Credit Refresher for Commercial Lenders and Credit Analysts: A Simple Stress Test

By Rex Beach

Is it fair to say that the U.S. economy has slowed significantly, perhaps to the point where it may have slipped into recession?

And is it fair to say that a growing number of economists and economic forecasts anticipate a significant decrease in commercial real estate values in 2008?

Further, is it fair to say that net operating income (NOI) – the primary source of repayment for an income producing property – becomes even more critical in the face of declining property values?

In addition, is it fair to say that a stagnant or declining economy usually results in decreasing occupancy levels and rental rates that erode NOI and the primary source of debt service?

Therefore, is it fair to conclude that we should stress test NOI for income producing properties in attempting to assess their ability to service interest-bearing debt in an economic downturn?

The answers are yes, yes, yes, yes, and yes.

An Array of Culprits
By all accounts, the economy is indeed in trouble.

• Gross domestic product was flat in the 4th quarter of 2007 and is widely expected to decrease in the 1st quarter of 2008;
• Unemployment and unemployment claims are up;
• Household debt now approximates 130% of disposable income;
• In many major markets, the average price of residential property fell more than 15% in 2007 although the national average was a 5.3% decrease;
• Mortgage debt now exceeds residential property values for approximately 10 million homeowners;
• Residential foreclosures are running 200,000 a month.
• Moody’s Investors Service estimates a 15% to 20% drop in commercial real estate values by the end of 2009 – one of the next big bubbles to burst.

Next Steps in Tough Times
Against this economic backdrop, let’s examine our options and possible actions by reference to River Heights , an office building in the greater Wilmington area. Exhibit I provides stabilized NOI from the June 2007 appraisal report used in arriving at an estimate of market value under the income capitalization approach.

The appraiser applied a 9.25% cap rate to stabilized NOI of $154,438 in arriving at a $1,669,600 estimate of market value, i.e., ($154,438) / (0.0925) = $1,669,600.

If we use a maximum loan-to-value underwriting standard of 75%, we would provide no more than $1,252,200 in term debt to finance the property’s acquisition. At an interest rate of 8.50% in June 2007 with a 25-year amortization schedule, debt service would be $121,000 (using a debt service constant of 0.09663). That translates to a very healthy 1.28 debt service coverage. All is well.

A Simple Stress Test
To estimate how much adverse market pressure River Heights could withstand, we could conduct various stress tests. 

• We could calculate how much interest rates could increase before debt service just matched stabilized NOI of $154,438;
• We could calculate how much the average stabilized rental rate of $1.92 per square foot could fall before NOI decreased to the debt service amount of $121,000; or
• We could calculate how much the stabilized vacancy rate of 5.0% could increase before NOI decreased to the debt service amount of $121,000.

Let’s focus only on the latter break-even calculation, since occupancy levels are every landlord’s primary concern. We can do so using the following equations:

At an average rental rate of $1.92 per square foot, the vacancy rate could increase from 5.0% to 19.1% and the property’s NOI would be just sufficient to cover $121,000 of debt service – a nice cushion against adverse events.

From “What If” to What Is
Now let’s examine excerpts from the rent rolls for River Heights in Exhibit II below. Note that two units are vacant as of the acquisition date, which reveals that the property had a 14.6% vacancy rate. Further, its effective gross income was $194,834, i.e., ($16,236.14) x (12). Using stabilized operating expenses in the absence of actual expense information, the property’s NOI was $123,213 – only marginally above the debt service of $121,000.

Given actual values, our break-even estimates change from 19.1% to 15.5% - rather disturbing in view of an existing 14.6% vacancy rate going into the deal.

Note, too, that the lease for Unit 2001 expires at the end of October 2007. It the tenant fails to renew and the two vacant units remain vacant, River Heights ’ actual vacancy level would exceed its break-even level and the property’s NOI would fail to service its interest-bearing debt.

Market Value versus NOI
Keep in mind that the sole objective of an appraisal report is to establish a reasonable estimate of market value. Of the three standard approaches to valuation, only the income capitalization approach routinely identifies the property’s NOI – the cash flow available to service interest-bearing debt – in arriving at an estimate of market value. 

Yet NOI identified in the income capitalization approach is stabilized NOI, i.e., NOI if and when vacancy rates, rental rates, and operating expenses approach stabilized values at some future point of market equilibrium. Actual NOI may be very different from stabilized NOI.

Observations and Conclusions

• In the final analysis, it is actual NOI – property cash flow – that services debt, not property market value.
• Any estimate of a property’s ability to withstand adverse market events should begin with actual operating information, not with stabilized or “what if” estimates.
• Request the rent rolls on a continuous and routine basis. They represent what is, not what might be.
• Review the current rent rolls to assess likely tenant run-off that could drop NOI below the debt service obligation.

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