Rising interest rates tend to steal the spotlight when it comes to stress testing your asset. This is understandable, since they will go up, although nobody can agree on how much or when. Preparing for this day makes sense, because, ultimately, it is coming.
Other potential stresses like vacancy, rent levels and cap rates round out the discussion and I’ll examine all of them here.
The asset we are going to stress test is a 17,100-square-foot neighbourhood retail plaza in Calgary. I’ve constructed the fictitious underwriting using the average figures for the Calgary market as defined in two reports from Colliers International: the National Retail Report Canada (Spring 2014) and the Cap Rate Report (Q1 2014).
Three alternate realities
I’ve created three alternate realities for this property. The first is a low-leverage debt structure of 60% loan-to-value (LTV). The mid-level is 75% LTV which would be a very common first mortgage in today’s market.
The third is a highly leveraged property that includes a first mortgage at 75% LTV and a second mortgage at 9.00% interest that raises the total debt to 85% LTV.
I’ve delineated two critical benchmarks to measure the stress applied to our three scenarios. The first is when the debt service coverage ratio (DSCR) reaches 1.00; when the total net operating income (NOI) is equal to the payments due to cover all mortgage debt obligations in a one year period. Investors will know this point as the end of positive cash flow for the property.
Other disaster point
The other disaster point is when the investor’s entire equity position has been wiped out. There are other benchmarks of poor asset performance such as an internal rate of return (IRR) that is 0%, angry investors with pitchforks and the bank seizing your yacht, but I will leave those for another day.
Our highly leveraged option reaches the DSCR threshold of no cash flow when vacancy goes from 2.50% to 13.50%. The mid-range leverage requires a 25% vacancy rate before reaching a DSCR of 1.00. The low leverage option would have to to reach a vacancy level of 35% before the monthly cheques stopped showing up.
It’s hard to imagine a double digit vacancy rate in a market that is currently at 2.50% but nothing lasts forever.
What if there was a drop in net rent? How much could your property withstand? In our example, the high leverage property loses cash flow with a 15% drop in net rent. The medium property can handle a drop of 31% in net rent before reaching the threshold.
The low-leverage option would have to experience a catastrophic 44% decrease in net rent before it stopped producing positive cash flow.
Now for my favourite topic, rising interest rates! The high-leverage property reached zero cash flow at a modest increase of 1.60%. The medium-leverage structure hit the DSCR wall with an increase of 3.90%. The most cautious debt level can withstand a 6.70% increase in interest rates. Given that many analysts are predicting an increase of 1.00%-2.00% over a two year time horizon, I would see reasons for concern with a highly leveraged property.
Cap rates a hot topic
Cap rates are the second hottest topic in most real estate circles right now. As they are predicted to rise when interest rates finally go up, you can expect some movement in the next one to two years. Not my prediction, but seems believable.
In our high-leverage model, an increase from a 6.50% cap rate to 7.75% wiped out all of the equity. Our medium level required cap rates to jump to 8.78% before owners would start having heart palpitations. The lowest-leverage option still has equity up until a cap rate of 10.98%.
In a major market shift, you wouldn’t see movement in just one of these metrics. Rising interest rates will increase cap rates. Increasing vacancy will decrease net rents. Rising rents means a strong economy and in turn will be a likely trigger event for interest rates to go up which in turn would raise cap rates.
The list of cause-and-effect combinations is quite long. The examples I’ve prepared above are a simple analysis of a complex reality.
Adam Powadiuk is a Business Development Manager with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at firstname.lastname@example.org.