How to stress test your rentals?

11 Replies

I would like to know... when you analyze a potential rental property deal, do you "stress test"? for example:

Crank your vacancy up to 12%? 

Figure you expenses at refi could go up x amount due to higher interest?

Or does $100 per door cash flow theoretically let you sleep at night?

Stress testing:  Very key for larger properties.  For smaller properties, an extra vacancy can throw the property immediately into negative financial performance.  Everything can possibly go wrong, but here is what usually goes wrong:   1.  You can't collect rent from certain tenants.  And you have to evict them and re-rent the place.  Lot's of money lost.   2.  A large repair item.  I call it capital expenditures. 

$100 per door cash flow - sounds tough.  Easily can be wiped out by just one repair. 

A stress test spreadsheet is something they should certainly add to the forms section of BP although I think the exact people who need it most: the high leverage, perpetual appreciation crowd, will never use them

This really is one of the things that I wonder about when I read about guys who go the managed-turnkey route, many OOS doors, low cashflow for each, paying contractors for every fix. I know my properties inside and out. I know their strong and weak points as structures. I pay a premium for hot-water heating, brick veneer and poured-concrete basements if I have to. I do almost all of my maintenance and what I don't do I have long-term business partners handle according to my specifications -- lasting fixes when necessary, high-quality paint that can be touched up repeatedly, Whirlpool appliances, hardwood and tile I do myself.

I am on the electrical board and the outlets, I am on the roof, I am inspecting the windows, I am on the gutters all the time, I am liberal with the weedkiller concentrate, saving myself money in the long run wherever I can.

What happens when you're extended from here to eternity with 75 SFR and three furnaces die in the first heavy cold snap? Or two pickups lose control and take out external roof supports at two properties in the same week and just drive on? Or a handrail fails and a kid falls and busts his head open on stairway ice because your PM knows nothing about how concrete should be finished and let a bad fix slip? Or you find out that your PM found his wife under the keyboard player of an 80s cover band last week and is locked up for ag-assault in the county jail for thirty days with no one available to collect rent or continue the process of evicting those people on Center St. who might or might not be running a under-the-table daycare center/illegal pain pill distribution center out of your property...

Does your whole house of debt collapse because Murphy wasn't in a good mood this week?

Originally posted by @Storm S. :

Credit default insurance and a home warranty if your cash flow will allow it will allow a property to survive those stress tests

So You’re  buying home warranty’s and credit swaps to protect your portfolio?

34.99 a month to cover all my capital expenditures and appliances. Credit Default Insurance is very common in Europe it used to be offered in the US but not anymore as far as I know. You can still get it through surplus lines or reinsurance. There is a workaround by using commercial surety bonds you can achieve the same thing. CDI also sometimes cover eviction costs depending on the insurer/guarantor. I've seen it range from 2% to 20% of the gross rents for CDI. 

That's a really good question @Will G. and I think people don't think about that enough. People that only have $100 in cashflow per door probably got crushed in 2008-2009. That just simply isn't enough in my opinion. However if you are wise like @Jim K. and know what the repairs will cost, what the properties weaknesses and strengths are, and have money in reserves, you should be fine. Grant Cardone put this very nicely in his second podcast. He takes the lowest possible rent from the past 5 years and uses that on top of his trusted contractors and inspectors opinions on how much repairs and maintenance will be. If it still cashflows after that he will buy it knowing it can survive anything. I personally believe though that it is very easy to get into the trap of analysis paralysis if you go to deep into this. There is never a "perfect" deal and if you only look at the numbers and let every small thing dissuade you from a deal you will never get started. Sh%t happens and sometimes you can't be prepared for it, that's just life. However that doesn't mean you shouldn't be conservative and think ahead before buying a property. I think it all boils down to knowing the neighborhood, property and doing your due diligence properly and really knowing the property and deal inside out like Jim does. 

@Michael Guzik Great points and clever to see if a deal cash flows from rents 5 years ago. I would submit that finding a property that would pass that test is nearly impossible in the current environment, still I beat my head against the wall daily in attempt! @Jim K. I see folks get into crazy deals not knowing what things will cost, so good on you for having that skill set and being able to fix everything! I have been considering getting my hvac certification cause of all the money I spend on a/c contractors.

I suspect 5 years from now there are going to be a ton of motivated sellers trying to get out of all these low cap rate, marginal deals.

Way to go, @Jim K. telling it like it is.  Until an 'investor' reaches critical mass (escape velocity) in number of units turning enough profit that even the occasional catastrophe won't  change their life style, it's got to be keep your head in the game and all hands on deck.

It's all fun until it's not.  

Put most of your 'profits' at first into contingency fund, then budget a percentage of monthly flow to keep that account growing.  BTW, I consider contingencies property-related emergencies, not "I'm so stressed, let's go on vacation."

It's a wonderful business, so long as we remember it is a BUSINESS and needs our careful attention and supervision.

@Will G. great topic that doesn't get enough attention. 

To me "stress" comes in two varieties: Income stress is things that happen that will reduce your income, vacancy, increased competition, change in market demand. Expense stress is things that cost you money above and beyond the planned for. The best way to stress test depends on the market, portfolio, and the asset class.

At the end of the day, both are solved by having adequate reserves, not sucking every last dollar out of your property, and having manageable expenses. 

I'd sleep like a baby if I had a brand new house that got $100/door/month free cash flow if I had reserved $250/month for Repairs and CapEx on top of $5k I brought into the deal. Different story if I had $0 capital reserves and saved $50/month for repairs for a house built in 1910.

Point being $100/month/door is just a number unless you understand its underlying assumptions.

Similar to @Michael Guzik 's mention of Cardone using historical rent, a conservative stress test for your current portfolio is to run a net worth (balance sheet) based on what you paid for the property, not the current market value, vs debt. This can show if properties are being paid down over time or is more debt added over time.