Many people get excited or impressed by stress tests and sensitivity analyses. Sponsors think they make them look smart and investors often are comforted by a range of outcomes which they can live with. However, most of these stress tests are just for show and carry less weight than others. However, the two stress tests which we heavily focus on that actually have an impact are the exit test and the breakeven occupancy test.
The exit test is most useful for shorter term investments focused on value creation, especially if they are financed with a bridge loan. The exit test is performed by forecasting NOI upon maturity of the going-in financing and perform various valuation calculations in order to see if the property projects to be able to support a new loan to refinance the maturing going-in debt. A refinance, rather than a sale, is the focus of this test since refinances are more liquid than sales and a failure of this test implies the need to either sell the property upon maturity of the going-in loan or bring new equity to the deal to perform a “cash-in” refinance. Neither are ideal, especially being forced to sell when it may not be opportune.
Another reason why the exit test is the most important analysis to focus on for an investment financed with a bridge loan is because bridge loans are a high leverage product which finances based on projected cash flows, not in-place. This high going-in leverage necessitates the creation of those projected cash flows through the implementation of a value-add business plan in order to increase the value of the property and justify a refinancing of the bridge loan with permanent financing, which is always based on in-place cash flows, not projections.
For example, let’s say we have a $9MM property with an anticipated renovation budget of $1MM. A bridge loan will finance the property at 80% loan-to-cost, resulting in a loan of $8MM (80% of $10MM). Let’s assume that permanent financing can only be obtained at 75% loan-to-value. This means that in order to accomplish a cash-neutral refinance to pay off the bridge loan, the business plan will need to increase the value of the property from $9MM to $10.67MM. This calculation does not include closing costs for the refinance transaction. Value isn’t the only thing that matters for achieving the refinance, there must also be higher NOI to support the new loan on a debt service coverage ratio (DSCR) basis.
This analysis essentially describes loan maturity risk. The shorter the loan term, the greater the maturity risk since you’re forcing value creation into a shorter period of time. Think about a 10-year loan for example. Maturity risk is low since you have 10 years for your business plan, management, and organic growth to create value. However, for more opportunistic value-add opportunities, where we underwrite assuming a bridge loan, maturity risk is high and therefore the exit test becomes essential. Because of our rigorous exit test, we pass on many deals that look interesting but overall have a poor risk-adjusted return. Ensuring risk mitigation naturally takes care of return projections. Said differently, if you protect the downside, the upside will take care of itself.
For longer-term, cash flow focused deals, the test we focus on is the breakeven occupancy test. Performing this test tells you the minimum occupancy required to pay all operating expenses and debt service and is a great indication of the ability of a cash flowing investment to survive through difficult times. If you plan on holding a property for 5+ years, there is a decent chance that the investment will run into challenges operationally or cyclically due to a recession or supply and demand changes.
The lower the breakeven occupancy is, the better the downside protection is, which should provide investors a lot of comfort. Reserves could be further factored into this analysis to determine how much cash is available in case occupancy dips below the breakeven threshold. One of my favorite Howard Marks quotes is, “Never forget the sixfoot tall man who drowned crossing the lake that’s five feet tall on average”. The average depth of the lake may only be five feet, but there may have been portions of the lake that were six feet, seven feet, or even eight feet, and the six-foot tall man crossing through didn’t make it. So, we don’t survive on averages. We need to make sure that during the lean times we can get through them, and that’s the breakeven occupancy test.
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About Lone Star Capital
Lone Star Capital is a real estate investment firm focused on underperforming multifamily properties in Texas and surrounding states. Lone Star creates core-plus and value-add opportunities that deliver superior risk-adjusted returns by implementing moderate to extensive renovations, improving management, and designing creative capital solutions. Lone Star owns over 1,500 units worth nearly $100M. Click through to view our company presentation here.
About the Author
Robert Beardsley oversees acquisitions and capital markets for the firm and has acquired over $100M of multifamily real estate. He has evaluated thousands of opportunities using proprietary underwriting models and published the number one book on multifamily underwriting, The Definitive Guide to Underwriting Multifamily Acquisitions. He has written over 50 articles about underwriting, deal structures, and capital markets and hosts the Capital Spotlight podcast, which is focused on interviewing institutional investors. Robert also helps run Greenoaks Capital, his family’s real estate investment and advisory firm. Robert grew up in Silicon Valley and currently lives in New York City, where he enjoys reading nonfiction, traveling, working out, meditating, playing golf and piano.