Stress Testing Real Estate Syndications
In medicine, a stress test shows how well the heart is handling its workload. Exercise makes the heart pump harder and faster, and a stress test can reveal problems with blood flow within the heart.
Much like a stress test used in medicine, stress testing a real estate syndication deal can help ensure that there’s enough “blood” flowing through the investment to keep it alive and well in potentially less-than-ideal situations.
When stress testing real estate deals, the sponsor alters the underwriting to show multiple scenarios to determine if the investment will still meet certain investment expectations when things go wrong. Doing these stress tests shows that the sponsor has thought about “worst-case” scenarios and a potential downturn in the future.
How is a stress test done?
In real estate syndications, a stress test occurs when a proforma variable is changed to determine how it will impact cash flow and investment returns. A proforma is only a forecast, and the longer a deal goes, the less accurate the predictions tend to be.
Performing a stress test can provide more confidence in a deal, that no matter what economic climate we find ourselves in 5, 7, or 10 years down the road, the deal will survive and meet return expectations.
To understand how a stress test is done on a real estate syndication, it’s important to understand how a commercial real estate property is valued.
Remember that: CAP RATE = NET OPERATING INCOME (NOI)/PRICE
So PRICE = NOI/CAP RATE.
The price of a property is determined by the NOI (gross income minus operating expenses) and cap rate.
With this formula in mind, there are two main drivers in valuing the price of a property: NOI and cap rate. A stress test aims to change each of these variables to provide investors with more insight into the proforma’s estimated returns.
Now let’s talk about how the sponsor can stress test these two variables:
#1. Stress Testing Income (Occupancy/Vacancy)
The largest component of a property’s income is occupancy (i.e. how many units are filled with paying tenants). The higher the occupancy, the higher the income. Most proformas have a line item for “vacancy loss” to account for units that aren’t earning income.
Most stabilized properties have a vacancy rate of about 5%. But you should look at how higher vacancy rates affect the NOI. What would happen to the NOI when vacancy rates jump to 10%, 20% or 30%?
Sponsors can determine what the breakeven occupancy would be with the new debt secured for the property. Breakeven occupancy is the economic occupancy that is needed to keep the operation running just to break even. Below this number, the property starts losing money. I would rather choose a deal that can go down to a 60-65% occupancy and still make money over a deal with a breakeven occupancy of 85%.
#2. Stress Testing Cap Rates
The sale price of a property is calculated by taking the NOI in the last year of the holding period and dividing it by the exit cap rate. Guessing what the exit cap rate will be significantly affects the sale price and in turn, the projected returns.
The exit cap rate is just an educated guess of what the market temperature will be at the end of the project. As such, the exit cap rate should be stress tested over a range of values to show how the sale price and investment returns are impacted. This can show you what sales price would allow you to hit your target returns.
Conclusion
The proforma of a real estate syndication deal is just an estimate. It is a baseline projection of a property’s income and expenses over a defined investment period. The further out these predictions are, the less accurate it’s likely to be.
By placing a deal under different stress tests, you can consider the range of possibilities, gain a better understanding of the investment’s risks and potential impact on returns, and ensure that the deal can weather potential storms ahead.
Interested in Learning More?
Whether you’ve invested before, or completely new to real estate syndications, Clear Vision Investing is here to help you every step of the way.
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