Your investment portfolio may be performing well in the current market, but what would happen if we entered a recession? A real estate portfolio stress test is the process of assessing your investment portfolio's ability to handle significant changes, which could include loss of income, reduction in value, increase in vacancy, or a combination of these.
Large investment firms, real estate investment trusts (REITs), crowdfunding platforms, and even banks regularly undergo real estate portfolio stress tests, but it's far less of a common practice for smaller-scale real estate investors. However, the current economic climate has a lot of real estate investors questioning the strength of their current portfolio and how it will handle the changes we're seeing in the marketplace.
What is a portfolio stress test?
A portfolio stress test is a tool used to help manage the risk of a real estate portfolio by examining the impact of multiple negative changes in the marketplace. The test analyzes how the portfolio would fare given a significant increase in vacancy, loss in revenue, decrease in real estate value, and reduction in capital levels.
This analysis will identify areas of weakness and risk, such as lack of capital reserves, inability to service debt, or negative loan to value. The findings allow the portfolio managers or property owners to adjust their holdings to reduce risk. A stress test can be done on a single investment property at a transactional level or on the portfolio as a whole.
How to conduct a real estate portfolio stress test
If you're a small-scale investor -- someone who only owns a few real estate investments -- you can conduct your own real estate portfolio stress test by running various scenarios into your current portfolio management software or in Excel. This is a time-intensive way to test your portfolio, but with some Excel knowledge, you can determine the vulnerabilities of your current holdings by creating various scenarios, such as:
- Doubling your current vacancy rate
- Reducing real estate values by 10%–20% or more depending on your market
- Increasing the number of delinquent accounts by 10%–20%
This information will tell you if you're still able to maintain your debt service and how long your capital reserves would be able to sustain you.
If you have a larger real estate portfolio or would prefer the help and advice of a professional, there are services like Hidden Levers and Black Rock that help analyze your portfolio by performing their own stress tests.
No matter what path you choose, a real estate portfolio stress test should be a regular part of your investing business no matter how big or small of an investor you are. Recessions and shifts in the market are inevitable. Those who are aware of their weaknesses and vulnerabilities have a higher chance of weathering the storm than those who are unaware and unprepared.