Every deal I've ever underwritten looked great at today's numbers. And today's numbers have never once lasted.
That's why the first thing I do with any deal isn't admire the base case. It's break the base case. I take the model that says this is a wonderful investment and I run it through the scenarios that say it isn't, on purpose, before anyone else's money is involved.
The agencies already do this to you. When Fannie and Freddie size a variable-rate loan, they don't use today's index rate — they underwrite to a stressed rate, a higher number built from a stressed version of the index plus the margin. They size your loan as if rates are already worse than they are. So I just do their job before they do it to me.
My stress test has three scenarios, and I run all three on every deal. The base case is what the broker sent me — current rents, current expenses, today's rate. The stressed case is the one that matters: rates up 200 basis points, vacancy up to 8 or 9 percent, expenses up 10 percent across the board. Insurance, taxes, payroll — everything costs more than you think, so I make the model admit it upfront.
Then there's the third scenario, the one nobody likes to run. I call it the everything-breaks case: the refi comes due in a higher rate environment, rents stall for two years, and a boiler dies in February. If the deal still covers debt service in that world — not comfortably, just honestly — it's a real deal.
Here's what most people get wrong about this exercise. They think the stress test is there to kill deals. It's not. It's there to tell you the price. If the stressed case only works at a purchase price 8 percent lower, then the stressed case just handed you your offer number. The stress test doesn't say no. It says how much.
I pay special attention to the refi test, because that's where deals actually die. I assume the exit rate will be higher than today's rate — not dramatically, just higher. If the debt service coverage still holds at 1.20x or better in that world, I can sleep. If it only works because I'm assuming I'll refinance into a friendlier market, I'm not underwriting. I'm hoping.
The expense stress deserves its own mention because expenses are the line everyone under-models. Rent you can verify — there are leases. Expenses are estimates, and estimates are optimistic by nature. When I push expenses up 10 percent and the deal still pencils, I know the deal has margin. Margin is what keeps you out of trouble when the surprise shows up, and the surprise always shows up.
The deals you kill in the model are the cheapest losses you'll ever take. They cost you an afternoon and some pride. The deals you don't stress test cost you real money, years later, when the market runs the scenarios you skipped. I'd rather lose a deal on paper than own a problem in real life.
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