How To Stress Test Every Deal Appraisal—The 10 Key Points [#REWIND]

We're revisiting a classic from the vault—an episode that covers everything you need to know about stress testing your deals.

I wanted to highlight this topic again because I've noticed a surge in questions from our community lately. This uptick is likely a result of rising prices, changing legislation, and a bit of market panic. 

Deals aren’t as profitable as they once were, and understandably, HMO property investors like you, want to plan effectively and ensure your deals are as strong as possible.

In this episode, we outline ten key points to stress test, including purchase price, interest rates, refurbishment costs, occupancy rates, and more.

So whether you need a refresher or you’re new to investing in HMOs and unsure how to start stacking deals, today’s episode is definitely for you.

Note: This episode was originally published on October 28, 2020.

Please leave us a quick review on Apple Podcasts or Spotify if you enjoyed this episode.

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Transcript

Andy Graham (00:02.67)
Hey, I'm Andy and you're listening to the HMO Podcast. Over 10 years ago, I set myself the challenge of building my own property portfolio. And what began as a short-term investment plan soon became a long-term commitment to change the way young people live together. I've now built several successful businesses. I've raised millions of pounds of investment and I've managed thousands of tenants. Join me and some very special guests to discover the tips, tricks and hacks the ups and the downs, the best practice and everything else you need to know to start, scale and systemise your very own HMO portfolio.

Andy Graham (00:40.75)
In today's episode, we're gonna rewind almost four years to bring you what I think is one of the most important episodes I ever recorded on the show. In today's episode, we're gonna bring back from the vault an episode I did covering everything you need to know about stress testing your deals. Now, look, why am I bringing this back from the vault? Now, well, the truth is almost four years later, we have amassed tens of thousands of new listeners along the way and understandably going back through the archives to find some of what I think are the most important episodes I ever did is a bit of a challenge. 

People tend to start from the most recent and work backwards. Well, actually, I want to bring this one forward because I'm seeing more questions being asked about this sort of thing than ever inside the community. And I think it's a consequence of rising prices, changes in legislation, a bit of panic in the market. Deals are just not quite as profitable as perhaps they used to be. And understandably, our community members, you guys, our listeners want to plan, you want to make sure that your deals are as good as they possibly can be. 

Now, look, there's loads of different ways to do that, but stress testing your deals, appraising your deals and testing all the different variables that make a deal what a deal is, is incredibly important. But there's a real skill to it. There's a knack to it. And it's not just what you need to test. It's actually understanding how to interpret the information that you get from it. So before we get stuck into this full disclosure, so I was four years old. It was before I had the confidence that I might now have on the show, even down to the audio quality. We had a bit to learn.

But look, don't worry too much about that because it's what I'm talking about that is so incredibly important. And the good news is this stuff just hasn't changed. The importance of this, it hasn't changed how we stack deals, how we make deals as good as we possibly can on paper. That hasn't changed. So if you need a refresher on this, or if you're new to investing in HMOs and you're just not sure how to get started with stacking deals, then today's episode is definitely one for you. Please sit back, relax, and enjoy today's episode of the HMO podcast from the vault.

Andy Graham (02:38.606)
Hey guys, it's Andy here. We're going to be getting back to the podcast in just a moment, but before we do, I want to tell you very quickly about the HMO roadmap. Now, if you're serious about replacing your income, or perhaps you've already got a HMO portfolio that you want to scale up, then the HMO roadmap really is your one-stop shop. Inside the roadmap, you'll find a full 60 lesson course delivered by me, teaching you how to find more deals, how to fund more deals and raise private finance, how to refurbish great properties, how to fill them with great tenants that stay for longer, and how to manage your properties and tenants for the future. 

We've also got guest workshops added every single month. We've got new videos added every single week about all sorts of topics. We've got downloadable resources, cheat sheets and swipe files to help you. We've got case studies from guests and community members who are doing incredible projects that you can learn from. And we've also built an application just for you, that allows you to appraise and evaluate your deals, stack them side by side and track the key metrics that are most important to you. To find out more, head to theHMOroadmap.co.uk now and come and join our incredible community of HMO property investors.


Andy Graham (03:48.718)
I've got a really important episode that I want to bring to you today. It's something that I feel quite passionate about. And I think it's something that we should all be doing a little bit more of. I'm going to talk to you about stress testing your deals. And in this episode, we're going to cover the 10 key points to stress in every single HMO investment appraisal. Now I get it. There is already a lot to think about when we're appraising deals. We've got yields and cashflow and equity and that's before we even think about the physical location and how to manage it. But stick with me because these principles are so, so important and they could really save your bacon. It's actually quite easy to do once you've got the hang of it and you can really de-risk any deal by spending a bit of time just working on stressing your deal. 

Now, if you're an experienced investor, you're probably not unfamiliar with the idea of stressing your deal at all, but what I want to explore in this episode is not just what to stress, but how and the relationship between the different components that we can stress. Because until we've done that, we can't really assess the full picture. In fact, we're looking at the outline. The idea of stressing all of these points is to color between the lines to really see exactly what this deal looks like under any circumstances. And by doing that, it helps us make informed decisions about every possibility, every scenario, and we can put contingencies in place or we can build the risk into the deal. And actually that might help us go back and renegotiate or have a slightly different conversation with our investors. So what are the 10 key points to stress? 

The first one is the purchase price. The second one is the interest rate. The third one are the refurbishment costs. The fourth is the possibility of down valuations. The fifth is the loan to value. Sixth is occupancy. The seventh is the rental achievement, the actual figure that we can get, the amount of money we can get for a room. The eighth is bills. The ninth are our maintenance costs and the 10th are the timeframes or the timeline. So there we go. The 10 key points that we should be stressing on every single deal. Let's get started then. Let's first look at the purchase price. Now you're probably saying, Andy, why on earth would we need to stress test the purchase price? We know what the purchase price is because we're buying it at that level, but

Andy Graham (06:14.274)
Bear with me. If we're buying on the open market, yes, it is relatively fixed. If we make an offer and they accept that offer, the chances are that that isn't going to change unless we allow it to change. But if the circumstances are slightly different, for example, if we're buying an auction and I've bought an auction a number of times, so I'm quite familiar with this process and I'm sure some of you guys listening in today have, you probably will then not be unfamiliar with the idea of getting a bit carried away in the auction room, that excitement, that buzz of the auction room and all the chatter and the bids and the overbids can get us carried away. And we need to be prepared for that if we're going to go and buy anything under auction terms, either in the room or even online. I've bought online before and it's, it's similar. 

So by stress testing the purchase price before we go in, it means that when we enter that scenario where it is a little bit stressful, the heart rates up a little bit and we're having to think on our feet. We know exactly where we can end up with this. We know the absolute upper threshold of where we're prepared to bid on this deal. So beforehand, when we're looking at the appraisal, we want to factor in these different levels of purchase price and see what the whole deal looks like. And as we work our way through the 10 key points in this episode, we can also test those different possibilities, those different purchase prices against the other elements. 

Of course, if you're buying on the open market and the purchase price is fixed, then this point won't be as important. And it isn't necessarily something that you need to worry about. But if you go into buy an auction or a similar circumstance, then you need to be prepared. You need to have stressed this component to know exactly where you could end up. Five, 10, 15,000 pound could make a huge difference on the output of your investment. And you certainly, if you're working with an investor, want to have had that conversation and have that plan before you go to the auction and start spending money. 

The second key point to stress then is the interest rates. Now, interest rates are still a historic low. We know that the Bank of England reduced them again recently and that can influence our deal quite significantly, but lenders are quite varied in how they risk assess deals. And ultimately the interest rates that they place on them are typically related to the perceived risk as far as they're concerned.

Andy Graham (08:37.281)
Some HMOs carry more risk, bigger HMOs, professional HMOs, they carry a bit more risk than, for example, small student HMOs. And different lenders do have different opinions, but the interest rates between the products, between the lenders can vary quite significantly. At the minute, it's not unfathomable to get interest rates in the two to three percents, even on HMOs. But a lot of lenders and a lot of people will be lending between four and six percent. And that difference of a few percent will make a massive, massive difference at the end. And we need to factor that in because when we're buying and go through the conveyancing process, we're talking to lenders and we're trying to get an idea of what our mortgage is going to cost us. 

But sometimes we need to consider the refinance later down the line. And what if interest rates change in the short term? We've seen that happen recently. There's no reason it couldn't happen again. In fact, what happened recently was when interest rates came down, with by the Bank of England, the actual interest rates being applied by the mortgage lenders went up because they were seeing it as a more risky environment. So we actually paid more in some circumstances. So stressing this in your deal is really important because it really will quite significantly affect the cashflow at the back end. If we're paying more on the mortgage, we're going to have less cash to spend every month. 

And what about if we are reliant on a refinance, either at nine months or 12 months? What if we're going from a short-term product or private lending to a term product? That means at the point of purchase, when we're actually appraising the deal, we can't stress that component. We aren't in a position to talk to lenders and get a mortgage in principle. So we need to be making a very accurate guess on what that interest rate is going to be. It'll be embarrassing if by the time you come to refinance, the deal that you get offered and all you can get is one or 2% more than you posture to your investor, because that really will make a huge, huge difference. So there we go. The second key point to stress in every single appraisal is the interest rate. And my suggestion would be at the minute to stress right up to 6% to see what it looks like. And it's good practice to stress beyond that to see what this deal could look like in the future. Interest rates will go up at some point. What could they look like in 5 to 10 years? Of course, we can't build.

Andy Graham (10:56.14)
picture for every single scenario, but we can consider, we can look at what it could look like and we can be prepared. Okay. The third point to stress in every single deal is the refurbishment cost. Now, most people listening will probably be saying, well, yeah, I factor in a contingency to every single refurb. That's good practice. That's great. That's really important, but that's not what we're talking about here. A contingency, certainly in my experience, almost consistently gets used on odd bits here and there.

But what if things change quite significantly? What if the planning inspector insists on something quite significantly different? What if building control insists on something quite different? What if you peel back a wall and it isn't what you expected? What if you have an issue with a builder? What if you have issues with materials, which some people have had in the last six months? There are a number of reasons why a budget cannot just eat into the contingency, but can be significantly overspent on.

See what happens in your deal if you stress 10, 20% overspend. What if something terrible happens? What if you discover something pretty awful that you've got to deal with? This has happened to me more than once. And if you buy enough property, it will definitely happen to you. You need a contingency there. It's good practice to have had that conversation with an investor. If you're working with an investor, see what the deal looks like. If something like that were to happen. Okay. The fourth point then that we're going to stress is down valuations. 

Now, this is one of the anchors, the real hinge for a lot of people buying, refurbishing and refinancing HMOs. That refinance figure, that revaluation figure often is one of the key determining factors at the back end. How much capital can we get out? It really will influence the return on the capital employed. Hopefully we can get a bit of capital out. That's usually the purpose. We can get a better return on the capital employed, but what will happen is the yield will be affected slightly because our mortgage costs will go up a little bit as we lend on some of that additional equity that we have to leave in the deal. But what happens if we don't achieve that reval? What if it's not what we expected? What if the surveyor is in a bad mood and he just doesn't want to give you what you think it's worth? Well, that's not uncommon, certainly not in the current climate. People are a little bit twitchy.

Andy Graham (13:22.542)
Lenders are feeling a little bit unsure about what's going on and surveyors are definitely downvaluing stuff at the minute. Now we can argue to a blue in the face about a down valuation. Is it a down valuation or is this actually the valuation and our expectations were a bit higher? Well, it doesn't really matter. We can appeal decisions. We can go to different lenders, but still we need to stress this. We need to really consider what happens if this comes back 30, 40, 50,000 under valuation because that is a very possible scenario and it can massively influence the deal. 

For some people, that refinance figure will be the difference between the deal working and the deal not working. And we need to have contingencies in place. We need to have had those conversations with investors. We need to have set expectations. We need to be able to manage those expectations as well. So play around with that revaluation figure and see what happens and how the whole deal is influenced by a down valuation. Let it inform you, let it guide you. 

Okay, moving on, the fifth point we're going to consider, the fifth thing to stress is the loan to value. Now, this is closely related to the possibility of down valuations. Sometimes lenders will come and praise something themselves. They'll look at something, they'll have the surveyor look at it and they'll look at the overall financial picture and your personal financial picture or your company's financial picture. And they may insist on you keeping more capital in that deal. They want to reduce their risk and they'll insist that you have a deposit that's a little bit chunkier left in that deal. And you need to take that into consideration. What happens if all of sudden the bank says, at revaluation, we're not going to give you a 25% loan to value product, we're going to give you this mortgage, but you'll have to leave a 30% deposit in or a 35%. That is not impossible. That is not unfathomable at the minute. So it's definitely a consideration that we want to have and make.

The sixth point to stress then in every single appraisal is the occupancy. Now we all talk about occupancy. There's definitely another podcast episode in here somewhere, but the occupancy is incredibly sensitive and the output of the deal will really be heavily influenced by the occupancy that we can achieve. With student lets, it's not uncommon to have occupancy at 98 to 100% in some circumstances, in some cities, letting the property out for 52 weeks of every single year.

Andy Graham (15:48.27)
is plausible. We actually run 51 week contracts, so our occupancy is effectively 98%. With professionals and social HMOs, it's slightly different. Of course, we can have very high occupancy at 95, 98, even 100%, but it's difficult and to maintain that is incredibly difficult. So we need to be realistic about what we're factoring in here in terms of occupancy. Now, my advice is always to stress occupancy for professional lets towards 85% and that's not necessarily a worst case, but perhaps a more pessimistic view of what the deal could look like. If you do everything right, you refurbish the right way and you buy in the right location and you manage your tenants properly and you have a good process and system for advertising, managing enquiries, then 95% is certainly possible, but don't rely on it. 

Don't stack the deal up with it having to work at that level because it's risky, you're kind of skating on thin ice there. So my advice is to stress it down to 85, 80 % and just see what the deal looks like. See what, at what point this deal isn't making money. Again, it's just useful to help you manage expectations. And this factor will really be determined at the end by the location. Mostly the number one factor for occupancy is predominantly location. So if the supply is there of tenants, then you're probably going to be okay, but don't just rely on it. Make sure you've done all your research and have a play around, test it. 

Okay. The seventh point we're going to stress is the rental achievement. This is the actual amount that we're going to be able to charge for our rent. So our average room rates are probably around a hundred to 110 pound per week. And that's inclusive of bills. In other parts of the country, that's significantly different. One of the things that I see a lot of investors doing is getting carried away with the idea of charging premium rents. Now.

There is almost always a market for that, so long as the tenant supply is there, but the market is thin, it's narrow. And over time, as your property starts to get worn in a little bit, that nice shiny look does wear off. That Instagram gloss does disappear after a period of time. And so that premium value isn't going to be there forever. Now we might find, and you might find that rents do continue to increase and you can maintain that, but

Andy Graham (18:15.052)
My advice is to factor in a long-term adjustment to your rent and just see what happens. And also factor in a short-term adjustment that you might have to make. What if actually that 650 pound a month figure that you think you can get because the nearest comparable is at about 550, 600 and yours is going to be better. But what if the market just says no? What if the tenants just aren't prepared or can't pay at that level? Maybe you'll get one or two and you might not get five or six tenants who can pay that. 

So factor in stressing that variable because you'll find the whole deal is quite sensitive to that rental achievement. Number eight then, the eighth point to stress is the bills and the utilities cost. This is a tricky one, this is a tough one to predict and to stress. With students it is a little bit easier because we can manage the usage, we can put a fair usage cap into a tenancy agreement and we can make sure that at the end of the tenancy agreement any overspend is clawed back. 

But with professionals and other types of tenants, it is more difficult. We can't point the finger at any one individual with them being on separate tenancies. We can't point the finger at any one individual and say, you spent more on utilities this month and you spent more on water and you spent more on the gas. We can't do that. We can't charge people for that. And that makes it very challenging for us as investors and as landlords to monitor and manage the utility spend. What we can do is manage them economically.

Communicate to our tenants, put smart systems in place, but that doesn't change the possibility of hefty bills coming through because tenants either ignore the advice or because we have a very cold winter. You need to plan for that. Now, my advice would be for a professional HMO five bed to stress around the 450 pound a month mark for bills. And that includes council tax.

If your council taxes more like 200 pound, then you need to add a bid on and so on and so forth. But stress your utilities and bills cost right the way up to 600 pounds and just see what happens. These deals, your investment deals will be quite sensitive to this factor. And that's not completely impossible. That scenario where tenants are really racking up energy costs. Five, 600 pound is something I've certainly seen in the past. Hopefully you won't with good systems in place, but stress it and just see what the deal.

Andy Graham (20:37.922)
looks like. Number nine then, the ninth point to stress is maintenance and maintenance costs. I typically factor in about 50 pound a month for maintenance, so let's call it 600 pound a year. If you've just done a shiny refurb then hopefully you don't actually need to stress that much. Hopefully the costs and the maintenance costs won't be that significant. But you never know, the boiler could break, some tenants could do some damage, things could just go wrong, there could be a leak. I've seen it all before and I'm never surprised by anything these days. It is definitely, definitely, definitely good practice to factor in as a minimum about 50 pound a month on maintenance, but stress it, see what happens if you have to spend a hundred, on average every single month, just see what the deal looks like. 

Okay. The 10th point of stress, and this is the only one that doesn't fit on the spreadsheet and it's the one that everybody forgets to think about and to assess. It's the timelines, the timeframes. How long is all of this going to take? If we're borrowing finance, particularly on debt, the clock's ticking. We're paying every single month that we're spending that money. And while we haven't got tenants in, we're losing money. So that period where we're refurbishing the property, we're preparing it, we're advertising it, we're losing money on it. We need to get tenants in as soon as we possibly can, but things go wrong. There could be a global pandemic that comes and scuppers your plans. 

Yes, that is a very plausible scenario, but seriously this stuff does happen these things that affect the timelines really do impact how much you might have to outlay on a deal and it's really good practice to factor this in if you're paying interest costs on a monthly basis see what happens actually if you run two three four months over budget make sure that that Continuities there see what the deal looks like see how much capital is going to be left in if you have to throw that into the mix as well. Okay, so timelines. There we go. 

They're the 10 key points to stress. Now, my advice is to throw all this into a spreadsheet and start playing around with each of these tabs, play around with the purchase price, play around with the interest rate and automate your spreadsheet, automate your appraisal so that if you change the interest rate figure, it applies to the mortgage that you've got in place and then that will apply and wash through to the mortgage costs every single month and so on and so forth.

Andy Graham (23:01.998)
Play around with all these components in a good appraisal tool. Then what you need to do, and this is the really, really important bit. This is the bit everybody forgets to do. You need to stress these components against each other. It's no good just stressing one at a time because it's unrealistic. In reality, what happens is we, all of these variables get affected in different ways. So let's build a picture. This is where we are cluttering in between the lines. See what happens if the interest rate is a little bit higher and our occupancy levels aren't quite as good. See what happens if our bills are 500 pound a month and we run over on our initial refurb timeline by four months. See what happens if the refurb cost comes in 25% over budget and we have to leave in a 30% deposit to get any mortgage. Play around with all of this stuff and just see what it looks like. 

I guarantee doing this a few times, you'll get the hang of it and you'll find it very easy to do. And I also guarantee that you'll feel much more confident with your deals. You'll be able to present a much more accurate picture of a number of scenarios that will help you determine the level that you wanna pay for, the property app. It'll help you ensure that you've got a contingency in place, a bit of a cash cushion or a secondary investor that could throw some money your way if that's what you need, but have a play around with this and see what it looks like. 

It really is one of the most important things that you could do. It'll hugely de-risk everything that you potentially buy. And it may even help you avoid buying a bad deal. Instead, focus your efforts on the next good deal. It removes the emotion. It's a very logic based exercise. And I spend a huge amount of time doing this on every single deal. So there we go. I hope you found that useful. The 10 key points to stress in every deal, please go away and have a go at that. Start implementing it on everything that you look at. 

That's it for today's episode guys. Thank you for tuning in. I hope you enjoyed that one from the vault. I think one of the most important episodes that I have recorded to date, this stuff is as important, if not even more important than ever. Now look, if you haven't got a good tool. If you don't know how to stack your deals, head over to the hmoroadmap.co.uk because inside there is the deal stacker. I built this just for you. It makes it really easy to put all of this information in and test it. It also makes it really easy to see the results and interpret the results. It gives you a scorecard and you can click and choose between different KPIs that you want to track. You might prefer to see some information rather than other information and you can make sure that you're seeing exactly what you want. You can stack it side by side across every single deal. Trust me. Again, I wish this existed when I was just getting started, but it is a no brainer and it will save you hours and hours of time and make your life so much easier. 

And of course, if you've got any questions about today's episode, if you need some more guidance or support or you could share any more insights on this, come on over to the HMO community. That is our free group in Facebook and it is the place to come and share ideas about anything like this and much, much more. Look, if it's about HMOs, then you can guarantee we are already talking about it inside the HMO community. So come and get involved in that conversation. 

That's it guys. Thank you once again. And don't forget that I'll be right back here in the very same place next week. So please join me then for another installment of the HMO podcast.