With all the chatter about the real estate market crashing soon, I’ve been looking at my current holdings and putting them through a “stress test” to see what would happen if, for example:
Interest rates on everything went up by 2%
Monthly rents suddenly plummeted by 20%
Housing values go down by 30%
It starts taking 2-3 times longer to sell properties or find tenants
Obviously, even one of these occurrences may be unlikely, but it’s not a bad exercise to think through.
If for no other reason, it could help make you aware of how much margin you have (or ought to have) in your business. If you’re over-leveraged or pushing your financial position beyond the point of safety, this might be a good time to implement a game plan for shoring up your financial position if things do fall apart in the not-too-distant future.
@mattpayne I know banks used to do this on the regular back in the last recession, because so many of them were on the brink of collapse. I can see the value in this kind of exercise.
How did you come up with those numbers, though? What makes you think interest rates are going up by 2% (not 1%? not 5%? not 10%?)? And a similar question for the other bullet points you have there.
I’m not saying those numbers are unreasonable, but even so, it would be helpful to know your line of thinking.
Not a bad idea. I actually put all of my rental properties through this kind of stress test before I bought them in the first place.
I’ll start by plugging in the numbers in the most realistic way I think they will work, and then I’ll apply multiple combinations of these things - not just hiking up interest rates, but also lowering monthly rents, and maybe adding some other negative impact (like property taxes going up, or property insurance costing more than I anticipated, etc).
If the pro forma still shows positive cash flow after the situation gets a lot worse, it’s a good way to make sure you get a property that performs better than expected (because in most cases, it won’t actually get that bad - and if it does, you’ve already accounted for it).
I think it depends on the products you are dealing and whether or not this is a side hustle or a primary source of income.
As for me and “how screwed”: I’ve been in the business since 2014. I only do land (I’ve actually - unknowingly - bought a couple parcels with house on them); don’t borrow to fund my deals - use my own funds or have money partners that know the business and share the risk - no interest rates involved; when sell on term get a substantial down payment that covers most or all of my basis in the property and finance at interest rates well market - so I could sell a note if need be; I still work my day job - when I give it up it will be because I’ve retired and am comfortable with the $ & lifestyle that would provide without the RE income - if need be.
But, I completely agree with both stress testing the markets / product types and one’s business model for a range of possible economic situations. Great thought provoking post.
@donyost _ I don’t think it is as important as to whether or not one thinks rates would go up by a specific amount, or rent down by a specific %, etc. as it is to consider a range of options or scenarios that may (currently) “seem way out there” so one can contemplate the What If’s and how to be prepared (or consider if you need to). As Matt suggest, it might compel one to have a large emergency fund, not quit one’s day job and go REI fulltime, or keep one’s saw sharpened so if one need to revert back to doing carpentry as a day day - they could. etc.