Most real estate moguls have one thing in common. They never become forced sellers.

In fact, they typically are most active at the depths of a market cycle. Buying from desperate sellers, trading pennies for dollars.

All while holding on to their existing portfolio. How were they able to take action while others were hurting?

The answer is risk mitigation.

Risk mitigation should be at the top of the list when evaluating a deal. Personally, I want to be comfortable with a deal in a 15-20% discounted market. When vacancies are rising and rents are falling. If a deal can handle that kind of stress then it will do great in a booming market. If a deal can’t handle that type of stress then I become a forced seller at market bottom. As an owner, this is the #1 situation I am trying to avoid. My goal as an investor is to avoid becoming the seller that I yearn for as a buyer.

You may ask, how can I protect myself from becoming a forced seller?

There are two quick tests that I put any deal through when underwriting.

1. Breakeven occupancy
2. Cash flow sensitivity analysis

Breakeven occupancy

A measure indicating how many units must be occupied in order to breakeven. A bottom line indicator. A baseline to work from.

Let’s make a few assumptions: We buy a $5M deal, 8% cap with 4% debt costs. Thus, NOI equals $400K and annual debt is $200K. Let’s assume this property has 100 units and operates at 50% efficiency (expense ratio).

To determine breakeven occupancy we first must understand total outflows. There are two outflows in real estate. (1) operating expenses (cost of running the property) and (2) mortgage payments (cost to payoff loan). We know the cost of running the property is 50% of income. Assuming annual income is $800K, operating expenses will equal $400K (50% expense ratio). We already know the mortgage payment is $200K. Add these together and total outflows are $600K/year, or $50K/month.  

Now we need to find out how many units must be occupied to cover this $50K/month outflow. Start with average rent per unit. We know rental income is $800K and the property has 100 units. Divide the rental income ($800K) by the number of units (100) to find the average rent of $667/unit. 

Divide the average rent per unit ($667) by the total outflow ($50K). This lets us know that we need at least 75 units occupied to breakeven. A breakeven occupancy of 75%.

How cash flow protects returns in a red market.

Cash flow is the best tool in protecting your capital. It’s easiest to explain by example. Let’s use the previous assumptions. $5M property, purchased at an 8% cap rate. Using debt costing 4% covering 70% of the purchase price. 5 years later we’re forced to sell at a 20% discount, a $1M devaluation. Over these 5 years we’ve been paying down principal, collecting $334K in equity. Additionally, since we purchased at a high cap rate we have cash flowed $200K/year, or $1M over the 5 year period. All in all we came out on top $330k on a $1.5M investment, returning 22.12% over the 5 year period. Pretty good for a stretch where the market was likely in a deep hole. 

On the other hand, if we purchased the same deal at a 4% cap, and the property devalued 20%, we would be out of $670K. Our initial investment of $1.5M would be worth $830K and we didn't receive any cash flow along the way. Losing 45% of our money. 

Protection is made on the purchase. Buy cash flowing assets and conduct a “worst case” sensitivity analysis.