Every set of projections for an apartment building is built on assumptions: rents grow at a certain pace, vacancy stays in a certain range, expenses rise by a certain amount, and the building can be refinanced or sold at a certain cap rate. A stress test asks what happens when some of those assumptions turn out worse. It does not predict the future; it shows how much room the deal has before it stops working.
Four assumptions worth stressing
| Assumption | A reasonable stress | What it tests |
|---|---|---|
| Interest rate | One to two points higher at refinance, or on a floating loan | Whether cash flow and DSCR survive a higher payment |
| Rent growth | Lower than planned, or flat for a period | Whether the deal depends on rising rents |
| Vacancy and bad debt | Several points above the base case | Resilience to a soft market or problem tenants |
| Operating expenses | Faster growth in taxes, insurance and repairs | Whether margins are thin |
| Exit cap rate | Higher than the purchase cap rate | How much a future sale price could fall |
Start with a base case you believe
A stress test is only useful if the base case is honest. That means NOI rebuilt as the next owner, as in Net Operating Income: The Number Every Apartment Deal Starts With, rent growth that fits Washington’s limits on increases for existing tenants, and a capital plan based on an inspection. If the base case already assumes optimistic rents and a thin expense budget, stressing it will only tell you how optimistic the optimism is.
Change one thing at a time, then several
Run each stress on its own first, so you can see which assumption the deal is most sensitive to. Then combine a few, because bad things tend to arrive together: a softer rental market often brings more vacancy and slower rent growth at the same time as higher costs.
An example with made-up numbers
A buyer’s base case shows a building with an NOI of $170,000 in year one, growing to about $190,000 by year five. The plan is to refinance in year five at a loan sized on a 1.25 DSCR. In the base case, the new loan pays off the original one with room to spare.
In a stress case, rent growth is lower, vacancy is two points higher and insurance rises faster, so year-five NOI is about $172,000 instead of $190,000. At the same time, the refinance rate is a point higher than planned. The refinance now supports a much smaller loan, and the buyer would need to bring cash to pay off the original loan. The deal does not fail in normal operation, but the refinance plan does. That is exactly the kind of result a stress test is for: it tells the buyer to choose a longer fixed-rate term or a lower initial loan.
The exit
If your projection includes a sale, test it at a higher cap rate than the one you bought at. A small change in the exit cap rate changes the sale price a great deal. Remember selling costs too: broker fees, closing costs and Washington’s real estate excise tax, which the Department of Revenue says is usually paid by the seller.
A step-by-step routine
- Build the base case with your own NOI, loan terms and capital plan.
- Stress each major assumption on its own and note the effect on cash flow, DSCR and cash-on-cash return.
- Combine the two or three most damaging stresses into one downside case.
- Check whether the deal still covers its loan and reserves in the downside case.
- Decide what would change your plan: a lower price, a smaller loan, a longer fixed rate or a larger reserve.
Tip: Write down the break-even points: the vacancy rate, interest rate or expense level at which cash flow reaches zero. They are easier to discuss with partners and lenders than a page of scenarios.
Reading the results
A stress test rarely gives a simple yes or no. More often it shows a deal that works in the base case, works with less comfort in a moderate downside and needs changes in a severe one. The useful question is whether you could live with the downside: could you cover a shortfall from reserves or other funds for a year or two, and would you still want to own the building? If the answer depends on everything going right, the price or the financing probably needs to change.
The calculator on our home page is a quick way to try different inputs. For the financing side, see DSCR: How Lenders Size an Apartment Loan; for the rules that limit rent growth, see Washington’s Rent Increase Limit and What It Means for Your Projections.