Multifamily Underwriting Series 9: Stress Testing

Welcome back to the Multifamily Underwriting Series. This is number 9, Stress Testing. Here are the previous posts in this series:

If you haven’t gotten caught up, I suggest that you take a look back at the previous posts in the series.

By now you have worked all the numbers and looked at the metrics. You’ll recall that I said no individual one can tell you to make the purchase. They can tell you to dump the deal, though. Here’s the thing that’s going to frustrate you: In the end, you have to go with your gut. You have to look at all the numbers and come to a decision, justifying the numbers that aren’t great. There is no perfectly mathematical way to do it. Which is why your next step is to stress test.

I used to order exercise cardiac stress testing out of the ER. I would do this for the patient who looked like might not have heart disease, but I could not be certain based on the laboratory testing alone. For these patients, we get them on a treadmill and see how they handle the stress it puts on the heart. Failing the stress test means getting an angiogram, which carries risk, but can look for narrowed blood vessels in the heart. Unlike my patients, we need to do a stress test on every deal that gets to this stage of underwriting.

How to Stress Test

First consider all the bad things that could happen. In other words, if next year the project is floundering, what are the possible reasons why? Here’s a list of some:

Vacancy was higher than expected
Rents were not increased as predicted
Expenses were higher than anticipated
Some look at exit strategy here, but I will put it as the next post because it is so important

Vacancy

Remember, we put the vacancy in our area into the spreadsheet. Right now in my area, I estimate 8%. That’s economic and physical vacancy. But, the economy might get worse this year. There’s concern for unemployment rising, which may mean some tenants won’t pay their rent. But, things could get better, and vacancy might go to 6%. For this, create a new tab on your spreadsheet for best-case scenario and set vacancy to 6%. Do another tab and set vacancy to 12% (if that’s what you think the worse case scenario is). The exact number isn’t as important as what this will show you. In our example deal, changing by 1% vacancy moves the income bottom line by about $5,000.

Rents

You’ll continue using the same tabs you just created. I’ll put worst case at 5% less and best case at 5% more. I’ll just multiply Total Scheduled Rent by 0.95 in one tab and by 1.05 in another tab. Each 5% change in our example is about a $20,000 difference in annual rent.

Expenses

For expenses, I prefer to go through each line item and adjust it down for worst case or up for best case. I think doing this gives an average change. In reality, you’ll have one line item that was way more expensive than you predicted, like a bad year for snow. It’ll be far off your prediction, but the others will be fine. So, if we change each by 5%, it all will average out in the end. Do as many tabs as you want, but this keeps me at 3. Worst, predicted, and best.

Important line items are: Property tax, utilities, snow removal, and repair. You might have other ones which you think might go up or down.

By now you should have three tabs which show you the worst and best case scenarios along with your predicted tab (which you created previously). Now ask yourself, “If the worst case scenario happened, how could the project continue?” and “What is the likelihood that the worst case scenario happens?” Worst case for me would be 10% likely, or once in 10 years. If your worst case seems much more remote, then go back and change your estimated worst case numbers to get there. Do the same thing for the best case scenario. If any of them don’t work (you don’t see a way the deal can continue in that scenario), then your deal is dead. If all three of them work out, you are nearly onto a great deal. But you can’t close on it yet. You still need to figure out your exit strategy. See you for that next week.