Stress-test your investment, before you get stressed out of your investment.
Before acquiring a commercial investment property, you will want to run different scenarios to understand if it will hold up during downcycles or a loss of tenants. We tend to run a variety of stresses on a property to ensure the "juice is worth the squeeze." We will run best-, average- and worst-case scenarios and then try to understand if the return on investment is worth the inherent risks. Let's look at how this is accomplished.
To begin the calculation, we will need to know three things: annual debt service, the annual operating expenses, and the potential rental income. You will add your total debt service with your operating expenses and then divide by your income. It looks like this:
The idea is to understand what absolutely has to be paid out (debt + opex) compared to what could potentially be coming in. How low can we go before these two are equal? Here's how it looks with some numbers attached:
Let's say we have the following:
ADS = $700,000
Opex = $850,000
PRI = $1,800,000
In this scenario we now know that we need to maintain a minimum occupancy % of roughly 86% to be cashflow neutral, meaning we can cover our cash outputs. Or to be said another way, our property can handle a 14% vacancy rate before we start getting into trouble.
Now that we have the minimum occupancy/vacancy numbers, we can start to do some market research on the submarket. We look for inflection points in the historical data to determine if we see vacancy numbers in the market ever reach these levels, and if so, how deeply. What is the long-term occupancy for this asset type in this market historically? If the market routinely hits 14% vacancy, then you could have some real troubles ahead. Either increase your equity to reduce your annual debt service, or look for another investment. The risks end up becoming too great.
Occupancy, or vacancy, can plague any commercial property so it's important to get a clear picture on what the property can handle and how it compares to the long-term occupancy rates of the market.