Stress Testing Your Real Estate Portfolio This Summer

This summer, I’m dedicating some time to an exercise I believe is crucial for every real estate investor: stress testing my portfolio. I’ve done this periodically over the years, and it’s an important part of the journey. How you approach it will, of course, depend on your portfolio’s size and the tools you have at your disposal.

For me, stress testing typically revolves around “what if” scenarios. We all know the market can be unpredictable, so it’s smart to prepare for various possibilities.

What Scenarios Should You Consider?

I like to explore a few key areas:

• Economic Downturns: What happens if there’s a recession? How will it impact property values and, critically, my rental income?
• Interest Rate Fluctuations: If interest rates go up, how does that affect my debt service coverage ratios (DSCR) and overall financing costs? This is a big one right now!
• Market Volatility & Vacancy Rates: What if vacancy rates climb? How does that hit the rent amounts I can ask for, and ultimately, my cash flow?
• Declining Rents or Property Values: What if rents or property values decline across the board? How does that ripple through the entire portfolio?
• Rising Operating Expenses: We’ve seen property taxes, insurance, maintenance, and utility costs all creep up. How do increases in these expenses affect my bottom line?
• Liquidity: In any of these scenarios, how does it affect the liquidity of my portfolio – not just individual properties, but the portfolio as a whole?

Quantifying the Impact

The goal here is to quantify the impacts of each scenario. For instance:

• What happens to my cash flow projections?
• How do my property valuations hold up?
• What’s the effect on my overall return on investment (ROI)?
• Do I need to consider selling properties? If so, when would be the best time?
• What’s the estimated recovery time for my portfolio in a downturn?
• And, of course, how does it all impact my income generation across the entire portfolio?

Simple Stress Tests to Start With

It doesn’t have to be overly complicated to begin. You could start with something as simple as:

• What if interest rates increase by just one percent? How does that affect my debt service?
• What if there’s a five percent decrease in rental income?
• What if operating expenses jump by 10 percent?
• What about changes in property values, whether due to cap rate changes or broader market shifts?

Learning from History

Another powerful way to stress test is by looking at historical events. How would your current portfolio have performed during:

• The 2008 financial crisis?
• The 2020 COVID-19 pandemic?

By analyzing how your specific properties fared during those times, you can gain valuable insights to model out potential future impacts.

Beyond the Numbers: Capital and Strategy

When you’re stress testing, also consider your capital reserves and any lines of credit you might have. Are there refinancing opportunities that could improve your cash flow or help you pull out capital?

Sometimes, stress testing might reveal that it’s time to re-evaluate the return on equity in particular projects. You might decide to refinance an asset, pull out capital, and redeploy it into another property or even another asset class. This can be a fantastic way to increase the diversity of your assets and strengthen your overall investment strategy.

There are many ways to approach stress testing your real estate portfolio, and the best method is the one that makes the most sense for you. If you don’t currently have the tools or models to conduct these tests, don’t worry – I will be sharing a solution in the near future!

Are you planning to stress test your portfolio this summer? What scenarios are top of mind for you?