Make Your Real Estate Deals Less Stressful by Adding More Upfront Stress

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Oh great, I probably already have you confused and I haven’t even finished my first sentence yet. As confusing as the title to this article may sound, from my experience, it makes perfect sense and my goal is to have it make perfect sense for you by the end.

Last week I wrote an article about how spreadsheets can be a great “sleeping pill” in regards to alleviating your stress about all the numbers that can surround a deal. I briefly mentioned that a spreadsheet, however, can only be as good as the numbers you include in it. If you get lazy or don’t do the proper analysis- the numbers you plug into the spreadsheet will lead you down a miserable path.

Why Stress Testing Is Important

When I used to work for Honeywell as a process engineer, the one thing that was really driven home to me was we needed to test everything beyond what was “satisfactory”. If we had a part that we knew could withstand ‘x-amount’ of pressure, we wanted to see how it would hold up under ‘y-amount’ and then take it a step farther and put it under ‘z-amount’ of pressure. This is a real estate blog obviously, so I’m not trying to turn this into a engineering class, but in short, these types of tests are called “stress tests”.

Honeywell cared about and profited from putting out good products. A big step in doing this is ensuring your customers have full confidence in you and the product. What better way to build confidence (and ease of mind) than to not only meet the minimum requirements, but be able to meet requirements BEYOND the minimum???

How to Stress Test Your Real Estate Deal Analysis

This same concept can be transferred over to your spreadsheets and deal analysis. I won’t say doing a stress test is a “must-do”; however, if you are a worry-wart like myself who is always thinking, “what if a worst case scenario happens?!?!”, then I would highly, highly recommend this.

So how does a real estate stress test work? In a nutshell, you are trying to turn a good deal into a bad one. By stacking the odds against yourself, you will see both how truly ‘strong’ the deal is, and build confidence and ease of mind about the deal (translating to better sleep at night).

Stress Test Variables for Your Real Estate Investment

I should first note, that there is no ‘right’ or ‘wrong’ variable. As long as the numbers are going against your deal in a negative fashion, then the concept is being accomplished. Don’t get hung up on “what” variables to use, just don’t put any variables in your favor.

Let’s go through a few examples of possibilities you could use for your stress test…

  1. Holding Time - do your projects usually only take 4 months from closing (to buy) to closing (to sell)? Instead of using the number ‘4’ in your analysis, what happens to your end profit if you enter in ‘6’… ‘8’…’12’… still profitable?
  2. Cost of Money - do you usually pay 10% on your money? What happens if you change that number to ‘10.5%’ with an additional ‘2’ months in Hold Time? How does your profit look?
  3. Utilities per Month - what happens when you add in another $250 per month for utilities?
  4. ‘Surprise’ Rehab Percentage - the standard number is 10-15%. What if you change this number to 18%? 20%?
  5. After-Repair-Value (ARV) - what happens to your profits if you deduct a couple thousand from this number?

Maybe you have all these numbers nailed down to a science and you know through multiple deal experience, they ‘are’ accurate. This is why I mentioned above that doing a stress test is not a ‘must-do’, but if you are a rookie or worry-wart, it certainly can’t hurt you.

My rule is this: if after adding ‘stress’ to the variables, the end result is still showing a profit… the deal is an absolute MUST-BUY.

Not only is it a MUST-BUY, it is one that I can buy and be totally relaxed (NOT the same as lazy) in regards too. I love sleeping like a baby :-)

Please note however, you shouldn’t care how big the profit is after the stress test. Remember, the deal should ALREADY be a deal when you do this. When the stress test is applied, your profit will get hit and drop. But… for example… if your deal that is ALREADY a deal can suffer through…

  1. An extra 3 months of holding time.
  2. An extra .50% on my cost of money.
  3. An extra $100 in utilities (or property taxes, or insurance, or whatever) per month.
  4. An extra $1,500 in ‘Surprise’ Rehab costs.
  5. An ARV that is $5,000 less.

Then BOO-YA, you got yourself an opportunity that you need to be pulling the trigger on… no question!

Conclusion

I know it is fun to look at the analysis and see all the profit that you stand to make; however, if you want the euphoria of being 110% confident, apply this upfront stress. Murphy’s Law has a predictable way of making its presence known, so always good to brace for the worst and see how your deal would still be holding up.

What kind of variables do you put through a “stress test” when analyzing your deals? Leave me a comment below and let’s talk!

Photo: John Morgan

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About Author

Clay (G+) is a licensed real estate agent and the owner of Huber Property Group, LLC, a real estate investment company located in Grand Rapids, MI. His company purchases distressed properties with the main exit strategy of fixing them up and reselling with owner financing, particularly, land contracts.

14 Comments

  1. Great Blog and spot on. I’m going through this right now myself. Not only did my ARV come in $4K lower, but now it looks like my rehab will push out about 10% due to some unexpected plumbing work. And, oh yeah, this has now moved out my make ready time by about a month. The trifecta. I did, however, do as you said and considered the worst case and that makes it much easier to take. I only hope no more unexpected problems arise though.

    • John, thanks for the comment. You nailed it perfectly, when you said surprises are “much easier to take” if you have already put your analysis under a stress test.

      I will keep my fingers crossed for ya that you do not come across any other ‘surprises’ though ;-)

  2. Brandon Turner

    Hey Clay – I think this article is so super important for new investors. Often times we all want to look at the scenario through rose colored glasses. This “stress test” is really important!

    • Exactly Brandon.

      It’s always so easy/pleasant to look at a deal analysis from the reference point of “look at all these profits”, even if that means the numbers are a bit too “rosey”.

  3. Great post and I will definitely apply your stress test formula from now on. It’s funny that most of the times we tend to do the exact opposite, trying to make up the numbers hoping for the ideal scenario, when the reality is that stress will come.

    Thanks for sharing this great formula,
    Alex

    • “It’s funny that most of the times we tend to do the exact opposite, trying to make up the numbers hoping for the ideal scenario”

      Exactly Alex! I know that’s what I was always tempted to do. One of my favorite sayings is simple, yet powerful when you stop and think about it: ” ‘hope’ is NOT an investment strategy”.

  4. Great article Clay! Seems like common sense when reading it but for someone new like myself, it’s a must to do in the due diligence portion of evaluating a deal. Thanks!

    • Chris, you’re right, it ‘is’ common sense in theory; however, in reality, when sitting down analyzing your deal, it can become very hard to assume the BETTER instead of assuming the worst for a project.

  5. Great points!
    I love this article.

    I always look at what happens if some bad things happen and make sure my numbers look okay even with at least 1 disaster. I usually do it sorta casually since I start off fairly conservative. However when I want to get serious I did develop a spreadsheet to do a sensativity analysis (Same basic idea in business school speak) that will spit out 145 different possibilities for my profit based on a sliding scale of possibilities for ARV, Rehab costs, Holding time and financing terms.
    Took a little while to make it but now I just have 3 inputs (Best guess ARV, estimated rehab budget and purchase price) and I get a lot of information!

  6. A stress test is a great tool. The application of this kind of math is absolutely paramount. Always apply a metric that represents the worst case scenario and let the reality of the numbers hit home, because the statistical probability of said scenario happening is quite high, particularly for novices – for anyone actually!
    In the REI world we have a culture of unrealistic expectations and unbridled optimism that gurus use to bring people in to their cults of personality. Novices often are lured into thinking that a can do spirit in conjunction with this unbridled optimism is enough to make one “successful” in REI. However, anyone with even a modicum of experience in this game can tell you that such optimistic thinking in lieu of an equally important dose of practical pessimism can spell doom. It is imperative that one apply stress tests such as your own and make that the new reality. As you said, this actually can make you feel better and sleep well at night.
    REI is not all about the money – it’s every bit as much about being a true professional. Your investors and your customers will view you as a professional when you provide these scenarios to them as well, and this will raise your personal stock value. I always show everyone my worst case scenarios as a means of setting expectations, both within my own mind and in the minds of those with whom I do business.
    Thanks for sharing your stress test, Clay. This is very important information.

    • Great comment Michael.

      The world is definitely not perfect, and that certainly pertains to the world of real estate too (despite what the guru’s want to illustrate/portray).

    • Kaiser – there are a multitude of spreadsheets available to start out with (that you can customize to your liking), I’d recommend just running a Google search.

      After you have a spreadsheet you are happy with, then it is just a matter of plugging in “worst case scenario” numbers and seeing how the deal still looks.

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