Underwriting Without a Net: How to Stress-Test a Real Estate Deal in a Flat-Rate Environment

The rate cut thesis has been wrong — repeatedly and expensively — for longer than most investors budgeted for. In this episode, Louis walks through how to underwrite a deal in two scenarios: one where rates stay flat for the duration of your hold, and one where cuts arrive later than your model assumed. Using a 20-unit value-add acquisition as a working example, the episode breaks down the math on bridge financing, stabilized NOI, permanent loan sizing, and DSCR at the refinance — the metric that actually determines whether a deal survives when your assumptions don't hold. 

You'll see exactly how many rate cuts it takes to make a marginal deal work, and what that number tells you about whether you're investing or speculating. Covered in this episode:

• Why burying a rate-cut assumption in your base case is the most common underwriting mistake operators make today
• How to build a flat-rate refinance model and use DSCR as your primary underwriting gate
• The three levers — purchase price, capital structure, and operating assumptions — and what each one actually moves
• How to stress-test occupancy and NOI alongside rate scenarios
• Bridge loan extension risk: what triggers to understand before you close
• Why a deal that cashflows on IO is not the same as a deal that works
• Plus a historical fun fact about the 30-year fixed rate that reframes what "normal" actually looks like over the past 50 years. This episode is for operators who want to underwrite the deal they have — not the deal they're hoping for.

Beacon Hill Property Advisors: https://bhpropertyadvisors.com/

Transcript

SPEAKER_00 0:12

Welcome to Beyond IRR. This podcast examines real estate investments through the lens of structure, risk, and capital durability, not just headline returns. I'm your host, Louis Heiza. This podcast is sponsored by Beacon Hill Property Advisors. Welcome back to the show, everyone. Let's talk about underwriting in the rate environment that we actually have, not the one that we're hoping for six months ago. There has been a persistent assumption embedded in a lot of acquisition underwriting over the past 18 months. The assumption goes something like this. Rates are elevated today, but they will come down, and when they do, our debt costs will decrease, our cash-on cash returns will improve, and the deals that look marginal right now will look good in hindsight. That assumption has driven a lot of capital off the sidelines and into deals that, if you stress tested them honestly, only work if the rate cut thesis plays out on schedule. The problem is that the rate cut thesis has been wrong consistently, repeatedly, and in some cases expensively for longer than most people budgeted for. So today I want to do something practical. I want to walk through how to underwrite a deal in two scenarios. One where rates stay flat for the duration of your hold, and one where you get a cut or two, but later than you planned. And I want to show you what changes in each scenario, what metrics to watch, and how to decide whether a deal actually pencils when you take the rate cut assumption off the table. Now, this is not about being pessimistic, it's about being honest with your underwriting so that when you make a decision, you know what you're actually deciding. So here's the starting point. Why the rate cut assumption is dangerous. When rates are elevated, it is natural to model them coming down. Lenders do it, investors do it, brokers definitely do it, and sometimes they're right. The issue is not that modeling a rate cut is wrong. The issue is what happens to the deal when you bury that assumption in your base case and call it conservative. So here's a common underwriting pattern I see. An operator acquires a deal with a bridge loan at, let's say, 8.5% or 9%. The Proforma shows a refinance in year two or three into permanent debt at, let's say, 6.5% or 7%. That bridge loan was interest only. So the early year cash flow is manageable, even at that higher rate. The refi is where the story is supposed to get better. So now ask yourself, what happens if that deal actually refies at 7.5% or 8% when the bridge matures? The refinance still has to happen. The bridge lender is not going to extend indefinitely. It's not supposed to be long-term debt, and you're only going to get maybe a couple extensions. But the rate that you're refinancing into is 100 to 150 basis points higher than your model assumed. Your debt service jumps, your DSCR tightens, your cash on cash return, which looked fine in year three of your model, is now underwater or barely breaking even. And if occupancy hasn't fully stabilized yet, you may not even qualify for the perm loan that you need. So that is the scenario we are underwriting against today, not as the worst case, but as the base case. So let's look at building a flat rate model. We'll work through an example here. Let's use a 20-unit multifamily acquisition in a secondary Midwest market, because I like the Midwest and I'm invested in the Midwest. So let's say the purchase price $2.1 million, sounds about right, a little over 100K per unit. Seller's a local operator who's held the asset for 15 years, hasn't done significant capital work. So there is upside in rents. Current rents are about, let's say, $200 below market each. And the physical condition is functional but dated. Probably a handful of deferred maintenance as well. So let's look at a bridge financing scenario here. So let's say it's a 65% LTV, that's $1.47 million. Interest only, let's call it 8.75%, and a 24-month term. And they'll give us a 12-month extension period. That's pretty generous. Three-year bridge loan. Well, with that extension. So let's look at the uh the property then. So year one gross rents at the current in-place rents, we're looking at 300k, a vacancy and credit loss, let's say 7%. So effective gross income is just over $290,000. Operating expenses, you know, let's add in management fees, taxes, insurance, maintenance, reserves, utilities, et cetera. So let's say total roughly about $138,000. So that gives us a year one NOI of $152K. So at 8.75% interest only on a $1.47 million loan, the annual debt service is $128,625. So year one cash on cash, our equity was $630, net cash flow $23,000, just over. So cash on cash return of 3.7%. So it's not a great return for the risk you're taking, but it's not supposed to be. This is a value add play, and the return profile is supposed to improve as rents are pushed and the asset is repositioned. So now let's model year three, the year where the bridge matures and the refi is supposed to happen. I did an entire episode, by the way, on the risks of stabilized proformas. And I point out that year three is the one you want to watch out for if you're ever looking at someone else's pro forma. Oftentimes, even in value add deals, and actually, especially in value add deals, you'll year three looks excellent. And there's a reason because most people think repositioning takes two, which it often does. But the point is, three years from now is very uncertain. And so if you're projecting a deal to be look good in three years, if you have a bunch of risks baked in through years one and two, and a couple of them go wrong, they're going to compound each other. So if you want to see more about that episode, it was in a season one, episode six: the hidden risks in stabilized proformas. So back to our year three, where the bridge matures and the refi is supposed to happen. So we've pushed rents 150, let's say, of the $200 gap. So we're very close. So new gross rents, that brings us to 348K. Vacancy, let's say it ticks down a little because of improved maintenance. Or um, uh, so let's call it 6% now. Effective gross income is therefore just over 327K. Operating expenses will have increased uh with inflation, as well as, you know, unless you're implementing a lot of expense reduction plans, such as swapping out lights for LEDs or rub systems for the utility billing, or, you know, you hire cheaper management, hopefully cheaper, not because the service is worse, but because the company is better and more efficient. But uh generally speaking, operating expenses are going to tick up uh as occupancy does. Um, so let's say the operating expenses have increased to 148,000. So that brings us to an NOI now of just over $179,000. This is year three. So the flat rate refi scenario, permanent financing, it's 7.5%, 25 year RAM, 75% LTV on the stabilized value. So what is that stabilized value? Let's say at a 6.25% cap rate, which is reasonable for this market in an asset class and in a flat rate environment. Coming into Q1 2026, we are seeing cap rates when bigger metros for class B plus to A, we're seeing them in the low fives. And people are expecting this to compress a little bit. But for let's call this a you know, a B minus C plus asset that just got repositioned to like a B, uh yeah, six and a quarter uh cap rate sounds probably reasonable, uh especially if it's a, let's say, you know, a tertiary market at the smallest. Uh so at a six and a quarter cap rate, that NY of uh just over 179K gives us a value of $2.865 million. That's a $765,000 gain on the $2.1 million purchase price, assuming that the market holds and your cap rate assumption is defensible, of course. So 75% LTV of that $2.865 million, that's a $2.149 million loan for your permanent debt. At 7.5%, 25 year AM, your annual debt service is now 192K. So NOI, uh 179, just over debt service 192. DSCR 0.93. You were underwater on debt coverage. The loan's not even going to qualify. A conventional lender wants 1.2 minimum, but really they want 1.25 DSCR. And so 0.93, you're not getting this loan, even though you're at 75% LTV, and maybe you got the appraisal you needed. Uh, in my experience and the experience of a lot of investors, especially right now, invest uh lenders are looking at two things really hard. It needs to appraise, and you they'll give you, you know, whatever their LTV is, 70, 75, 80%. And DSCR needs to match. It's both of those things. So this is the conversation that flat rate underwriting forces you to have before you close the deal, not after the bridge matures. So, what happens then if you were to see this in advance? When the flat rate model shows you a DSCR problem at the refi, you have three levers to pull the purchase price, the capital structure, or the operating exemptions. So lever one, purchase price. If you paid $1.85 million instead of $2.1, your LTV on the acquisition drops, your equity contribution increases, but the permanent loan size on a similar value also decreases. So let's run that. At $1.85 million, 65% LTV bridge. So we're going to drop that LTV a bit. That's $1.2 million. Stabilized value at the same cap rate, um, again, 2.865. So on a 75% LTV perm of $2.149 million. Uh it's the same loan, same problem. The permanent loan amount is driven by the stabilized value, not the purchase price. But the price reduction alone doesn't fix a DSCR problem if the ReFi is against stabilized value. So lever two, capital structure. What if you bring more equity to reduce the permanent loan size? So if you target 70% LTV instead of 75 on the ReFi, the loan drops to 2 million at 7.5%, 25 year am annual debt service is approximately 1.7, uh, excuse me, 179,500. Remember, NOI was 179 basically even. So you're at a DCR of basically 1.0. That's still below lender requirements. You got to get up to 1.2. So that means either um a 214,000, just under $215,000 in NOI at that $179K debt service, or you need the debt service to go down to $149K at your same $179K NOI to get that $1.2 minimum DSCR. So to get debt service to $149K at 7.5%, you need a loan of about $1.67 million. That's a 58% LTV on the stabilized value. And so that means you're bringing roughly $1.2 million in equity to the $2.1 million deal. Your equity multiple and cash on cash return have to justify that concentration. So now that's when you're going to look hard at capital efficiency. So let's look at lever three then, operating assumptions. If you can push rents all the way to market, like that full $200 gap rather than $150, remember we had expected rents to be $200 below market when we acquired it, but in our original assumption, we only pushed it up to $150. And that's, you know, that's a good conservative way to look at things. If you do that, if you were to get the full $200, your NOI improves. So at the full market rent, gross income is $360K. Let's say vacancy is still at that 6%. Your EGI is $338, uh, $338,400. Uh let's say expenses of $150K. So that's a little tick down. You know, you're maybe you're sharpening your pencil on expenses. NOI is now $188,400. So at that 75% um uh 7.5% uh in interest rate on a $2.149 million dollar perm. DSCR in this case, 0.98. We're still not there. So uh adjusting lever three, your operating assumptions is not good enough. That's not gonna get you there. And the last thing you want to do is to start making your assumptions a little unrealistic. You know, maybe you're like, eh, maybe vacancy could be 3%, or, you know, maintenance is only gonna be 4% of EGI as opposed to a standard, let's say 7%. You don't want to get into that trap of forcing your proformer to look good. This flat rate model is telling you something important. This deal at this price in this rate environment does not produce a clean refi path. And that doesn't mean you don't do the deal. It means you restructure it, reprice it, or repass. This deal needs to be looked at harder before you acquire it. Because once you acquire it, the ball is rolling. So now let's add that rate cut to our assumption. So let's assume the same deal we just looked at, uh, but now there is a 150 basis point cut rate before or before the bridge matures. So let's say rates move from uh 8.75% on that bridge to now a permanent debt uh of around 7% instead of that 7.5. So that same NOI we were looking at, just over 179K, permanent financing of 7%, 25 year RAM, 75% LTV. And so therefore that loan was 2.149 million. Your annual debt service is now okay. In this case, DSCR, 0.98. So still below, still doesn't work. So one cut does not fix this. Let's try two cuts. What if the permanent market is now 6.5%? So look at the same loan, 2.149 million, now 6.5%, 25 year am. Now we're looking at a DSCR of 170,000 even. DSCR 1.053. We're getting closer, but that's still too low for most lenders' thresholds. And remember, if it's too low for a lender, it's probably too low for you. Not trying to assume everyone's strategy. I'm not trying to make a blanket statement on what kind of DSCR you should chase, but I'm a conservative investor. And so if a bank doesn't like a deal, I like to know why. Generally it's DSCR. And I take that very seriously. I like to underwrite deals and buy property that banks like too. Because don't forget, bank is the other partner in every single deal. Now there's equity partners and there's debt partners. The bank's the debt partner. Everyone is interested in this deal being financially successful. And they are professionals just as much as you are professionals. So if they have dissenting opinions, you should look at that carefully. So let's try our assumption uh with three cuts this time. So now we've got a permanent market at 6%. So annual debt service on this same $2.149 million loan. Now we're at $158K annual debt service. So that DSCR 1.133. So we're still short of the 1.2, uh, though some life companies and maybe portfolio lenders will go to 1.15 in a strong market. The deal gets to 1.2 DSCR when permanent rates hit approximately 5.5. And we are a long way from 5.5 in today's environment. So what this analysis tells you is not don't buy. It tells you exactly how much rate movement you would need to make your refinance thesis work. And when you see that, the answer is I need rates to fall 300 basis points. You need to ask yourself whether you're investing or you're speculating. So a couple practical, excuse me, practical takeaways. What doesn't an operator actually do with this analysis? So first, you're going to run DSCR at the refi as your primary underwriting gate, not your internal rate of return. IRR is a summary metric. It tells you the output of your assumptions. DCR at the refinance tells you whether the deal survives when those assumptions are wrong. Build your permanent loan scenario in the flat rate case before you build anything else. So that's what is what are rates right now. I'm going to build my model, assuming that rates two years from now, three years from now, whenever I need to refinance, are going to be the same. We're not going to look at any cuts. We're not going to build in any cuts. And let's see what that looks like. Second takeaway here: stress test occupancy and NOI, not just the rates. The deals that blow up in a flat rate environment often have two problems simultaneously. Rates didn't move, and rent growth underperformed. Model NOI at 90% of your projected stabilized rates. And if DSCR holds at 1.2 or above in that scenario at today's permanent rates, you got a great deal, or you have a deal. If it doesn't, you need to understand exactly why before you proceed. And so to our third takeaway here, know your extension risk. Bridge loans have extension options, but those options come with conditions, usually a DSCR test or a debt yield test. So if your property doesn't hit the extension trigger, your bridge lender can force a maturity event. So understand what that trigger is before you close and model whether your property hits it in the flat rate case. Fourth takeaway, negotiate the permanent financing assumption into the deal structure. If you're buying from a seller who has been counting on rate cuts to make their ask price work, they may be more flexible on price than they are letting on. A flat rate underwriting model is a negotiating tool. It shows a seller exactly what their asset supports at today's rates and today's cap rates. The gap between their expectation and that number is your negotiating room. And our fifth and final takeaway, do not confuse a bridge loan that cash flows with a deal that works. Interest-only bridge financing can make almost any deal cash flow in year one. That's not underwriting, that is deferral. The deal works when the permanent financing pencils, when the exit cap rate is defensible or even conservative, and when your equity multiple holds up without a rate cut. And if those three things are true, you have a real deal. If one of them requires a rate cut to be true, you have a rate bet. So honest summary here, the operators who are buying well right now are not the ones who believe in rate cuts most confidently. They are the ones who have built their underwriting to survive without them. That means lower purchase prices, more equity in the deal, tighter NOI assumptions, and a clear-eyed view of what the permanent loan looks like when rates are exactly where they are today. That is hard. It's harder than it sounds when deal flow is slow and competition is pushing prices. But the discipline of flat rate underwriting is what separates operators who build durable portfolios from operators who get a few years into a hold and realize the thesis never penciled out in the first place. So underwrite the deal you have, not the deal you are hoping for. That's it for today's episode. Hope you got a lot out of it, and we'll see you next Monday. Thank you for listening to Beyond IRR. This podcast is produced by Beacon Hill Property Advisors, where we focus on bringing clarity, structure, and rigor to real estate investment analysis. If you If you want to evaluate deals beyond headline metrics and better understand the mechanics driving performance, you can learn more about our tools and approach at bhpropertyadvisors.com. You can also connect with us directly for demonstrations, resources, and additional insights. Until next time, analyze deeply, allocate wisely, and always go beyond IRR.