Would you pass the Stress Test?

There is a mechanism in the financial world called a stress test.?It is used by the government and other institutions to test whether an institution or an investment portfolio can withstand future negative financial environments.?The results of these tests help determine future decisions of that institution or portfolio (do we get more conservative or can we push our risk profile higher).?Lenders will also use this same test when reviewing your loan request to determine if the property can handle any future market disruptions (higher vacancy, lower CAP Rates, higher interest rates at the exit, etc).?First, let’s discuss how they stress test, then we can explore what they do with that information and what can be done to compensate.

Each lender has its own stress test that it will apply.?With the recent shift in the capital markets and the rather dim forecasts, we are seeing this come up more in underwriting.?Here is how it typically gets applied.?In this example, the lender has a standard guideline of underwriting to a 1.25x DSCR and a note rate of 6.0%.?For the stress test, the lender will take the underwritten NOI and apply a 1.3x DSCR or use an underwriting rate of 6.5% (or both!).?I recently spoke with a capital source that was using a 25-year amortization and a 7% rate to stress test the exit of a multifamily construction project.?

This stress test is done both at the outset (when they are preparing an initial term sheet) and in final underwriting.?At both of those points, they can lower the loan proceeds to fit these more stringent guidelines.?What can be done about it??There are actions we can take to either avoid or lessen the impacts of stress testing.?The first is to simply have more capital sources to choose from.?Our platform is already set up to bring you quotes from a variety of capital providers.?The more options you have, the easier it is to avoid those that have stricter measures.?We can screen each quote, so we know who is applying stress tests and who isn’t, bringing this into your decision-making process.?But what if it can’t be avoided??We can lessen the impact of stress tests by making sure the NOI that the capital source is using is as strong (but accurate) as possible.?This involves analyzing the P&L and Rent Roll very carefully to ensure that there are no extra expenses included and/or the income is represented properly.?I have written numerous articles about this specific subject (reach out if you would like links).?The other action we can take is to work closely with the appraiser while they are preparing their report to ensure they also have the most accurate and complete picture of how your property aligns with the market.?There is no reason to leave this up to chance and is a step I take in every transaction, I have seen it make a tangible difference.

It is hard to blame capital sources for wanting to be careful about the proceeds they extend on any commercial asset right now.?Caution should be taken by you, the investor, as well as by a capital provider, it is only prudent.?That doesn’t mean that an investor has to absorb a large cut in proceeds though, as that would stifle the market even more than it already is.?But reasonable steps can be taken to provide reasonable proceeds.

Michael Coffee | Capital Advisor | [email protected] | 503.866.8817