CREModels was started during the Global Financial Crisis (GFC) performing services such as real estate portfolio stress testing for investors, developers and lenders at a time of heightened uncertainty in the markets. We have always excelled at providing expert analytical services to the real estate industry. In strong markets, we are tapped to perform more transactional services like due diligence and acquisition underwriting. In uncertain times, however, we see a drastic uptick in demand for clients who want to review a myriad of possible scenarios and how they affect their overall portfolio.
Real estate portfolio stress testing is one method we use to assess the ability of a portfolio to weather upcoming (or ongoing) economic turmoil. The process also provides a baseline for prudent business planning. There are four primary factors we like to start with when doing a stress test on a real estate portfolio.
- Tenant Risk Assessment
- Timing of Cash Flows
- Asset Valuation
- Liquidity Risks & Debt Covenants
Tenant Risk Assessment
Initially, the biggest concern of any investor when stress testing real estate portfolios is whether or not the property will continue to generate income as expected. A key piece of this analysis is a tenant risk assessment. While this is generally reserved for leased assets like retail, office or industrial properties, it can also be valuable for multifamily assets. A good first step is to review individual tenants alongside property managers to get a tenant-by-tenant assessment of credit quality and past payment history. It is also important to subjectively review individual tenant relationships. Do they communicate openly and often? Are they maintaining the interior of their unit or space at a high-level and notifying the property manager quickly when there are problems? At times of stress, often the intangibles involved force a dramatic shift in the way landlords and tenants interact and these seemingly non-financial factors can make big financial differences.
For larger portfolios, it may be difficult to get this tenant-level granularity, so asset managers often use broad industry measures to assess risk. We often see stress tests that involve categorizing tenants by industry (for leased assets) or credit/income levels (for multifamily) and model scenarios that involve rent reductions at different levels for each group. In most recessionary times, there will be spending pullbacks by consumers which can be concentrated in different areas depending on the industries hardest hit. Projecting how these pullbacks will flow through to the tenants in those industries is a prudent and recommended step in the real estate portfolio stress testing process. (Example: What if all my travel agencies and nail salons go dark?)
Macroeconomic factors are also worth building into scenario models as they can affect the entire portfolio. Testing a wholesale pullback on the entire portfolio helps owners understand where the pain points may begin.
In any portfolio there will be tenants that were signed at peak periods who will be contracted at “stretch rent”. Stretch rent is an amount that is viable and collectible, but a tenant may have initial difficulty paying because they are paying out of startup capital, lack existing foot traffic, or are starting a new and unproven endeavor. Investors should discount the rent from these tenants anticipating they will either need to be replaced or have their rent reduced to maintain occupancy or ensure some reasonable level of cash flows. We see this often in new construction strip centers that are outparcels to larger anchors like Walmart or Publix for example.
Cascading vacancies are primarily a factor in retail properties and can be brought on by co-tenancy clauses in individual leases. If anchor tenants go dark or vacate premises in a shopping center, this can trigger other tenants to follow-suit by exercising co-tenancy clauses. This cascades into further problems as occupancy drops, since many leases also include generalized occupancy provisions that are not linked to a specific tenant. It is vitally important to perform detailed lease abstraction of all tenant agreements during times of extreme stress to understand exactly how far reaching this effect can be.
Liquidity & Timing of Cash Flows
Real estate assets require regular capital expenditures to maintain appearance, quality and value. Owners typically plan these investments to take place at times when income is high and other expenses are low. It is also common to stagger them so many uses of cash don’t take place all at once. Stress testing cash flows involves evaluating possible cash needs that may no longer have cash inflows to offset. As such, other plans may be required for funding these improvements or they just might need to be delayed. Having a strong budgetary process that ensures there is minimal deferred maintenance is important as well, as that gives owners more flexibility to delay these large cash uses when necessary. It is also important to maintain or expand capital reserves and lines of credit to cover any unexpected uses of cash until some level of clarity returns.
Not all uses of cash and capital are discretionary. In some cases tenant renewal is contingent upon the landlord refreshing the space and investing significant tenant improvement dollars. This is an additional stress since a tenant’s continued income stream may rely on the landlord’s ability to execute on these contractual obligations.
Ideally, long before the crisis occurs, owners should be aware of all options available including unsecured credit lines, mezzanine financing, equity capital, etc. It is important that owners are in constant contact with funding sources so when disruptions occur, they can act quickly without having to go down an extended path of introductions and approvals. However, if these plans have not been put in place in advance, owners should move quickly to ensure liquidity is available.
Asset valuation is a crucial consideration for many reasons. First and foremost, if there are any upcoming loan repayments or refinancing events, valuation will be a key component of successfully completing those transactions. Having defensible, well thought-out financial projections demonstrating prudent consideration of a wide variety of potential future events will go a long way in convincing lenders and appraisers that property values can be preserved at some level.
At acquisition, it is common for forward-looking projections to be quite rosy, with cap rate compression and extended periods of strong rent growth. Real estate portfolio stress testing should question these assumptions and re-forecast cash flows based on updated projections with moderated expectations. Asset managers generally do this quarterly as a rule anyways, but at times of severe market disruption it is crucial to use judgment and insight to evaluate possible outcomes and prepare business plans for each.
Keep in mind that in many of these cases, comparable sales will be difficult or impossible to obtain and in many cases it will be simply impossible to value properties reliably enough to serve as loan collateral. In these cases, owners will often find themselves in direct negotiation with existing lenders to extend loan terms, reduce payments, or take other workout actions.
Another key area of real estate portfolio stress testing is evaluating debt covenants and how they may be affected throughout the different scenarios. Debt covenants can be extremely complex and we always recommend detailed loan abstractions for the entire portfolio.
Debt service coverage ratio, debt yield, rollover reserves, cross-default, and springing recourse are just a few examples of quantitative and qualitative tests and events that occur during down cycles. A stress test should include evaluating the major lender ratios and run sensitivity analysis to identify primary risk areas.
Borrowers should have full understanding on how to navigate the servicing environment especially for any properties where their loans are part of a securitization such as Fannie Mae, Freddie Mac, or Commercial Mortgage Backed Securities (CMBS). Knowing the various servicing agents involved (master servicer, special servicer, sub-servicer) and having counsel review the pooling and servicing agreement are important efforts to undertake.
Pulling it all Together
While each of the above areas can be taken in isolation, real estate portfolio stress testing gets complex quickly as these factors are combined into a single analysis. However, it is only when all the various factors are viewed through this lens that stakeholders can properly evaluate potential opportunities.
Oftentimes individual levers may create nightmare scenarios that can be offset by active management in other areas. During times of crisis and drastic uncertainty, real estate portfolio stress testing is a crucial activity that is thrust upon owners, investors and lenders. Failing to fully appreciate risks and opportunities is almost certain to create blind spots that may otherwise be easily avoided.
Be Prepared & Look for Opportunities
Understanding the field of possible outcomes is the ultimate goal of real estate portfolio stress testing. The process gives you the ability to assess any existing issues or concerns throughout the portfolio, as well as predict and prevent future potential problems before they happen. Communicating the outcome of this process to relevant stakeholders is also crucial, as all these questions are almost certainly on the mind of everyone involved; the general partner, limited partners, investors, lenders, etc.
When severe market disruptions take place, having a firm understanding of downside risks is key to being able to take advantage of any opportunities that may arise. Those who have the ability to move quickly and confidently in the face of mass hysteria can make fortunes in times of mass hysteria. Knowing how to do so within the limits of your existing portfolio is the key to taking advantage of price dislocations, reduced borrowing costs, and other rare opportunities.