This is a chapter taken from the upcoming comprehensive guide titled, Market Cycles: How Investors Can Survive (+ Thrive) in a Turbulent Economy. If you would like to sign up for early bird access to this comprehensive guide, please sign up here.
University of Alabama head football coach “Bear” Bryant once said that defense is what wins championships, and the same thing is true about real estate investing.
In fact, one of the best ways to win in a down real estate market is by building up defensive financial modeling across your real estate portfolio. Here’s the game plan to follow today to help you prepare for the recessionary times that may lay ahead.
Test #1: Stress test regularly
A stress test simulates how your real estate portfolio performs under a variety of different conditions. Many real estate investors are too optimistic when times are tough. They pay too much attention to the upside and don’t consider how bad things could get before the cyclical recovery begins.
The Federal Reserve requires banks to stress test annually, and serious real estate investors should do the same, whether a portfolio has a single property or 100.
Start by adding up your total income streams, then categorize your expenses as fixed or variable. Fixed expenses include things like mortgage and property tax payments, while variable costs include routine maintenance, and the timing of capital repairs and upgrades.
Test #2: Double the vacancy rate
Every quarter the U.S. Census Bureau publishes a report of residential vacancies and homeownership. The Q1 2020 report shows a rental vacancy rate of 6.6%, which ties into the pro forma vacancy rate that many rental property owners use.
However, when you back into the number, a vacancy rate of 6.6% is only 24 days. During a recession, tenants often double up where they live, choosing to share a place or move in with a family member.
If you own a rental property in market conditions like this, it could take much longer than a month to find a new tenant. By using a vacancy rate of 12%, 15%, or even 20% you’ll have a much clearer picture of how vacancy affects your rental income and gross cash flow.
Test #3: Double the loan interest rate
As of July 9th, the average interest rate on a 30-year conventional mortgage in the U.S. is 3.03%, according to the Federal Reserve Bank of St. Louis. In fact, since the Global Financial Crisis of 2008 (GFC), the interest rate on fixed-rate mortgages has averaged less than 5%.
But what happens if mortgage interest rates start to rise?
From the mid-1980s until the GFC, mortgage rates ranged from between 7% and 10%, more than double from where they are today. Interest rates are affected by the cost of borrowing money and the compensation for a bank taking the risk of lending money. That means that even if the federal funds rate stays ultra-low (currently at 0.25%), banks could still raise rates on rental property loans if overall default rates rise because of the recession, or if future purchasing power is expected to decrease due to rising inflation.
By doubling the loan interest rate you’re paying now, you’ll have a better idea of how much your cash flow is reduced during a worst-case scenario.
Under the current low-interest rate environment we find ourselves, it’s also a great time to take a step back and consider all your mortgage options.
Test #4: Decrease your property value by 50%
Speaking of worst-case scenarios, real estate investors should also consider what happens if property values decrease.
For the buy-and-hold real estate investor, a fluctuation in property value over the short-term may not matter as much because they own property for the cash flow and view appreciation as icing on the cake. However, if you’re trying to sell or refinance during a recessionary down cycle, asset value is a critical consideration.
Granted, since the 1960s the median sales price of houses sold in the U.S. has continued to increase. Even during the GFC, median prices decreased by about 10% before recovering. But there’s a very good reason to decrease your property value by up to 50% during a portfolio stress test.
Transaction volumes are frequently depressed during difficult economic times. When sales volumes are low, accurate appraisals can be difficult to find if there aren’t a lot of property changing hands. Buyers and lenders will err on the side of caution, and value your property at much less than it may have been worth just one or two years earlier.
Oftentimes, mid-range business plans include conducting a cash-out refinance to raise capital, or selling an asset as part of a pre-planned exit strategy. Projecting a decrease in property values over the next several years will provide you with different scenarios of how much cash you might really raise depending on short-term value fluctuations.
Test #5: CapEx: Account for major expenses
You’ve probably heard the saying, “Anything that can go wrong will – at the worst possible moment.”
A CapEx account (or capital reserve account) for capital expenditures is just like having a rainy day fund for each of your rental properties. The last thing an investor wants to do is scramble to find the cash for a major expense like an HVAC or furnace replacement, or to repair a main plumbing line break.
How much money to hold in reserve for each of your rental properties can vary on a case-by-case basis.
Factors that affect the size of a CapEx account include property age and condition, climate, and when items such as the roof and plumbing system were last replaced. So, if the furnace in your rental is 18 years old, the odds are it will need to be replaced sooner rather than later.
As for how much to hold in reserves, a good rule of thumb is six months of your regular monthly expenses, including the mortgage. That means that if your normal expenses are $900 per month, you should hold at least $5,400 in your CapEx account, which is about what a new air conditioning system costs.
Patrick Carlisle, Chief Market Analyst at Compass notes that:
“It mostly comes down to being adequately capitalized. If rental income drops by X%, can they continue to service debt and pay expenses? In every financial crisis, high levels of debt have always been a huge factor in those businesses that fail.”
Test #6: Factor in construction cost overruns
If you’re building or doing a major rehab, be sure to include a cost overrun column in your construction budget. There are several good ways to reduce the risk of a cost overrun on a building project, such as using an experienced general contractor and signing a contract with a general maximum price (GMP).
But even with the best project plans, unexpected events can still occur. A sub-contractor could suddenly go out of business, or building materials may be in short supply, causing prices to increase. Using a construction contingency of 5% and a 20% cost overrun is a good best practice to stress test construction cost overruns to ensure the project is still viable with an acceptable ROI.
Test #7: Special assessments for condos and HOAs
One of the biggest mistakes investors make when they buy a condo or a property in a homeowners’ association (HOA) is to only review the association’s P&L and not the balance sheet. While the profit and loss statement may show positive cash flow, an HOA with a nearly empty reserve account on the balance sheet creates the risk of an unexpected special assessment for every owner.
An HOA will usually record any unpaid dues and assessments as a lien against your property, to provide public notice that the debt exists. In some jurisdictions, an HOA can even foreclose for unpaid assessments, even if you’re current on your mortgage and property tax payments.
So, if you own a rental property in an HOA, always ask for the most recent P&L statement and year-to-date balance sheet to make sure the association is holding funds in reserve for upcoming improvements and capital expenditures.
Defensive modeling in a crisis
While each of these seven stress tests can be done individually, you should also combine each variable into a single analysis. By doing this, you’ll be able to evaluate potential risks along with possible opportunities.
The worst-case scenario of each test could create a nightmare scenario that might never occur. But during difficult economic times, knowing what could happen helps you to become both mentally and financially prepared for every downside risk.