Market stress puts your industrial investment property under stress, which in turn puts the investor under considerable stress. Should you be worried? This article will examine the effects of increased vacancy, drops in net rent, escalating interest rates and rising cap rates.
In a previous version of the stress test, I applied these yield inhibitors to a retail plaza in Calgary. For the industrial stress test, I’ve created a fictitious property using the market averages presented from four sources.
– Colliers International – Cap Rate Report Q2 2014
– Colliers International – Toronto Industrial Market Report Q1 2014
– Colliers International – GTA Industrial Stats Q1 2014
– Toronto Real Estate Board – MLS
The geography I’ve chosen is Mississauga, as it is Canada’s largest industrial market and attracts a considerable amount of investment dollars from institutions, REITs and private players. I’ve created a three-unit, 88,000-square-foot industrial investment property that is achieving net rents of $5.47.
Three different financing structures are used to demonstrate the ability of the property to withstand pressure. The first is a highly leveraged property with a first mortgage of 75% loan-to-value ratio (LTV) with a high interest second mortgage bringing the total debt level to 85%. The second structure is the same property with just the first mortgage of 75% LTV. The third version has a conservative 60% LTV first mortgage.
There are two benchmarks we will use to measure the stress levels being applied by vacancy, net rents, interest rates and cap rates. The first is when the debt service coverage ratio (DSCR) reaches 1:1. This means that the net rent being generated is equal only to the mortgage payments and positive cash flow ceases to exist. The other metric is when the value of the property has decreased to a point in which the investor no longer has any equity.
Decreasing net rents
The first stressor we are going to apply to these three financing structures is decreasing net rents. I consider this stressor to be the least likely to impact the Mississauga market as rents there are quite low when compared to other major markets. The highly leveraged property would require a decrease of 15% before hitting a DSCR of 1:1. The 75% leveraged investment property would require net rents to drop by 31% before reaching the point of no cash flow. The lowest LTV property could withstand net rents plunging 44%.
The next negative pressure to consider is vacancy. Mississauga currently enjoys a low vacancy rate of 3.25% but the number could climb higher due to over-building or tenants leaving the area. I’ve excluded sub-lease availability from this figure as landlords will continue to receive rent while the space awaits a sub-tenant. The 85% LTV structure would stop cash flowing once vacancy rates had climbed to 12%. The medium leverage option would need that number to climb to 12.5% while the conservative borrower would need to see vacancy rates as high as 29.25%.
Rising interest rates are interesting to examine as most predictions are indicating this will be happening in 18-24 months. In a bubble, you could argue that industrial properties are in a better position to withstand interest rate increases due to the higher cap rates as compared to other asset classes.
The highest leveraged property would need to see interest rates move 165 basis points (bps) higher on its first and second mortgage before it hit a DSCR of 1. The medium property could handle considerably more at 391 bps. The lowest leverage property would need a market meltdown that saw a 676 bps rise in interest rates.
Preservation of capital is always a consideration and no investor wants to see his equity reduced. She especially doesn’t want to see it wiped out entirely. Rising cap rates can have this effect and it’s amplified through increased leverage. Our 85% LTV example would see this with an increase in cap rates of 115 bps.
The medium leverage property would see this at an increase of 215 bps. The most cautious borrower would need to see cap rates move upwards by 435 bps.
No variables move in a vacuum
As I said in my last article, none of these market variables will move in a vacuum. They each have influence on the other and should be considered as a whole.
As an example, the highly leveraged option would lose cash flow with a combination of a nine pr cent decrease in net rents and vacancy increasing to seven per cent. Obviously, most of the figures presented here are considerable market changes but that is exactly what a stress test is designed to gauge.
The upside to leverage is that it significantly enhances investment yield when market conditions move in positive directions. This makes finding the right balance of risk appetite, leverage and timing the market a little tricky. If commercial real estate was easy, everybody would do it.
Adam Powadiuk is a Business Development Manager with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at firstname.lastname@example.org.