SS278: How to Stress-Test a Multifamily Deal

SS278: How to Stress-Test a Multifamily Deal

Stress testing a multifamily deal is the process of pushing your underwriting to the point where the deal no longer makes sense. In this episode, Charles discusses the best ways to quickly stress test your multifamily deal.

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Talking Points:

  • When we are stress testing a deal, we adjust the underwriting to see how much could go wrong before the deal starts losing money. This is mainly focused on adjusting for vacancies, expenses, and interest rates.
    • 1. Past Income and Current Expenses. My favorite.
      • Step 1 is to normalize all property expenses to what you believe they will be after purchase. This includes the property taxes that will be adjusted, your insurance quote, and your maintenance expenses.
      • Step 2 is to take the seller’s average monthly gross income over the past 12 months and see if the property will still cash flow with the new expenses.
      • If it still cash flows, then it has passed the stress test. Furthermore, if you are planning to renovate the property and raise rents, this provides an additional buffer as you begin implementing your business plan.
    • 2. The Breakeven Occupancy Test. We want to take those normalized expenses, the actual ones you will be paying after purchasing the property, add your mortgage to that number, and divide it by the property’s gross potential rent upon purchase. That is the rent you would collect if 100% of the units were occupied and everyone paid. So, if the property has 10 units that rent for $1,000 per unit, the property would have a gross potential rent of $120,000. If the property has $80,000 in annual expenses and mortgage costs, your breakeven occupancy would be 67%, which is great. That means you need your property to be only 67% occupied with paying tenants to cover your bills. You are looking for property with a breakeven of no more than 80%. Our goal is the high to mid-70s. The lower, the greater the margin of safety.
    • 3. Expense and Income Growth. This is easy to calculate: remove all rent increases for the first 24-36 months while your expenses increase. If you have already normalized the expenses, test it with a 5% annual increase and see how high you can go before the deal stops cash-flowing.
    • 4. Interest Rates. If you have 5-year term debt or less, you need to be aware of interest rate sensitivity. The longer your mortgage interest rate is fixed, the less important this analysis becomes. If you have a 20- or 25-year term, by the time that debt comes due, you will have little to no mortgage on the property. Even after 10 years, your value will have greatly increased in most scenarios. Adjust your underwriting to see how high your interest rate can go before the deal stops cash flowing. Additionally, at what interest rate does your DSCR drop below 1.25, at which point you would start having issues obtaining financing?
    • 5. Exit Cap Rate Expansion. The profitability of a deal can be significantly altered by adjusting the exit cap rate. I always adjust this when someone sends me underwriting, usually to invest in one of their deals. Change it just .1-.5% and see how much it changes the returns. 
  •  Stress testing a deal involves taking your underwriting and adjusting it negatively until the deal doesn’t work. The further you can manipulate your income downward and your expenses upward, the more you will see how good your deal actually is and if it is truly resilient.
  • If you’re interested in learning how property expenses increase as properties get older, check out episode SS252.

Transcript:

Charles:
What if your multifamily deal only works when everything goes right? I’ve reviewed hundreds of multifamily deals, and I’ve seen how small assumptions can completely change the outcome. If interest rates jump tomorrow or if you change your exit cap rate by half percent, would your deal survive? A welcome strategy Saturday, I’m Charles Carillo. Today we’re breaking down how to stress test a multi-family deal, so you can see how much could go wrong before the property starts losing money. Because stress testing isn’t about being negative, it’s about protecting your downside. Let’s get started. When we are stress testing a deal, we adjust the underwriting to see how much could go wrong before the deal starts losing money. This is mainly focused on adjusting for vacancies expenses and interest rates. Number one is past income and current expenses. So this is my favorite stress test, and step one is to normalize all property expenses to what you believe they’ll be after purchase.

Charles:
This includes the property taxes that will be adjusted, your insurance quote, and your maintenance expenses. Step two is to take the seller’s average monthly gross income over the past 12 months and see if the property will still cash flow within new expenses if it still cash flows that has passed the stress test. Furthermore, if you’re planning to renovate the property and raise rent, this provides an additional buffer as you begin implementing your business Plan number two is the break even occupancy test. We want to take those normalized expenses, the actual ones you’ll be paying after purchasing a property, add your mortgage to that number and divide it by the property’s gross potential rent upon purchase. Now, this is the rent you would collect if 100% of the units were occupied and everybody paid. So if the property has 10 units that rent for a thousand dollars per unit, the property would have a gross potential rent of $120,000.

Charles:
If the property has $80,000 in annual expenses and mortgage costs, your break even occupancy would be 67%, which is great. That means you need your property to be only 67% occupied with paying tenants to cover your bills. You are looking for property with a break even of no more than 80%. Our goal is the high to mid seventies and the lower, the greater the margin of safety. Number three, expense and income growth. This is easy to calculate. Remove all rent increases for the first 24 to 36 months while your expenses increase. If you have already normalized the expenses, test it with a 5% annual increase and see how high you can go before the deal stops cash flowing. Number four, interest rates. If you have five year term debt or less, you need to be aware of interest rate sensitivity. The longer your mortgage interest rate fixed, the less important this analysis becomes.

Charles:
If you have a 20 or 25 year term, by the time that debt comes due, you’ll have little to no mortgage on the property. Even after 10 years, your value will have greatly increased in most scenarios. Adjust your underwriting to see how high your interest rate can go before the deal stops cash flowing. Additionally, at what interest rate does your DSCR debt service coverage ratio drop below 1.25, at which point you would start having issues obtaining financing. Number five, exit cap rate expansion. The profitability of a deal can be significantly altered by adjusting the exit cap rate. I always adjust this when someone sends me underwriting, usually to invest in one of their deals, change it by just 0.1% to 0.5% and see how much it changes returns. It can be quite significant in most deals. Stress testing a deal involves taking your underwriting and adjusting it negatively until the deal doesn’t work. The further you can manipulate your income downward and your expenses upward, the more you will see how good your deal actually is and if it’s truly resilient. If you’re interested in learning how property expenses increase as properties, get older, check out episode SS 2 52. That’s SS 2 5 2. I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentoring programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Links Mentioned In The Episode:

  • SS252: Property Expenses Increase as Properties Get Older

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