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…
- 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?
- 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?
- Utilities per Month – what happens when you add in another $250 per month for utilities?
- ‘Surprise’ Rehab Percentage – the standard number is 10-15%. What if you change this number to 18%? 20%?
- 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…
- An extra 3 months of holding time.
- An extra .50% on my cost of money.
- An extra $100 in utilities (or property taxes, or insurance, or whatever) per month.
- An extra $1,500 in ‘Surprise’ Rehab costs.
- 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!
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