Stress Testing Your Real Estate Investing Portfolio – Part I

Historically, using The World's Greatest Real Estate Deal Analysis Spreadsheet™ most people use a static rent appreciation rate and price appreciation rate.

In other words, when analyzing a deal they used 2 or 3% for rent appreciation.

Static Rent Appreciation Rate
Static Rent Appreciation Rate

And, 2 to 3% for price appreciation.

Static Price Appreciation Rate
Static Price Appreciation Rate

You could do some changes to these appreciation rates by using the rent OVERRIDE feature:

Variable Rent Appreciation Rate
Variable Rent Appreciation Rate

And, you can do a similar thing with the price OVERRIDE feature lower on the spreadsheet:

Variable Price Appreciation Rate
Variable Price Appreciation Rate

But the OVERRIDE feature… as good as it is… is limited in its ability to stress test a property and… unless you create an amalgamation of all your properties into one deal… impossible to use to stress test your entire portfolio at once.

Enter the Real Estate Financial Planner™ software.

In the past you may have heard me talk about using the  Monte Carlo feature of the software to run through dozens or hundreds of different tests and then summarizing the results into special monte carlo charts.

But, earlier this year I added a new one-click stress test button that allows you to take your existing plan and stress test your portfolio with about a dozen different market conditions. More on this in a bit.

Different Types of Portfolio Stress

There are 3 categories or types of real estate (and other investment) portfolio stress:

  1. Shocks
  2. Market Corrections
  3. Market Cycles

Shocks

These should NOT be unexpected… we know about them and that they happen and approximately how likely they are to happen.

If you’re not planning for these, you should be.

Here is a table and some select quotes from “Shocks and the Unexpected: An Important Factor in Retirement” from the Society of Actuaries®.

Shocks
Shocks

Select quotes from the report:

  • “Shocks are important and multiple shocks do occur. About one in five retirees (19%) and one in four (24%) of retired widows experienced four or more shocks during retirement. In contrast, 28% of retirees and 13% of retired widows had not yet experienced any shocks.”
  • “Difficulties tend to increase with the number of shock events. Shocks and unexpected expenses affect the majority of retirees. Families that deal well with one or two shocks may find the situation becomes increasingly difficult when faced with additional shocks.”
  • “The most common shocks reported were home repairs and dental expenses. The two most frequently mentioned financial shock and unexpected expense items are home repairs and upgrades (28%) and major dental expenses (24%).”
  • “Assets decline. More than one in three who experienced shocks had their assets reduced by 25% or more because of those shocks.”
  • “Spending reductions. More than one in 10 who experienced shocks had to reduce spending by 50% or more because of those shocks.”
  • “Long-term care, divorce and long-term help to children were the most troublesome. Retirees felt they could make adjustments and deal with unexpected expenses in a number of areas, but not with major long-term care events requiring paid long-term care, or divorce after retirement. Adult children receiving longer term support was also a major issue.”
  • “Devastating shocks were low in frequency. The survey included some shocks that could easily be devastating, including fraud, foreclosure of home and bankruptcy. All these shocks had low frequency.”
  • Parents:
    • “58% of parents had experienced illness/disability compared to 15% of respondents”
    • “4% of parents had experienced a loss of capacity as compared to 1% of respondents”
    • “23% of parents had gone on Medicaid as compared to 14% of respondents”
    • “8% of parents were reported to have experienced major home repairs/upgrades as compared to 28% of respondents”

Market Corrections

A sudden drop in prices, rents and values.

We use the  Market Correction rule for modeling these in the software.

You select which  Accounts and  Properties are impacted by the  Rule, the amount or range it declines and how frequently it randomly happens.

Then, the software will:

  • Reduce the Property Value of the selected  Properties by this random percentage, and
  • Reduce the Monthly Rent of the selected  Properties by this random percentage (that will come into effect on lease renewal), and
  • Reduce the Account Balance of the selected  Accounts by this random percentage

Market Cycles

  • M Markets – Up, then down, then up, then down… then return to what it was doing prior
  • W Markets – Down, then up, then down, then up… then return to what it was doing prior
  • V Dip – Down then up… then return to what is was doing prior
  • “Inverted V” – quick run up and give some back
  • Sawblade – perpetual dip then rise
  • Flatline – no increase in price/rents

The number of year is the time it takes to go through the entire 4 stage cycle:

  • 4 years – 1 year per stage
  • 8 years – 2 years per stage
  • 12 years – 3 years per stage
  • 20 years – 5 years per stage

M Market Cycle Examples

Here's an example of how an M Market cycle might be modeled in the Real Estate Financial Planner™ software.

First, you can see that we might model the appreciation rate to be +3% for a couple years (the first upstroke of the M), then down -3% for the next two years (the first downstroke in the M), then up 3% then back down 3%. After that, the appreciation rate returns to whatever the user had set for the property to begin with. In this case, it happens to be 3%.

M Market - Appreciation Rate
M Market – Appreciation Rate

Having the appreciation rate above it impacts the value of the property as shown in the chart below:

M Market - Property Value Change
M Market – Property Value Change

If we zoom in, we can see the M shaped pattern emerging in the property price.

M Market - Property Value Change - Zoomed In
M Market – Property Value Change – Zoomed In

Since the rent appreciation rate was similar to the price appreciation rate, you can see the impact on True Cash Flow™ below:

M Market - True Cash Flow Change - Zoomed In
M Market – True Cash Flow Change – Zoomed In

And, finally, we also set the yearly rate of return for the account to be the same as the property appreciation rate and rent appreciation rate. You can see that as well below:

M Market - Account Balance Yearly Rate of Return
M Market – Account Balance Yearly Rate of Return

Demo of One-Click Stress Testing

The rest of the class I opted to demo the new one-click stress testing button for the Real Estate Financial Planner™ software.

Assess Market Risk
Assess Market Risk

Once you click the “Assess Market Risk” button, the software creates a number of new  Scenarios for you with a variety of market conditions.

Assess Market Risk - Resulting Scenarios
Assess Market Risk – Resulting Scenarios

Click on the spot marked “2” to see a comparison of all the  Scenarios to see how they perform.

Or, click on the spot marked “3” to be able to see any  Chart for all the  Scenarios.

And, when you're done, clean up the clutter by deleting the  Scenarios created to assess market risk using the button in the spot marked “1”.

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