Stress Testing Your Real Estate Portfolio to Maintain Liquidity
As a real estate investor, stress testing your real estate portfolio to maintain liquidity is necessary to evaluate how your portfolio would fare under adverse or difficult conditions. This test assesses a real estate investor’s portfolio (real estate investments) by subjecting it to various hypothetical situations or scenarios, which would determine how it can withstand inflation, market changes, and others.
A real estate portfolio includes a collection of real estate investment assets. Real estate investors sell or rent out these assets to bring positive cash flow or serve as an extra source of income. Building a real estate portfolio is a solid investment for long-term gain.
Maintaining liquidity in real estate investment refers to how fast and easily real estate properties can be sold without significantly affecting their market value.
Due to higher interest rates and inflation impacting real estate portfolios, commercial debt rates could change from a 4% rate to a 7.8%+ rate. Some investors utilizing HELOCs (home equity lines of credit) could default on their payments due to negative cash flow positions during an economic decline, market changes, and other important factors. The economy in addition to the real estate market goes up and down, which could significantly affect real estate investors if they do not maintain the correct liquidity within their real estate portfolio.
Why You Should Stress Test Your Real Estate Portfolio
Knowing the risks involved in real estate investment requires stress testing your real estate portfolio to assess how it can fare in challenging situations. Stress testing your real estate portfolio to maintain liquidity involves adjusting key variables to see how they would affect a property’s cash flow (whether positive or negative cash flow).
Importance of Stress Testing
- Allows you to Manage Risk
- The insights from stress testing can provide knowledge on how your portfolio can withstand risk. It also enables you to adjust your portfolio to reduce risk.
- Identify Vulnerabilities
- By stress testing, investors can determine potential weaknesses in their portfolio, such as delayed capital expenditures, high vacancy rates, high tax-assessed areas, high insurance premium areas, and floating rates to mention a few.
- Determines Liquidity Needs in Advance
- Understanding how your portfolio reacts under adverse situations would help you determine the liquidity levels required to withstand real-life stressful conditions.
Steps to Conduct Stress Testing
- Identify and Define Stress Scenarios
- Identify and define potential stress hypothetical situations for your real estate investments.
- You could test the following:
- Increased interest rates
- Economic recessions
- High vacancy rates
- Late payers – 60, 90 days, or more
- Unplanned capital expenditures
- Increased operating expenses (R&M – Repairs & Maintenance)
- Analyze Cash Flow
- Assess the cash flow of each property in your portfolio under stressful scenarios.
- Do you have enough liquidity for 4+ months if cash flow would go into a negative position for multiple months?
- Determine Debt Capacity
- Assess the ability of your real estate portfolio to manage debt obligations during an economic meltdown.
- The rule of thumb is always to stay above 1.20 DSCR (debt service coverage ratio).
- Evaluate Liquidity Needs
- Determine the level of liquidity needed to cover debt payments, operating expenses, and potential capital expenditures during stress scenarios.
- Review Diversification and Asset Allocation
- Evaluate the diversification of your portfolio across different locations and property types.
- Diversification improves an investor’s portfolio resilience and mitigates risks.
- You may want to liquidate certain real estate holdings if they hold a higher risk for the overall portfolio.
Vacancy Rates
Can high vacancy rates impact your portfolio? Yes..! We saw this in the last recession (2007 – 2010), leading to an increase in vacancy rates of 11%+.
A vacancy rate is used to identify all units in a rental property that are unoccupied. It is expected that during a recession, there is less access to credit and cash. This would deter potential renters from renting, while those currently renting an apartment may find it difficult to pay their rent. Different factors can cause a high vacancy rate. Maybe the property is in bad condition. Or maybe it’s due to an economic downturn that would require you to take extra measures to protect your property.
To assess if your real estate portfolio can withstand a higher vacancy rate, use this formula:
Whether you want to calculate physical vacancy rate, economy vacancy rate, or market vacancy rate, here are the formulas:
- Physical vacancy rate = Number of days property sat vacant ∕ Number of days available to rent.
- Economic vacancy rate = Lost rental income ∕ Gross potential income
- Market vacancy rate = number of vacant units × 100 ÷ total number of units
Make up any figure you have in mind to calculate the vacancy rate. Increase the numbers to give you a higher vacancy rate and assess how your portfolio can withstand it.
Now, ask yourself these questions:
- Would I still have a positive cash flow now or in the next few months despite having a high vacancy rate?
- Would the cash flow from other rental units cover the vacant units?
- Would I be losing money?
- If you realize that you won’t be making a profit based on this scenario, it’s time to plan the steps to curb this if you ever record a real-life high vacancy rate.
Calculating this figure would let you know how to protect your investment and what to do to boost your cash flow for properties with a high vacancy rate. Usually, a vacancy rate above 10% is considered very high. Above 10% means the demand to rent the property is low, leading to reduced cash flow for the real estate investor. However, in some areas, demographic or geographic factors influence the vacancy rate. For example, in certain areas, a vacancy rate of 5% is still considered high. To know if your vacancy rate is average, low, or high, research the average vacancy rate within your demographic location.
How Property Values Can Affect Your REI Portfolio
Your real estate investing (REI) portfolio can withstand market volatility based on your preparation for uncertainties. One of the best strategies to prepare for uncertainties in the real estate market is by researching the rate at which property values would drop in the local real estate market during an economic downturn. Researching would help you know the right steps to take if there is a decline in real estate market values.
We won’t expect property values to go as low as the Great Recession in late 2007 to 2009. Excessive mortgage lending to borrowers who did not qualify for a home loan was the main cause of the great recession at that period, and since then, lenders have put in stringent requirements for loan approvals. This measure has improved the real estate market and prevented a massive drop in property values compared to years ago.
What to Do After Stress Testing
- Keep Efficient Cash Reserves
- Ensure you have adequate cash reserves or lines of credit to maintain a positive cash flow during challenging times.
- Implement Risk Mitigation Strategies
- Implement risk mitigation strategies identified during stress testing, such as renovating the property, refinancing your debt, or changing lease terms.
- Reallocate Your Assets
- Depending on the outcome of the stress test, you may consider diversifying your investments into other types of assets such as stocks, cash, and bonds.
- If an asset loses liquidity, you can easily rely on others. Just like the popular saying, “Don’t put all your eggs in one basket”.
- The key is to diversify which spreads your risk over other assets.
Ways To Maintain Liquidity During A Recession
A recession can be a scary situation for investors, but when you plan well, you don’t need to panic about liquidity levels during an economic meltdown.
Have Other Streams of Income
Because real estate investment is just like any other business investment with potential risks, it would be wise to have other sources of income so that there would still be positive cash flow despite the recession. During a recession, some tenants may not be able to afford the rent again and may decide to move out. One thing you can do to bring in positive cash flow is to diversify your sources of income so that you can still make a profit even when the economy is slow. You may decide to kick-start a new business that can withstand a recession such as a niche construction business like plumbing.
Don’t Spend Unnecessarily
Avoid the urge to buy what you don’t need. Save the money and keep it for other important needs or add it to your capital reserve to fund future real estate investments. Maintain a frugal lifestyle and continue to roll cash flow into more investments.
Manage Your HELOC Efficiently
Check the HELOC interest rates as often as possible. This would help you plan how many lines of credit to borrow or whether to withdraw from it. High interest rates can also contribute to a high debt-to-income ratio if cash flow can’t cover the debt.
You could also refinance your HELOC if the current rates are no longer favorable as HELOCs adjust quickly.
Because the interest rates of a HELOC are variable, using it for short-term investment is advisable. The best time to withdraw from a home equity line of credit (HELOC) is when the interest rates are average or low. If rates are low then you can arbitrage on the lower interest % and utilize it somewhere else with a better return.
Upgrade Your Properties
It may be challenging to sell or rent out a home during a recession, but it’s still possible. During a recession, people are less likely to buy a home. You can upgrade your real estate properties to boost the chances of selling (if needed) or renting them out to tenants. You can also increase the price of the rental units or property when upgrading it. Doing the necessary repairs and installing higher-quality appliances can still attract potential renters or buyers despite the recession.
Buy More Properties and Stocks
Recession opens new opportunities for smart investment. Usually, properties are cheaper during a recession since consumers tend to spend less. Stocks are also cheaper during a recession, making it a smart time to invest. Real estate investors can purchase discounted properties or stocks to resell later at a higher price, opening an avenue for more profit.
Boost Your Property’s Equity
One of the best ways to boost equity in a property is to pay your mortgage as quickly as possible. There are different schools of thought on this point. You can pay off 10 properties which might cash flow just as well as 40. Others will keep a reasonable LTV (loan to value) percentage to utilize open capital on other projects. Another way to boost equity is keeping the properties in great condition for when we come out of the recession. You can also pull equity out by refinancing multiple properties or all of them to place the capital into capital upgrades while buying more real estate.
In Conclusion – Stress Testing Your Real Estate Portfolio to Maintain Liquidity
Stress testing your real estate portfolio to maintain liquidity is one of the best strategies for a successful real estate investment. Test your real estate portfolio by subjecting it to worse-case scenarios to understand and determine strategic measures to bring in positive cash flow.
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