Stress-Test Your Investment Like a Pro: Tools & Strategies You Need Now | Ep 51

James: Welcome to the Furlo Capital Real Estate Podcast, where we dive into the intricacies of passive real estate investing. And our mission is to equip people to invest wisely in both properties and residents so that together we can build wealth while improving housing. I'm James and this is my wife, Jessi.

Jessi: I'm here and I made hamburgers for dinner. I actually, I was saved because I forgot that we had buns in the fridge and our son apparently will not eat hamburgers without a bun. I was like, whatever, just eat the patty. Like, I don't know, chop it up. And he was like, that's not a hamburger. I Hopefully we have buns, and he found some, so.

James: Cool, cool. It worked out. Yeah, and when we tend to make burgers, we don't do them on a grill. Typically, we just do them on a little pan. Pan fried, is that what that is?

Jessi: Yeah, pan fried burgers. Sure, technically,

James: right? Pan grilled burgers?

Jessi: I don't know,

James: it's a

Jessi: burger either way. It's

James: fine, works for me.

Jessi: Winter burgers.

James: Winter burgers! Yeah, I like burgers, I can eat a lot of burgers. Winter burgers. Alright, question, if you, let's see, if you were stuck with having to eat hamburgers all the time, or, I guess let me rephrase this, if there was one food that like, this is what you're stuck eating the rest of your life, this one thing, what would it be?

Jessi: Pumpkin pie.

James: Pumpkin pie, huh? Done. Just all three meals, everything. Oh yeah. Wow, I feel like that would cause a problem after a while. My answer is pizza, because I feel like you can also get a lot of variety in there. And it's just like, it's a good, but it's a good, but it's a, even if it's the same topping every time, it's a good mix of all the different types of food groups.

Even within, like within

Jessi: the slice, there's variety.

James: Correct. Correct. Yeah. I don't know that. It was cheese pizza. I don't know so much. I mean, there's got

Jessi: to be some pretty extreme circumstances for me to be eating one thing the rest of my life. Well, I'm glad

James: you bring that up because today we are going to be talking about exploring extreme circumstances, specifically talking about stress testing deals.

And part of doing that is going to the extreme of a thought process, right? Of saying, Hey, maybe you like, you like this food. Awesome. How much do you like this food? How far are you willing to go? At what point in time does this mental model of yours break? Yeah. So so that's what I'm talking about and it's all important for all sorts of issues, right?

It's good for identifying risks to keep with this food metaphor we got going on. Right. What's the downside of you just eating pumpkin pie? Malnourishment, eventually. Yeah. There's probably some obesity in there. Who knows? I don't

Jessi: know. I mean, three slices a day. That's reasonable. I think,

James: I think the other thing too, is it helps you overcome overconfidence, right?

If you're like, Oh, this is like, you make that initial, I could eat this all the time, right? Yeah, it's so good. The, the value of stress testing something is like, all right, well, like, let's actually play that out. What does it look like, right? And you were already starting to hedge in your comments there, right?

Like, your initial reaction was like, pumpkin pie, easy. And you're already in like, Okay, let me think about it. And that's the part of, that's the point of the stress testing, not just to make these overconfident off the cuff assumptions, but to just like to spend a little bit more time

Jessi: through. Yeah.

Yeah.

James: And I think it's also just important to smart investors just don't, they're not afraid of uncertainty instead of they plan for it. They plan it for the unknown and they're not afraid to ask like, what could go wrong and how do we ensure that. Whatever this thing is doesn't sync us.

Jessi: Okay. Yeah, so you don't necessarily know

James: Maybe you could do pumpkin pie the rest of your life.

Jessi: Yeah. Yeah, I don't know you don't necessarily know but you You're like poking holes or, or at least taking things to their logical conclusion to, to try to estimate what would happen.

James: It's a fundamental mindset of saying, I don't actually know what the outcome

Jessi: is,

James: and I'm okay with that,

Jessi: but you're considering all the possibilities,

James: explore different tendrils of options.

Yeah, that

Jessi: makes sense.

James: Yeah. And there's there's a couple of different sources that, that I use. One of them, I don't even think I wrote it down. It's the, it's the art. of, what is it called? It's the Art of Scenarios, the Art of the Long Term. That's it. The Art of the Long Term. Which is this whole idea of long term.

But we're gonna get to that in a little bit. It's a really good book. It's, it's an okay book. But there's really, there's two ways that you can think about scenario planning. There's your short, short term. Like your micro, thinking about some key variables. And then you have your long term, which is more macro, and that's more like, what are your, what are those bigger driving forces going on.

And depending on when you're looking at a deal, and you kind of want to pay attention to both, but, like, you want to either zoom in, weigh in on like, okay, what's happening right here, right now, or zooming out. So, on the zooming in, I bet you can guess what some of those like, key metrics are that you want to take a look at.

Jessi: Like, is the property in good condition?

James: Yeah, that's a known thing, right? This is more like, okay, yeah, yeah, yeah, okay, great. So, it's less of like, looking at it today, it's more of like saying, this is what I think it'll be tomorrow, six months from now, a year from now. It's like, what's a very key metric that's really important that you don't technically know six months to a year from now?

Jessi: How much it will rent for? Yeah,

James: yeah, that's a huge one. Yeah, what are the market rents going to be? I mean,

Jessi: you kind of could make some assumptions, I guess. Right,

James: well, that's the point. It's recognizing that it's an assumption,

Jessi: that

James: you don't actually know. And obviously, the nice part about having, like, say, a multifamily, is you have a lot of other data to go with.

If it's a single family home, you obviously have a lot less.

Jessi: If

James: you are fixing up the units, you have a lot less. Yeah. And there's those kinds. Other ones would be occupancy rates. Oh, and even on the, and

Jessi: does that change? Oh, yeah, totally

James: does. It's it's it's very low in this area right now. But yeah, generally, like, for example, think about we're near OSU campus, though, the occupancy, like the rent rates are very different springtime.

Oh, you

Jessi: mean like vacancy? Yeah. I was thinking like how many people could stay in a unit or not. No, that's pretty stable. What's the occupancy? There are

James: discrimination laws for that one. There's rules about how many people. It's a cheaper bedroom plus one by the way. It's

Jessi: like vacancy. Yeah, that changes over different seasons.

Yeah, yeah, yeah.

James: That's fair. Oh, and I would also say in terms of like for the rent piece of it too, it's not just what do you think it is in six months from now, but like what's your annual growth rate that you give to it? That's a huge assumption. Yeah. That you just, you just don't know. So that's on the revenue side.

Okay. And then you have, The expense side of things. Maintenance costs. Yeah.

Jessi: Or like if you don't know if something's going to break or not. Yeah. Yeah.

James: Repair and maintenance costs are definitely one of them. And so that's an area where you can, you can tweak those assumptions up and down.

Jessi: Yeah. Depending on.

A lot more conservative or not.

James: Yeah. And that's a huge one for like when we're flipping a property.

Jessi: Mm hmm.

James: And we're going to be spending a significant amount of money on the rehab.

Jessi: Yeah.

James: It's really important to scenario plan those out. Hmm. And say like, okay, what do we do if. If costs end up being not just 10 percent higher, but 30 percent higher.

What does that look like? What's, what's my break even point where man, if costs get out of control, like we're okay with it being this, but man, if it goes even higher, I'm in trouble.

Jessi: So as you're stress testing this out and going through those scenarios, do you create. Like contingency plans for, you know, if you, for example, like, like in the one that you just said, if costs end up being 30 percent more than you initially planned on or calculated, like, what do you do?

Do you raise more funds? Do you just punt? Do you walk away? Like what are like, you know what I mean? Do you think through the answers as well?

James: Yeah. And, and usually at the time that you're doing the stress test is at the acquisition side. So it's before you bought it. And so you might be saying, you might say stuff like, usually it's a yes or no, right?

Yes, I can, I can handle 30 percent overruns and at least break even or something like that. But if I think there's a high probability that it would go, it could go beyond that. Like, I just don't buy it.

Jessi: Yeah.

James: And then I suppose you can have a situation where you say, if it gets above this, we're gonna like, this is all gets dynamic really quick, right?

If you're like, well, we're not going to finish the garage. Now, the price that you can sell it for 1 to 4 goes down, and so there's, there's some trade offs there.

Jessi: That makes sense. Yeah. But you're thinking through that ahead of time. Correct. Yes. So that it's not a surprise. Yes. Yeah.

James: Correct. Yeah. And then there is the exit side of things, right?

You've got how long are you holding it on? How long are you holding on to it for? If it's a flip, you know, we're talking in terms of months. Yeah. If it's a syndication, we're talking in terms of years, that kind of stuff. And then you have your What, you're actually gonna sell it for? Yeah. Number. That is a huge assumption.

Jessi: And,

James: As I pick up my paper that I dropped it's, you know, that's, that's ginormous when it comes to calculating your final return. Yeah. Right? Being off by 10 percent on your final sales price. Yeah, that's significant. It's massive. Yeah. Yeah, that's worse than messing up on your construction cost.

Yeah. Typically. And so so that's a big one. And then if you're refine, if you're refinancing it, Assumptions about like, well, what loan devalue can I get on the loan? What are the interest going to be? Those are all different variables that play into this thing. And so there's a bunch of different tools that you can use to figure this out.

The first one is simple scenario analysis, right? You, and I, this is probably the one that I, I start with. It's like, okay, well, what if we do this business model, this plan? What if we do this or this? What if we structure the deal this way? What does that look like? And just kind of, Are you like, writing

Jessi: that out in a spreadsheet, on a whiteboard?

Yeah, I've got a spreadsheet model

James: that I'm doing it with. Alright. Yep, yep, yep. Another one, and I do this one a lot with with Flips, is what's called a Monte Carlo simulation.

Jessi: Oh, yes, you've talked about this before. Yeah,

James: it's super fancy.

Jessi: I don't fully, I can't fully wrap my head around it. Okay,

James: so, essentially, You run a lot of scenarios.

I do a thousand. You could do, you know, whatever, 80, 000, a hundred thousand computers, make it easy to do a lot of them. And then there are certain variables that you pick that are key variables. So in my case I have three of them. I have, what is the hold time? How long am I going to hold onto the property?

What do I think the rehab costs will be?

Jessi: And

James: then what do I think it will sell for when it's all said and done?

Jessi: Okay.

James: So like for example, on the, on the cell phone, the ARV part, I look at comps and go, okay, houses that were similar in size and condition and whatever area they, they had a, they sold for as little as this and they sold for as much as this.

And so I get a range in there and then what the simulation does for each one, it picks a random number within that range to go, okay, what if it sold for? Like this one, sometimes it's in the middle, sometimes it's near the top, sometimes it's near the bottom. And it's, and it tends to be a normal distribution, evenly distributed between between those two.

And then it does the same thing for the hold time and for the rehab costs. Oh,

Jessi: at the same time. And the rehab

James: costs are another one where it's, I've got a, I think it could be as cheap as this. I think it could be as expensive as this. And then it picks a number in between that range. And so it's picking one random here, one random here.

And so every. all different scenario. All the thousand scenarios technically have different inputs. Yeah. So they're all slightly different outputs. Uhhuh, , and then it does, it just goes through and it does all the math and says, okay, here's what your profit should be. Interesting. As a result of it. And then it, you can average 'em all together.

Jessi: Yeah.

James: Or look at the range of 'em really. Right. And try to get a sense for, yeah. And then you have the numbers that are, and so now you have. Your scenario, which is like you're, you made a, you made a single point estimate for each of those things. Then you can compare it to the Monte Carlo simulation to go, okay, where does my guess land within there?

Jessi: Okay.

James: Yeah,

Jessi: that makes more sense.

James: Yeah. That's kind of the, that's kind of the idea behind it. You can also do just a sensitivity analysis, similar idea. And I do a lot of these with a, with a syndication piece where you're not necessarily modeling out the entire thing thousands of times, but you're more saying it's more like, Hey, maybe I have these five different levels.

Like what if I could sell it at you 10 percent more or 10 percent less or 15 percent more, 15 percent less. And you just kind of, you just play, it's essentially doing scenarios But for a very specific measure that you're playing with and it lets you look at all of them at once and kind of see different outcomes and rates.

Jessi: And then as you're, as you're putting in the different rates or switching the numbers around, you're also comparing that to what you know about the market and Correct. Yes. You know, you're not just choosing a random number. You're like, okay, I think there's a range in here. What if I could get at the top of that range.

What would that look like? Yep. What if it was at the bottom? And yeah, yeah, yeah, exactly. And that's like a negotiating tool as well. If you're talking about doing all of this before buying a property, you know, theoretically you can be like, well, I think my expenses are going to be this much, my, I can only sell it for about this much.

And you, you've tweaked the numbers to know like, okay, I think I get the best return.

James: And I think importantly, it. It helps me just know how conservative I'm being in these models and how much play do I have to where again, like, Ooh, this is a breakeven point here. Or, you know, cause there's times where it's like, man, in order for this thing to work out, I actually need to have 95 percent of my units rented all the time, which is like, like the numbers technically work, but in my head you go, Ooh, that's not actually a lot of buffer on it.

Yeah. So there's things like that. There's a couple of mistakes that sometimes people make. The first one is. They actually just make really, really complicated models and they look for small nuances and difference. So one of the things that like, I enjoy the scenario planning, I think it's important, but at the same time, before me to buy a deal, it has to be obviously good.

Jessi: Yeah.

James: You know, one of those where it's like, even at a high level, dumbed down model,

Jessi: I'm

James: like, this makes sense.

Jessi: Okay. I may

James: not be, it's directionally. I go, this is a good deal. Yeah. There's maybe some nuance here that I'm missing, but. It's a good deal. Am I going to make 35 grand or 30 grand? I don't know, but I know I'm in that neighborhood.

Am I doing the more complicated model? I can then say, Oh, it's actually a 32.

Jessi: 5

James: and, and have a more, have a better estimate and know like, and there's a 20 percent chance that it's actually higher if these things work out. And then I can manage towards those specific risks.

Jessi: So you're saying it's better to have a more complicated model or better to have a more simplified model?

James: I think it's yeah, I didn't order very well. It's, I think it's It's the risk is you get caught up in all the small number differences where you might say, Oh man, go back to my, my example, you go, man, at 32, 000, like this isn't a good deal, but at 32 five it, it, it crosses into, yes, it's a good deal.

Like those situations, that's not obviously good. Right. Where you're like, in order for this to work out some, I have to have 51 or 51 percent of my scenarios turn out good. Yeah. Like that's. That's too, like, that's too nuanced of underwriting. Again, you want it to be like, oh, this is obviously good.

Jessi: Yeah, I think that makes sense.

I mean, you kind of want to do both. I would think, just so that you have more accurate numbers. Yeah, no, I agree. But, if it passes the sniff test at the less complicated model, then it's like, okay, yeah, I know it's a big deal. Now I can

James: figure out the specifics. Correct. Yep, yep, yep. Yep. You got it. And I think there are just another risk is you just aren't using overly, too overly optimistic of assumptions on stuff where you're like, man, these costs really aren't going to go up this high and we will be able to turn this thing quick.

And like, I think there's just a lot of that, that you gotta, like, that's a risk. I know

Jessi: for myself, if I made it too complicated, I would just confuse myself and be like,

James: Oh,

Jessi: what was I talking again?

James: Yeah. Yeah.

Jessi: So. Yeah. So that's,

James: so that's a lot of like the short term just looking at the variables for that specific deal.

But then there are also longer term macro driving forces that I think are also good for looking at. Just as, and, and now we're talking five, 10, 20 years down the line, right? And I got a bunch of them. And there's your obvious one here to guess. It's pretty obvious. Big macro. Natural disasters.

Jessi: Economy.

Yeah, yeah.

James: Yeah, economic trends, right? So you're thinking about things like inflation. interest rates, market demand, just your, your normal economic stuff. You want to, and those things move slowly enough. Yes. There's a lot of jittering that happens in the short term, but there are some really like not too hard bigger trends.

Yeah. Yeah. Especially like market demand type of stuff. Sure. Here's a fun one. That's hard to do technological advancements

Jessi: and their

James: impact on. business, whether that's remote work or just the software that's involved. Obviously generative AI right now is this like big unknown that's kind of like, yeah, what will the impact be on our investments 20 years from now?

I was just I was listening to this podcast earlier today and it was talking about It's a Cheb, Cheg, C H E G, I think, E G G. Their stock price has dropped 99%.

Jessi: Yikes.

James: Because what it used to be was it would take a bunch of educational content,

Jessi: Huh.

James: put it together, and then they would help students study for tests.

You know, it was like a study aid type of thing. Yeah. And students have stopped using it, they just now use ChatGPT to help them out with their study and to answer questions.

Jessi: Mm hmm. And

James: their company, like They're not even sure how they're going to be able to pay their bills type of thing. Like it's not good.

And so there's one where it's from an investment standpoint. Oops.

Jessi: Yeah. You know

James: yeah. And, and part of the thought that they were also talking about with generative AI in particular is how about this? So ad agencies typically used to charge per hour to do their creative work. Well now like to come up with like 20 different ad ideas, well, now what they do is they come up with five.

And then they use chat GPT to say, Hey, give me four alternatives for these to get to their 20. And so projects that used to take. I don't know what's a reasonable number of hours, a hundred hours to do they're now doing in like 20 and traditionally ad agencies charge per hour. And so all of a sudden, right, they're watching their revenue per customer drop.

And, and so there's all sorts of like, what's that business model going to look like going forward in the future? Law firms, the exact same thing, right? Where there's going to get a lot more automation, a lot more assistance. And so there's all these companies who used to charge per hour. Now what? I think about like, for example, property management, there's a percentage based on the rent.

What's going to happen in the future with software and automation that could render that particular business model done or does not make sense. Or you watch revenues dramatically fall because somehow one of the cost things is like intense to the human side of it just disappears.

Jessi: I

James: don't know. And so those are like some of those are some of those longer term questions that you want to wrestle with.

Another one are social dynamics, right? Shifts in tenant preferences. Could just be as simple as urban, suburban, again, you can go like, do I want a home office or not a home office? Are we going to do a co living thing because I want to hang out with my friends or do I want to be all by myself? And the trend, by the way, has been more and more solo, living all by yourself.

But those are the kind of trends that you want to pay attention to. Regulatory risks, right? Geez, what was this now, a month ago? We were talking about different policies and now we know which person won. And. We at least know which ways policies are leaned, right? Like, some of those can have an impact on us.

And so so those are worth talking about. It could be like zoning, rent control, even more potentially. Though, knock on wood, I feel like Oregon has kind of settled into what it is right now.

Jessi: For now.

James: For now, we'll see. Probably

Jessi: will change.

James: And so what you want to do, I don't know. With those different areas, and this is the art of the long term Stewart's, I think is his last name.

He he talks about doing essentially like, Like game it out, narrate it out, tell the story, not just like, it's more, so it's less quantitative, right? So the, like the micro stuff I was like, we're throwing it into a spreadsheet and it's a model. This is a lot more of I mean, you just kind of feel it, right?

It's

Jessi: like scenario planning, almost

James: qualitative type of thing. Like, Oh, what do you think the impact on this? Well, cause I

Jessi: mean, a lot of those are not, some of them are, but a lot of them aren't like measurable in the sense of like,

James: even if they are, Like you're not going to measure 20 years out, right? So he actually recommends to do three different types of scenarios.

The first one is you stable market, modest growth, essentially status quo. Things keep on the way that they are with a little bit of growth. What does that look like? Again, just, you could do the numbers piece. You could do a, you know, just more like, and he'd sell and he is like, Tell a story, write paragraphs of stuff.

That's, that was his style of doing it, which, you know, I don't mind. And or the second, or I should say, and the second scenario is it's a sudden economic downturn, like, or, and it could be like with high unemployment or whatever, right? Things go like not in your direction at all. And then the third one is the other direction, right?

Rapid market growth. Of some other of one of those areas that could benefit you or not. And maybe that's part of the, like, you choose like one of them, right? Interest rates, right? Rapid increase. Okay. What's that impact going to be for us? Or rapid decrease. What does that look like? Essentially do, do the base case and then do some extremes to see what that looks like and run through the ones that you think are are important to you.

Jessi: Which is similar to the micro, your, the micro assessment, you're creating these ranges. Of like, okay, what if this extreme happened or that extreme happened? Where do I follow? And it's, you're right. It's, it's different measures, but essentially you're doing that same thing, creating a range of like, all right, we're, it's probably going to fall somewhere in the middle, you know, but,

James: and I, and I think there's some things and

Jessi: extremes.

James: And one of the things that he recommends is that you don't think too narrowly. Right. So, and I, and I've kind of already brought this in. Right. So like generative AI. Is an example of a more broad, like, yeah, he's this thing that's not investment related, but I can already point to a couple other areas, industries that will impact.

And so to kind of borrow from that and say, okay, what will this impact be on our investing? I think you know, there's some bigger ones that you could, that you could game out as well. I just think, yeah, on the, on the on the regulatory side of things, right? If let's say tariffs get enacted.

And, and so therefore the cost of goods being shipped, imported into the United States go up, like that could have a very, that could have a profound effect on say construction costs potentially or something depends on what it is.

Jessi: Well, I could see, you know, even affecting if people's expenses go up, they may not be able to afford, you know, higher rents or rents they're currently paying and that you have, Or

James: what's more likely is it just leads to rapid inflation and, and therefore you go, okay, what's going to be, what are some of those things that are going to happen to offset it potentially again, kind of all depends on what it is and how it goes down.

But that's what that, but that's the point, right? The potential is that thing that you want to model out. And, and his point isn't just say like how do I say it? You want to have that open mind about it, right? You want to say yes, they could come in and things could go up or they could go down or they could stay the same, like game it out.

And you want to look at your business model, your business plan, your investment strategy and say, what happens? How do I hold up on this? Are there certain checkpoints where, Hey, if this happens, I need to go back and reevaluate my portfolio and make a move sooner rather than later. Like that's his point.

Yeah. His other one is another. This was interesting is ignoring black swans. Those are low probability, high impact events.

Jessi: Like a natural disaster.

James: Yeah, that's a great one. Yeah. What happens if there's a massive earthquake, and it causes a problem. What happens if the

Jessi: world explodes? Yeah, yeah.

James: What if World War III starts up? You know, that kind of stuff. Yeah. Low probability, but Some

Jessi: would say higher than others, but

James: At this current moment in time, yes. But higher impact. Yeah. You know, very high impact on what happens. Mm

Jessi: hmm.

James: Yeah. And he

Jessi: says, ignore those?

James: No, he says that, that's the mistake that people make.

Oh,

Jessi: that's the mistake. I was

James: like, no,

Jessi: no,

James: no. He's like, and the answer might be like, I don't know, man. We're hosed. It was okay. And, but that's where things like productive paranoia come into it. That's the, that's the Bill Gates principle saying like, yeah, I know. Like, what should we do?

Jessi: You don't want to be, you don't want to be shocked.

And if you think through all the extreme possibilities, then when you come up against different scenarios. You won't be shocked. Yeah. You're like, this isn't as bad as what I thought. Another,

James: Another like low probability, high impact would be what if, hypothetically, this isn't hypothetical you have a property manager who stops paying distributions for a couple of months,

Jessi: right?

That's one of those,

James: like, wow, that's a black swan type of thing. I wouldn't normally expect it. What do you do? What's your reaction? Yeah. And how, like, yeah, what do you do when something like that happens? Yeah. Again, I wish that was just a random hypothetical, but oh, well we might share that story someday in the future.

But anyways, that's that's the kind of stuff that that you want to think through. And so I think when you combine those two things together, right, when you are thinking first and foremost, longterm, okay, what are those big forces? this will, this will influence the type of investments that I make or that I stay in the directions that I go.

And then once you've kind of categorically decided like, okay, this makes sense for me. long term given where I think things could go. That's where you look at specific investments and you get more micro and you focus on those key variables and saying like, okay, now I want to stress test this thing. You know, with doing some actual financial modeling type of stuff.

And so anyways, I think combined that is how you, that's how you think about different scenarios and different risks and like that's how smart investors do it.

Jessi: Yeah,

James: there you go. And I like to think that we are smart investors. As you can guess, we do a lot of that kind of stuff. And so if you are into that, we would love to partner with you and have you join us.

And so you can check us out at furlo.com to learn more about our investment thesis and how we think about investing just in general. And so with that, thanks for listening and have a great day.