Why Scenario Analysis and Cash Flow Is Important
All large corporations consider scenario analysis as part of their risk management. In heavily regulated industries such as banking, the central bank (such as the Bank of England) will impose scenario analysis (also known as stress testing) on individual banks to ensure they have adequate capital reserves to cope.
This article covers two things:
- Scenario Analysis
- What is is.
- Lessons from the financial crash of 2008.
- What scenarios have become reality in recent years.
- Cash Flow vs. Profit
- Why they are not the same.
- When to conduct a cash flow forecast.
A scenario analysis considers multiple risks that could reasonably expect to occur together. What impact would that have on your portfolio and strategy?
This is where risk correlation plays a part. For example, in an economic downturn, it is likely that all of the following could occur:
- Demand for property reduces as people are less certain about their own financial standing and opt to stay put.
- Rental arrears could rise, as people lose jobs and can no longer afford their rent.
- Banks withdraw from lending, as they now think property investing as being riskier.
For example, the financial crash of 2008 had the following effects:
- Mortgage lending for Buy-to-Let restricted considerably, with some banks withdrawing entirely from the sector, especially those that needed government rescue.
- LTV’s lowered. Pre-2008, 90% BTL loans were available (I should know, I got one)! This reduced to 75% max in the immediate aftermath.
- Property transactions slowed considerably, as people were more concerned with managing their own debt levels and keeping their jobs rather than moving up the property ladder.
- The Bank of England interest rate was reduced drastically in an effort to stimulate the economy.
What did this mean for property investors? Some examples:
- Some landlords went bust. Certain investors were not focusing on cash flow, relying on remortgaging in a constant cycle in order to fund a lifestyle and to use on the properties themselves. When this stopped, the high LTV meant that they were in significant trouble if they experienced voids, arrears or expensive repairs, not to mention the impact on their lifestyle.
- Some landlords did well from extra cash flow that resulted from the Bank of England reducing the base interest rate to a historic low. Anyone on a tracker mortgage benefited enormously.
- Some developers went bust. As purchasers vanished, developers were left with stock to sell on expensive development finance, which they couldn’t sustain.
It is prudent to consider appropriate scenario analysis on your own portfolio and not just assume that things will always stay the same.
As an example, how would your Property Investment Blueprint look if the following occurred?
- Bank base rate hit 5%.
- Rents drop by 10%.
- Voids increase to an average of 1 month per year per property.
Would your head still be above water? Does your Risk Management work?
Again, what scenario testing you should consider will be dependent on your strategy. The idea is to think of realistic scenarios that could occur and manage your associated risks appropriately.
Do you think this is boring and irrelevant planning? If so, just consider some of the changes property investors have had to deal with over the last few years:
- A 3% surcharge on Stamp Duty Land Tax, on top of the current rates.
- Removal of 10% Wear and Tear tax allowance.
- Introduction of Section 24, essentially a tax on turnover with mortgage interest relief restricted to 20% by 2020.
- PRA regulation of mortgages, leading to more stringent rent stress tests, limiting the amount you can borrow in certain circumstances.
- Introduction of increased licensing and associated costs, particularly for HMO’s.
It might be boring, but you are running a business. All good businesses consider the downsides and not just get excited by the potential upsides.
Cash flow vs. Profit
It is perfectly possible to have a profitable business and still go bust. As such, you must consider your cash flow and maintain adequate reserves and not just focus on the bottom line profit.
As a simple example, consider the negative drain on cash in a typical development project. You only realise your profit on selling, but in the meantime have to account for:
- Paying suppliers and trades people.
- Paying holding costs such as financing interest.
A lack of cash to meet these outflows will have you going bust, even if the project was going to be profitable when the sale of the development was completed.
Managing your cash flow is even more important in the beginning of your investment career, as you won’t have the benefit of cash flowing assets to draw on.
A cash flow forecast is simply a document that calculates the likely income and expenses for a business, or in this case, your Property Investment Blueprint. A typical cash flow forecast is over a 12 month time frame, but in this context it makes sense to estimate this over the duration of each individual property purchase and the time frame of your Property Investment Blueprint. In the case of a Buy-to-Hold, until the point it is tenanted and in the case of a Buy-to-Sell, until the cash has been banked from the sales.
By understanding the demands on your cash on a month-by-month basis, you can ensure you have the reserves to meet this.
The point of a scenario analysis is to model some realistic, real-world movements in the risk factors that affect your Property Investment Blueprint. These could be:
- Financial: E.g. A movement upwards in interest rates and effective mortgage rates as a result.
- Regulatory: E.g. The impact of your local authority moving to band every room in a House in Multiple Occupation with its own council tax (already a reality in many areas of the country).
- Demand Driven: E.g. An increase in voids across your portfolio.
By modelling scenarios, we can monitor the effect on our cash flow. Not profit, as your business can still be profitable but encounter a short-term cash flow issue when mortgages, suppliers and tradespeople still need to be paid.
This is prudent planning and will act as a brake on over exuberance and stop you from taking unnecessary risk such as being highly leveraged and assuming the world will always remain rosy.
This stuff does actually happen, it is not just an academic exercise. An example would be the financial crash of 2008. For an actual example of a recent scenario analysis and its potential impact on an investors cash flow, take a look on my article written during the coronavirus epidemic.