Stress Testing Income Property – Commercial Underwriting

One of the shortcomings that I have noticed in small community bank’s credit underwriting has been the lack of analysis depth on loan requests to finance income producing property.

Regulators expect bank lenders to do a good job assessing the income from the underlying property, to adequately service the debt. In most small banks, this is accomplished crudely by performing a quick debt service coverage calculation based on the current occupancy and operating expenses. The analysis of the primary source of repayment is limited to a table such as the one below, and a paragraph indicating that the ratio is good enough to repay the proposed debt.

Potential Gross Income

576,000

100.0%

  Less: Vacancy & Loss

47,808

8.3%

Effective Gross Income

528,192

91.7%

Real Estate Taxes

109,000

Insurance

44,852

8.5%

General & Administrative

25,000

4.7%

Repairs & Maintenance

30,960

5.9%

Janitorial

5,500

1.0%

Utilities

46,200

8.7%

Management Fee

29,214

5.5%

Replacement Reserves

21,000

4.0%

Other

5,000

0.9%

Total Operating Expenses

316,726

60.0%

Net Operating Income

211,466

40.0%

Proposed Debt Service

142,524

Net Profit After Debt Service

68,942

 
 
DSCR

1.48X

The problem with limiting the analysis to the current rent roll and operating expenses is that those two items do not give us the whole story.  Let’s take the above example and dig deeper into it by creating downside scenarios.

When creating stress or downside scenarios, we want to look at the possible variables whose change can adversely affect our primary source of repayment. For income producing properties, the lender normally only has to worry about three important variables.

Vacancy Rate Downside.

A low occupancy rate is usually the #1 reason for inadequate cash flow in income producing loans. In the table above, we noted that the current vacancy exhibited by the property the bank is looking to finance is 8.3%. We know that the building has 60 apartment units and that 5 of those units are vacant. We also know from the appraisal that vacancy rates for similar buildings in the area is closer to 12%.

A well designed vacancy stress test would determine how high the vacancy rate can go with no other changes, and still have enough cash flow to repay the proposed loan. The result will look similar to this:

Potential Gross Income

576,000

100.0%

  Less: Vacancy & Loss

116,750

20.3%

Effective Gross Income

459,250

79.7%

Total Operating Expenses

316,726

69.0%

Net Operating Income

142,524

31.0%

Debt Service

142,524

Net Profit After Debt Service

(0)

 
DSCR

1.00X

After doing the calculation, we have found out that vacancies can go up to 20.3% under the current cost structure, and the building will still be able to service the debt on a one-to-one basis. This would be cited as a strength of the loan in the analysis since it shows that not only can the property’s occupancy match the market, but it could deteriorate even further and still cash flow.

Rental Rate Downside.

The second variable that can impact repayment is a decrease in rental rates. From time to time, property owners’ rental rates are squeezed due to competition from other buildings or a decrease in demand due to shifting demographics.

In our example, each of the apartment units is being rented at $800 a month. However, the appraisal indicates that similar units are being rented for $725 in the area. The process for preparing a downside is similar to the one we used for rental rates, the difference is that we will be leaving vacancy at 8.3% and will be doing changes solely to the rental rate per unit.

Potential Gross Income

500,400

100.0%

  Less: Vacancy & Loss

41,533

8.3%

Effective Gross Income

458,867

91.7%

Total Operating Expenses

316,726

69.0%

Net Operating Income

142,141

31.0%

Debt Service

142,524

Net Profit After Debt Service

(383)

 
DSCR

1.00X

The downside calculation for rental rate shows that our borrower could decrease the asking rent to $695 a month per unit and still produce sufficient cash flow to repay the proposed loan. Once again, this is a strength that should be noted in the loan underwriting as $695 is lower than even the average rental rate reported by the appraiser.

Interest Rate Downside.

I am not going to spend time on this particular one because most of the real estate loans that you should be doing as a bank lender should be at a fixed rate. If your bank is doing variable rate loans, the downside calculation is similar to the ones shown above. The difference of course is that you will be trying to find out how high can the interest rate get while still showing 1.00X coverage.

Conclusion:

The above downside scenarios provide valuable insight on the ability of income producing properties to repay loans while under the stress of changing variables. While the example used was one of an apartment building, the same tests could be applied to industrial or office properties by using Square Foot values instead of units.

Some related books that you can buy from Amazon.com Investing in Apartment Buildings: Create a Reliable Stream of Income and Build Long-Term Wealth

and Commercial Mortgages 101: Everything You Need to Know to Create a Winning Loan Request Package

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