The CRE Stress Test: How To Know When You’re in Trouble
Commercial real estate debt typically comes with certain conditions or ‘loan covenants.’ These covenants vary widely depending on the lender and their preferences. However, most require borrowers to maintain a debt service coverage ratio (DSCR) of at least 1.15x to 1.25x.
DSCR measures a property’s ability to fulfill its debt obligations from its cash flow. And should the debt exceed the income — in other words, the DSCR falls below an agreed-upon standard — lenders have the authority to seize a property.
Even worse, they can demand the loan be paid in full immediately and without notice. As a result, commercial real estate owners are strongly motivated to anticipate and recognize financial trouble and know how to avoid it.
Fortunately, there’s a way to forecast and minimize this real, though harrowing, possibility. Stress tests play a vital role in steering owners and operators away from potential ruin.
What is a stress test?
Stress tests are used in finance to determine how well assets and liabilities can withstand negative changes in the market. In real estate, stress-testing reveals how well a portfolio holds up when different variables that underpin its profitability are altered.
While the name may imply a physical component in many industries, stress tests in CRE largely take place in digital forms, such as Excel spreadsheets or sophisticated data modeling software.
This technique involves manipulating financial data of a property to simulate different hypothetical scenarios and noting the effects on net operating income (NOI). The computed results are then summarized in a decipherable format to inform decision-makers on potential outcomes if a critical assumption in a model is negatively impacted.
What variables are tested?
Although a variety of variables are introduced in a commercial real estate stress test, the following are the most commonly used to gauge the resulting impact on the DSCR of a real estate portfolio.
A subsection of commercial real estate loans set the DSCR based on an interest rate, whether it is the interest rate of the loan or a rate tied to Treasury Bonds.
In this instance, it is important to measure the theoretical effect of fluctuations in interest rates. Usually, the base interest rate of each property loan is increased across the board by 1 to 3 percentage points to simulate mild, moderate, and severe jumps in the cost of interest.
If a rate jump sends a property into the negative, it’s a clear sign that the property is highly susceptible to interest rate increases and therefore must be monitored by the owner or operator closely.
For the remaining subsection of commercial real estate loans, DSCR is calculated by dividing the NOI of a property by the monthly loan payments.
Vacancy rate affects NOI, and that relationship implies that a vacant portion of a property cannot generate revenue to pay the debt service and operational expenses. Even if a property is 100% occupied, financial models will factor in the cost of vacancy as a line item in the operating budget, usually at a rate of 5-7% of the rent amount.
But during a commercial real estate stress test, these vacancy rates are increased to double or even triple the base amount. Extreme stress tests may even set them to 100% to see what would happen to the DSCR if all tenants of a property were to break their leases.
What’s the point?
Stress-testing vacancy rates gives operators an idea of just how high vacancy rates can climb before expenditures surpass revenues. If they know the property will be cash negative at a 60% vacancy rate, they can reconsider their marketing approach to improve occupancy.
Lease rates are the last major variable in a commercial real estate stress test. It’s a crucial metric because the amount of rent received contributes directly to the income generated.
Rental income underscores the ability of a property to meet its debt obligations. Therefore, by determining the rental rate at which a project would be cash negative, an operator has a specific marker to track and prevent future adverse consequences.
For example, if a stress test reveals rental rates below $3 per square foot would lead to financial losses, commercial real estate owners and operators can encourage their brokers to push for rates that exceed this threshold. Owners may also improve business operations and decisions to ensure they stimulate sufficient demand to secure optimal lease rates.
Stress test requirements
Stress tests cannot be done in isolation and require a certain amount of information about the property or portfolio. In fact, the more property and portfolio data an owner or operator collects for this purpose, the more accurate a commercial real estate stress test will be.
Thus, in preparation for a stress test, it’s best to have all past financial statements, pro formas, and the following details:
- The type of commercial loan.
- The loan amount.
- The net operating income.
- The appraised value.
- The date of appraisal.
- The capitalization rate.
- The original loan to value.
- The interest rate spread.
- The basis of rate index.
- The current interest rate.
- The current loan balance.
- The principal and interest payment amounts.
- The minimum debt-service coverage ratio requirements.
Owners and operators who gather this extensive set of data points and incorporate them into their stress tests typically generate the best insights.
When in doubt, find out
Success in commercial real estate depends on the interaction and intersection of a number of factors, including rental income, interest rates, and key market conditions. Stress-testing provides commercial real estate owners the unique opportunity to understand and anticipate what contingencies could expose their portfolios.
Short of being a crystal ball, stress tests provide valuable foresight that operators can leverage to optimize their methods and steer clear of crushing losses. That is, they are the best tool for commercial real estate owners and operators to manage risk and be proactive in building financial legacies.