What Is a Reasonable Downside Case?

A reasonable downside case is a set of adverse assumptions that are linked to each other and traced through cash flow and the loan until they reach equity proceeds. Its severity is judged by where the deal first misses an obligation, such as debt service or a maturity refinance. A single lower return target or a flat haircut to sale price does not show that path.

Why the downside is measured from a base that may already carry a cushion

A downside case is only as informative as the base case it departs from. If the base already builds in a rising exit cap rate, the stress has less to add, and the gap between the two cases understates the full shock. Cap rate is one year of net operating income divided by price, so any drift in it changes the sale value directly.

One development base case assumed a 5.75 percent exit cap rate and then raised it by 10 percent on a straight line basis, at 2 percent per year. Exit cap rate is set by the market and sits outside management control, so a cushion there is a pricing assumption and not an operating result.

In one fund presentation, the downside case showed an 8 percent IRR and the base case showed 17 percent, both stated after fees and promote. The upside case was 23 percent.

A positive downside IRR means the case still returns equity with a gain. The useful follow-up asks which inputs produce it, and whether fees and promote are treated the same way in each case.

“Our base case capitalization rate on exit already assumes a 10% increase in the rate. We do this on a straight line basis and increase the rate 2% per year.”

The chain from an adverse input to equity proceeds

Every downside input reaches equity through one of four doors. Occupancy and rent set net operating income. Borrowing cost sets debt service. Construction cost and schedule set how much capital is needed before income starts. The exit cap rate converts income into price.

Occupancy, net operating income, interest rates and construction costs are the variables that deal screening stresses to find the level at which a deal breaks.

Price equals net operating income divided by the cap rate, so a case that moves both inputs reaches farther than a case that moves one. A lower income figure and a higher cap rate compound.

Equity is the residual. Sale proceeds to equity equal sale price minus the loan balance minus selling costs, and the loan balance does not shrink when price does. Any percentage fall in price therefore lands on equity as a larger percentage fall.

How severe is severe: reference points from bank stress scenarios

Supervisory scenarios for large banks assume a 40 percent decline in commercial property prices amid a severe global recession. The trough comes after roughly two years, and prices are still below their starting level when the scenario ends.

The projected loss rate on commercial real estate loans in that scenario was 8.8 percent, the same as in the prior round. An earlier scenario that paired a 40 percent commercial price decline with a 30 percent house price decline projected 8.3 percent.

Loss rates in hypothetical portfolios under one severely adverse scenario depended heavily on portfolio quality. Lower-risk portfolios lost 3.5 percent and typical portfolios lost 4.1 percent. Higher-risk portfolios lost 14.0 percent.

A separate stress applied 20 percent defaults and 40 percent loss severities to the office and retail loans of every bank over three years. The worst-case result was a 30 basis point reduction in Tier 1 capital for the most exposed banks.

These are loan-level and portfolio-level measures for lenders. They calibrate how deep a market shock can be, and they are neither a forecast nor a standard downside for one property. Equity sits beneath the loan, so a price decline that produces a single-digit loss rate for a loan book can consume the equity in a deal carrying a high debt ratio.

Development stress and stabilized stress fail at different points

In a development deal, time is the first input to test. A longer schedule extends interest carry and other project costs before rent begins, and the extra cost is funded by equity or by contingency. In one illustrative development stress test, the base case assumed 18 months of construction and the stress added two months.

The same test cut exit price per square foot by 25 percent, and the equity multiple fell from 2.6 to 1.4 in the high-stress scenario. Stacking a schedule delay on a price cut compresses a development multiple quickly because both shocks hit the same dollars of equity.

For a stabilized asset, the pressure point is usually the loan maturity. Lenders apply their own coverage and loan to value tests, and thresholds differ by lender, so the case reports income and value next to the loan balance and lets any lender test be run against those figures.

The two stages can share an exit value and still fail at different places. A development can run out of completion funding years before a stabilized asset faces a refinance.

“The price per square on exit in this stress test has declined from $306 per square foot to $228 per square foot, a 25% decrease in exit price.”

Worked example: a hypothetical 25,000,000 stabilized asset under base and stressed inputs

Both cases share one capital structure and one five-year hold. The purchase price is 25,000,000 at a going-in cap rate of 6 percent, which implies net operating income of 1,500,000 (25,000,000 multiplied by 6 percent). The loan is 60 percent of price, or 15,000,000, so equity is 25,000,000 minus 15,000,000, or 10,000,000. The loan is interest only at 6 percent, so debt service is 900,000 per year. Acquisition and sale costs are ignored. All figures are hypothetical.

Base case: income stays at 1,500,000, so cash after debt service is 1,500,000 minus 900,000, or 600,000 per year, and 3,000,000 over five years. Exit at a 6 percent cap rate gives a price of 1,500,000 divided by 0.06, or 25,000,000. Sale proceeds after the 15,000,000 loan are 10,000,000. Total equity proceeds are 3,000,000 plus 10,000,000, or 13,000,000, an equity multiple of 13,000,000 divided by 10,000,000, or 1.3x.

Stressed case: income falls by 100,000 (1,500,000 minus 1,400,000) to 1,400,000, and the exit cap rate is 7 percent. Cash after debt service is 1,400,000 minus 900,000, or 500,000 per year, and 2,500,000 over five years. Exit price is 1,400,000 divided by 0.07, or 20,000,000, which is 5,000,000 below the purchase price, a 20 percent decline. Sale proceeds after the loan are 20,000,000 minus 15,000,000, or 5,000,000. Total proceeds are 2,500,000 plus 5,000,000, or 7,500,000, an equity multiple of 0.75x and a loss of 2,500,000 on 10,000,000 of equity.

The 20 percent price decline cut sale proceeds to equity from 10,000,000 to 5,000,000, a fall of 50 percent, because the loan stayed at 15,000,000. Loan to value at exit rose from 60 percent (15,000,000 divided by 25,000,000) to 75 percent (15,000,000 divided by 20,000,000).

The decision test sits at maturity. If a refinance lender sized the new loan at 65 percent of value, the stressed asset would support 13,000,000 (20,000,000 multiplied by 65 percent). The existing loan is 15,000,000, so a 2,000,000 paydown would be due from equity or from other sources. A return table alone would not reveal that gap.

Common mistakes in building a downside case

Cutting the exit price while holding income flat leaves interim cash flow at the base level. In the example above, that overstates five-year cash by 500,000, the difference between 3,000,000 and 2,500,000, and it hides the fact that a lower price and lower income usually arrive together.

Reading a lender loss rate as an equity loss confuses two positions in the capital stack. A projected loan loss rate of 8.8 percent describes a book of loans after a 40 percent price decline. In the example, a 40 percent decline takes 10,000,000 off the 25,000,000 price, leaving 15,000,000, which equals the loan, so the equity is fully absorbed.

Applying a portfolio scenario directly to one asset ignores mix. Hypothetical portfolio loss rates ranged from 3.5 percent for lower-risk to 14.0 percent for higher-risk under the same macro scenario, so the shock does not translate into a single loss figure for any one property.

Treating the base-to-downside gap as the total shock misstates it when the base already carries a higher exit cap rate. The stress should be labeled as an increment above that adjusted base.

Comparing a downside return net of fees and promote with a base or upside return that is gross mixes structure with scenario. Part of the gap between the cases then comes from the waterfall and has nothing to do with the market.

Questions that test whether a downside case is decision-useful

Which inputs move, and through which door does each reach cash flow or price? Each stress needs a mechanism, and a collection of unexplained haircuts does not supply one.

What does the base case already assume? A base with a rising exit cap rate or a built-in cushion changes how far the stress has to go to mean the same thing.

Where does the first constraint appear? Completion funding, debt service, refinance proceeds and sale proceeds each run out at a different point, and the earliest one defines the failure.

At what net operating income and exit cap rate does sale price equal the loan balance? That break-even pair shows how much room the equity has before it is gone.

Do schedule and cost shocks extend carry in the same timeline? A delayed delivery that leaves interest and project costs unchanged leaves the shock incomplete.

Are returns shown net of the same fees and promote in every case? Consistent treatment keeps the scenario effect separate from the structure effect.

How does the severity compare with documented reference scenarios? A 40 percent price decline is a published supervisory benchmark for banks, and a case far milder or far harsher is worth explaining.

Who absorbs the shortfall if refinance proceeds fall short of the loan? Sponsor capital that sits first in line for losses changes the answer for investors.