cap rates have been stable or declining, leading to significant profits. However, what if the market cap rate were to move in the opposite direction?
Metric #2: Exit Cap Rate Sensitivity
This metric monitors your exit cap rate, which is the market cap rate at the time you sell the property. Consider, five years from now, the market cap rate increases by half a percent. Would you still be able to exit with an acceptable profit? If the market cap rate increases and values are dropping, can you still profit when you exit the deal?
Stress Test #3: Higher Interest Rate
The third stress test to conduct before you buy is assessing your deal’s resilience to higher interest rates. Imagine you’ve acquired a multifamily property with the intention to renovate, raise rents, boost its value, and then perform a cash-out refinancing with a lender. While this is an excellent strategy that we specialize in, it’s crucial to consider this question: What if interest rates remain high or even increase?
Metric #3: Interest Rate Sensitivity
The metric for this test is interest rate sensitivity, which test how vulnerable your deal is to fluctuating interest rates. In the current climate of unstable interest rates, this test is indispensable. You should run scenarios where interest rates either remain constant or increase by half a percent, despite speculation that the Federal Reserve has inflation in check and that interest rates will decrease. What if that doesn’t happen? You need to verify that your deal can withstand higher rates to avoid potential difficulties down the road.
Unfortunately, many syndicators are currently in trouble because they failed to stress test their deals with higher interest rates. They secured deals at low rates and are now looking to refinance, but their properties can’t afford the increased rates, leading many to either seek additional funding or face foreclosure.
So, assuming interest rates will stay the same or rise, ask yourself, “Will your property qualify for a refinance with higher mortgage payments? Can your deal support the new payments and still have enough equity to pull the money out? You must test that. It’s not safe to assume that in three years, the Federal Reserve will have everything under control and interest rates will come down. You need to be ready for whatever comes.
Stress Test #4: Extended Hold Period
The final stress test is often overlooked by new investors due to lack of knowledge and foresight. This is where the advantage of having a mentor comes into play; we anticipate potential issues well in advance to mitigate risks and ensure the success of our students. The fourth stress test asks: What happens if you have to hold onto your property longer than anticipated? What if your plan is to sell in five years, but values have dropped and you can’t sell?
Metric #4: Loan Hold Period Extension
This stress metric is your loan hold period, with the assumption that you may not be able to sell your property when you planned. You may need to hold it for seven, eight, or even ten years. So the critical question you need to ask is: Will the loan you’re considering allow you to hold onto the property longer than anticipated?
Every Successful Commercial Real Estate Investor Has a Mentor
Stress testing is crucial to ensure your property works today, tomorrow, and even when things take an unexpected turn. If you have questions about stress testing your deal, text PETER to 833-942-4516.
Every successful multifamily investor has a mentor: Commercial Property Advisors Protege Program
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