Stress testing is a vital component of evaluating various factors’ impact on cash flows due to changes in micro and macroeconomic forces. These forces include vacancies, changes in market behaviors, financial crises, or other risk factors.
In this article, we explore portfolio stress testing, why it is vital in commercial real estate, and the four risk factors that every lender should stress test before partnering with an investor.
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What is portfolio stress testing?
Portfolio stress testing is adjusting various factors to see the potential impact on a property’s cash flow. It allows investors and lenders to see the correlations between risk factors and cash flow in a risk-free environment.
In commercial real estate, stress testing is a risk management tool used to evaluate a portfolio’s current and future risk potential by analyzing various scenarios where one or more factors change as a result of market forces.
Many investors and lenders use widespread testing for vacancies and sale prices. For example, an investor might use a vacancy line item on their cash flow statements to account for units or properties that aren’t generating income. Or, what happens when you change the cap rate applied to net operating income over a specific time horizon?
Stress tests like these test several variables of a portfolio to evaluate performance. At Blooma, we go a step further and stress a wide range of factors, including:
- Interest rates
- Cap rates
To evaluate how they affect:
- Debt yield
Using Blooma’s CRE platform, stress testing is only the beginning. Enjoy dedicated CRE software that helps eliminate time-consuming processes that elongate the CRE buying and selling process. Try us today to see how you can change the way your deals get done!
Why is stress testing for commercial real estate important?
Stress testing is an invaluable analytical tool for lenders to help assess the risk of a commercial real estate portfolio. Although it can be a speculative tool, it can help highlight certain assets’ pros and cons, even illuminating underperforming assets or properties.
In a commercial real estate environment, stress testing helps mitigate risk and better adapt to changes or take action to prevent loss. But it’s not just the bottom line that benefits; stress testing can provide other great benefits, like:
- Favorable lending rates and expanded access to capital
- Avoiding penalties from financial regulators and government entities
- Data-backed decision-making during economic downturns or financial hardships
It’s vital that you use accurate, up-to-date data for your stress-testing variable range. Without precise information, your simulations are worthless and can lead to inappropriate action that leads to reduced cash flow.
When stress-testing a commercial real estate portfolio, there are many factors you can choose from. However, there are four main components that are among the best for predicting future portfolio performance.
Tenant risk assessment
A tenant risk assessment evaluates the potential risk of various tenants, whether it’s retail, office, industrial, or multi-family assets. It seeks to answer the question of what happens to cash flow when market conditions cause tenants to stop paying rent.
This risk factor is one of the first that investors, lenders, and real estate agents look at when evaluating a piece of commercial real estate. That makes it vital that property managers review all tenants’ payment history, credit risk, and ongoing relationships.
When evaluating larger investment portfolios, assessing tenants by asset classes and segmenting tenants for scenario analysis is helpful. This lets you see what happens to your cash flow when you stop receiving rent from specific assets.
Additionally, macroeconomic forces can create volatility in your expected income. For example, due to the pandemic, many businesses are choosing to offer remote or hybrid work solutions, meaning a sharp increase in office vacancies. That shift will impact CRE portfolios.
It’s also advantageous to cook “stretch rent” into your stress testing, as that allows you to account for businesses operating on startup funding or unproven business models. These types of businesses may stop paying, need a discount, or will need a replacement, causing cash flow shortages.
Push your tenant risk assessments to the limit by carrying out scenarios involving cascading vacancies, or in other words, what happens when one business leaving causes others to follow suit? By understanding tenants’ pain points and market conditions, you can implement contingencies to avoid catastrophe.
Timing of cash flows & liquidity risks
Most investments have costs associated with them. For example, ETFs might have trading fees, and blue-chip stocks may carry broker fees. Commercial real estate assets incur capital expenses in the form of upkeep, remodeling, refreshes, and preventative maintenance.
To help pay for these bigger expenses, investors stagger capital expenditures to offset them with cash flow. But you know what they say about timing. Stress testing allows lenders and investors to see the potential impact of cash needs that exceed inflows that may require alternative funding methods.
Those alternative funding methods could include lines of credit, credit cards, or access to mezzanine financing and equity capital. However, investors will need a strong credit relationship with lenders to ensure they can access that credit when needed. And a stress test can help illuminate how much on-hand availability you will need.
The inability to unlock credit when needed is a significant portfolio risk, as large capital expenses can sometimes stand in the way of a continued revenue stream. For instance, a tenant has a lease up for renewal but wants improvements before resigning the lease.
Therefore, by stress-testing portfolios for cash flow timing, lenders can evaluate potential needs for capital and offer options and advisory services to meet demands.
Valuation is key for the asset management of commercial real estate properties. You need accurate valuations for refinancing, upcoming load payments, sales, and even to negotiate interest rates.
In fact, an expertly crafted financial plan with stress testing of various market scenarios gives financial institutions more confidence that income and cash flow values will remain constant at some level. These plans also help illuminate vulnerabilities in assets during disruptions.
Stress testing portfolios for asset valuation challenges the rose-covered glasses that rents will be high and vacancies low by re-evaluating cash flows should another financial crisis occur. Use the following six methods for obtaining a valuation and stress test each methodology for risk factors.
- Cost approach
- Sales comparison approach
- Income capitalization
- Value per gross rent multiplier
- Value per door
- Cost per rentable square footage
Although it is complicated to use valuation as collateral for a loan, running simulations based on each methodology can provide valuable insight into which properties offer the highest ROI, have the most prominent risks associated with volatility, or don’t meet investment goals.
Debt covenants can be complex requirements lenders use as a risk management strategy. They are contractual agreements or disclosures protecting lenders from added risk and borrowers from overextending repayment capabilities.
There are two types of debt covenants—positive and negative. A positive covenant is a clause that promotes some activities, while a negative covenant disallows specific actions. By stress testing primary risk factors, you can receive insight into the following:
- Debt service ratios
- Debt yield
- Rollover reserves
- Springing recourses
Failure to adhere to debt covenants doesn’t just sour partnerships between lenders and borrowers. Breaking debt covenants cause negative recourses, such as increased interest rates, reduced access to capital, or total cancellation of a loan or commercial lending agreement.
Additionally, as a result of the 2008 financial collapse at the hands of Fannie Mae, Freddie Mac, and others, the federal government may step in to help lenders collect on private equity with debt contract enforcement. These actions help protect against large-scale GDP damages from failed debt covenants and missed payments.
Improve your CRE portfolio with Blooma
Stress testing a portfolio is an excellent way to evaluate how it will perform under certain market conditions. It provides valuable insight into the effectiveness of any given portfolio, along with a guide for preventing disaster should things take a turn for the worse.
You can stress test a number of variables, from vacancy to interest rates. However, doing it the old-fashioned way with outdated historical data is a good way of getting inaccurate results that lead to poor decision-making.
Instead, trust that you have the most up-to-date information in one easy-to-use system. That’s where Blooma comes to save the day. Our AI-powered CRE software platform gives you a centralized dashboard with everything you need to monitor your commercial real estate portfolio. Try a demo today and start getting decisions in as little as one hour!