Everyone has heard of the Federal Reserve "Stress Test" for large Wall Street banks, but many of the same principles apply to us as real estate investors. A stress test involves preparing for the rare "crisis," a once in a life time event. Having a plan in place is the first step to ensure your success through the next downturn. The time to plan is now before the crisis rears its ugly head. Below I detail some ideas regarding market exposure, liquidity, and interest rate risks.
Market Exposure: One possible stress test is for a bank to consider their exposure to a particular industry, location, or market. For example, a lot of banks in Texas and Oklahoma went under in the 1980s when there was a sudden drop in oil prices and the oil field producers could not repay their loans. The market I am invested in is heavily tied to the price of agricultural commodities. To make matters worse 4 large companies provide most of the jobs in our community.
One easy way to combat this would be to invest in a different area as well as my home town. I am not ready yet to take this step, but I do consider source of income when screening for new tenants. I recently selected a tenant who worked at a local college, after she passed the background check, in part because her source of income is not correlated with the local economy.
This type of analysis should still be completed for investors in large urban areas with diverse employment opportunities for tenants. The example that comes most readily to mind is natural disasters, like Hurricane Katrina for investors in New Orleans. Do you have a plan in place to survive if something completely disrupts your local market?
Liquidity: Many financial institutions will ensure that they have cash on hand and available credit lines to support paying off all short term debt. An inability to survive without access to the overnight commercial paper market is listed as one of the causes for the downfall of Bear Stearns in the book "House of Cards."
Though it is unlikely that many real estate investors will have access to the institutional commercial paper market, we may check our liquidity in other ways. I like to consider, "Do I have enough cash reserves, short term paper investments, and access to cheap lines of capital (not credit cards) to survive 6 months if I lost my job and my vacancy rate went to 50%?" (See above as this is a possible scenario in my area if the price of corn dropped significantly.)
The goal here is to make sure you have resources in place so that you do not have to sell your properties at fire sale rates just to put food on the table for your family. Bonus, have a plan in place to pick up properties if such a drop were to happen in your markets.
Interest Rates: Do you have any floating ARMs or HELOC? Do you have a balloon mortgage coming due in the next couple of years? If so, would your properties still provide enough cash flow if rates spiked up by 2%? Rates have increased by this much in as little as 90 days 4 times in the last 35 years. Some investors have bought properties that only provide great cash flow when rates are at historic lows.
These represent only a couple of thoughts on testing your portfolio. I would love to hear ideas from other members on how you stress test your portfolio. I picture having a copy of my "Stress Test Response" as a part of our real estate business plan.
(Disclosure: This post represents my own thoughts and the examples I use do not relate to my employer. Each situation is different and my stress test methodology may not be complete for your area. Finally, Adrian Allen wrote a post a little over a year ago on "stress testing" individual deals. To not repeat what has already been written, this post focuses on an approach to test your entire portfolio. You can read Adrian's post here:
Interesting post; you bring up some rigorous analytics to consider.
I'd venture to say that it's hard to have any property stand up to most of those, unless you own them outright. So, in a larger sense, your best bet for stress testing might just be adopting conservative business practices and projections to shield yourself against volatility. I like the idea of cooking in some safeguards against industry-specific reliance in your tenant choices.
Thank you Peter. I agree that it is impossible to offset every risk, and buying right mitigates a lot of risks. I think the trick is being conscious of what risks you are taking with your portfolio.
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