Ask an investor what a downturn does to a rental and almost everyone says the same thing: rents fall. Then they stress test the deal by knocking ten percent off the rent, watch the coverage ratio hold, and conclude the property is fine.
That is the wrong stress test. It is testing for the thing that mostly does not happen, and it is not testing for the thing that does.
Residential rents are sticky downward. Landlords do not cut the asking rent, partly because it feels like a permanent concession and partly because a lower rent resets the base for every future increase. What happens instead is that the unit sits, and then somebody offers a month free to get it filled. The listed rent never moves. The money does.
The damage arrives as days, not as dollars per month
Take a 1,600 dollar unit that performs normally.
| Normal year | Downturn year | |
|---|---|---|
| Asking rent | 1,600 | 1,600 |
| Gross scheduled rent | 19,200 | 19,200 |
| Days vacant between tenancies | 21 | 55 |
| Vacancy loss | 1,120 | 2,933 |
| Concession to fill (one month free) | 0 | 1,600 |
| Actually collected | 18,080 | 14,667 |
Collected revenue falls 18.9 percent against a normal year, and 23.6 percent against the gross scheduled number your pro forma uses. The asking rent is identical in both columns. If you had stress tested by cutting rent ten percent, you would have modeled 17,280 of revenue, which is 2,613 dollars a year better than what actually happens.
The ten percent rent cut is the optimistic scenario. Nobody realizes that.
Why the concession is worse than it looks
A month free on a twelve month lease is an 8.3 percent rent cut for that year, delivered in a way that lets everyone pretend the rent is still 1,600. The listing says 1,600. The lease says 1,600. Your rent roll says 1,600. Your bank account is 1,600 dollars lighter and your renewal conversation next year starts from a number the tenant has never actually paid for twelve consecutive months.
When you underwrite a purchase in a soft market, ask specifically whether the in place leases carry concessions. A seller’s rent roll showing 1,600 across the board tells you nothing about what was collected. This is one more reason to insist on an estoppel and a ledger rather than a rent roll, which we covered in the tenant estoppel certificate.
Which expenses move, and in which direction
The second wrong assumption is that expenses soften along with revenue. Here is what actually happens to each line.
| Line item | In a downturn |
|---|---|
| Property taxes | Flat or rising |
| Insurance | Flat or rising |
| Debt service (fixed rate) | Flat |
| Utilities on vacant units | Rising |
| Turnover and make ready | Rising |
| Marketing and leasing | Rising |
| Management fee | Falling |
| Discretionary capex | Whatever you decide |
Property taxes do not fall when values do. Assessment cycles run years behind the market, and in a lot of jurisdictions the assessment that lands during a downturn is the one based on the peak. An appeal is available and it is worth filing, but it is slow. We wrote about the version of this that catches new buyers in property tax reassessment after purchase.
Insurance does not fall either. Carrier pricing tracks claims experience and reinsurance cost, neither of which cares about your local rent market, and the trend has been one direction for several years. See how rising insurance and tax costs are reshaping deals, and if your property has an aging roof, roof age and your rental loan, because a non renewal during a cash crunch is a genuinely bad sequence.
Maintenance rises, which surprises people. In a soft market the unit has to show better to lease at all. The paint you would have skipped, the appliance you would have repaired instead of replaced, the landscaping. Competition for a smaller pool of tenants is paid for in make ready.
Management is the only genuinely counter cyclical line, because it is a percentage of collected rent. On 14,667 collected instead of 18,080 at 9 percent, the fee drops from 1,627 to 1,320. You save 307 dollars. You lost 3,413. That is the entire natural hedge in the operating statement.
Capex is the only line you control, which is why it is the one everybody cuts. Deferring it is borrowing from the next cycle at a bad rate, since deferred maintenance compounds and the bill arrives when the roof forces it rather than when you choose it. That decision has its own arithmetic and we laid it out in repair or replace. The reserve that is supposed to absorb it is in capex reserves on a rental.
What this does to the coverage ratio, and what it does not
Say the property carries 180,000 at 6.75 percent on a 30 year amortization. Principal and interest is about 1,167. Taxes 260, insurance 95. PITIA of roughly 1,522.
| As underwritten | As lived | |
|---|---|---|
| Monthly rent used | 1,600 | 1,222 |
| PITIA | 1,522 | 1,522 |
| Coverage ratio | 1.05 | 0.80 |
| Monthly result to owner | plus 78 | minus 300 |
The “as lived” rent is just the 14,667 collected divided by twelve. Nothing exotic.
Here is the part worth sitting with. The loan does not reprice, does not get called, and does not know any of this happened. The coverage ratio was computed once, at underwriting, off a signed lease, and it still reads 1.05 in the file. You are the only party to the transaction who experiences the 0.80. You can run your own version of both columns on the DSCR deal calculator, and the mechanics are in how to calculate DSCR.
This is the same structural gap that shows up over and over: the lender’s ratio measures whether the property can carry the debt on the day the file closed. Only you measure whether it did.
What actually protects you
Not rent. Not the rate. Two things, and neither is exciting.
Months of reserves. The shortfall above is 300 dollars a month, which is survivable. What is not survivable is 300 a month plus a 4,800 dollar furnace plus 55 days of vacancy landing in the same quarter. Lenders require reserves for exactly this reason and the requirement is usually lighter than what you actually need. See reserve requirements.
The absence of a forced sale date. A downturn only converts a paper loss into a real one if something makes you transact. Balloon maturities, bridge debt, and short interest only periods all create dates you do not control. Fixed rate amortizing debt on a property that covers itself has no date. That is the whole defense.
If the shortfall does outrun the reserve, the order of operations matters and it is worth knowing before you need it. Forbearance and payment deferral options exist and are far better handled early. So is understanding exactly what happens when a payment is late, which is in missing a payment. The credit consequences that follow are in collections, charge offs and judgments.
Flips are a different animal and the exposure is worse
Everything above describes a rental, which at least generates revenue while it waits. A flip in a downturn has no revenue and a running clock.
On a 285,000 dollar rehab loan at 11 percent interest only, carry is roughly 2,612 a month in interest plus about 300 in taxes and insurance. Call it 2,912.
An extra 90 days on market costs 8,736 dollars. On a project underwritten to a 42,000 dollar profit, a single quarter of delay takes 21 percent of the profit, and downturns do not produce one quarter of delay, they produce two or three.
Three things make that materially better or worse:
- How your interest is calculated. Whether you pay on the full loan amount or only on drawn funds is the difference between carrying a rehab budget you have not spent and not carrying it. That is the whole subject of dutch vs non dutch interest, and in a slow market it stops being a technicality.
- Who your buyer is and how they are financed. A soft market pushes you toward buyers using government backed financing, which drags in seasoning and appraisal rules that control your exit timing. The FHA 90 day flip rule is the one that catches people, and it bites hardest exactly when you need the widest possible buyer pool.
- Whether you have a second exit. The flip that will not sell is a rental if the numbers work and a disaster if they do not, and that determination should be made before you buy, not in month eight. Exit strategies covers the decision and bridge loan exit options for a flip that did not sell covers the recovery. How the entity is structured matters to both, and that is in fix and flip loans for LLCs.
Three things to do before, not during
First, stress test on days and concessions instead of rent. Model 55 vacant days and one month free. If the deal survives that, it survives.
Second, hold reserves against the vacancy plus one capital event, not against the vacancy alone. Those arrive together more often than chance would suggest, because a downturn is when you stop deferring things.
Third, eliminate dates you do not control. Every balloon and every interest only expiry is a decision somebody else gets to make on your behalf at the worst possible moment.
None of this requires predicting anything. It requires modeling the correct failure mode, which is a quiet one. The rent never falls. The unit just sits, and then you give a month away, and the number in your rent roll stays exactly where it always was.
If you want a property modeled against a real downturn case rather than a rent haircut, FMC Capital is a Pittsburgh-based brokerage financing investment property for investors across Pennsylvania and additional states, NMLS #1840537. Send us the deal and we will run both columns.
FMC Capital LLC, NMLS #1840537. This article is general information for real estate investors and is not legal, tax or investment advice. All figures are illustrative worked examples, not quotes. Loan terms, program parameters and rates vary by lender, property and borrower profile and are subject to change. Property tax assessment and appeal procedures are governed by state and local law.