Interest Rate Stress Test

Run the pro forma assuming your loan refinances in year 5 at 200 basis points higher interest rate than your entry rate. This stress test simulates rising-rate environments and the refinancing cliff many leveraged deals face.

Key takeaways

• A 200 bps interest rate shock is severe but realistic. Mortgage rates moved from 3% (2020–2021) to 7% (2023), a 4-percentage-point swing over two years.
• Refinancing at a higher rate increases annual debt service by 10–25%, depending on leverage and remaining balance
• Properties that survive refinancing stress are less vulnerable to macro shocks; those that don't must be de-leveraged or sold before year 5
• This test is critical for deals with balloons, adjustable-rate loans, or planned refinancing
• A deal that only works if rates stay flat is a duration bet, not an investment

Why 200 basis points?

Interest rates fluctuate within economic cycles. Here's the history:

• 2000–2002: Fed funds fell from 6.5% to 1%. Mortgage rates fell from 8.5% to 4%.
• 2003–2006: Fed funds rose from 1% to 5.25%. Mortgage rates rose from 4% to 6.5%.
• 2007–2009: Fed funds fell from 5.25% to 0%. Mortgage rates fell from 6.5% to 3.5%.
• 2010–2021: Fed funds near 0%. Mortgage rates stayed at 3–5%.
• 2022–2024: Fed funds rose from 0% to 5.25%. Mortgage rates rose from 3% to 7%.

A 200 bps (2%) move is well within historical norms. It represents a moderate, realistic rate shock, not an apocalyptic scenario. In the 2022–2024 cycle, many investors who took out 3% mortgages in 2021 faced 5.5–6.5% rates by 2023 at refinancing, a 250–350 bps shock.

Mechanics: how 200 bps increases debt service

Suppose you have a $1,000,000 loan at 5% interest for 30 years. Annual debt service is approximately $61,000 (principal + interest).

If you refinance at year 5 with $900,000 remaining balance at 7% (5% + 200 bps) for a new 25-year term, annual debt service becomes approximately $66,000.

The increase: $5,000 annually, or 8% higher than the original payment. On a $2 million property with $100,000 NOI, that's a 5% hit to net cash flow available to equity.

But here's the compounding danger: if you also face the occupancy stress test simultaneously (90% occupancy, 10% lower NOI), debt service is now consuming a much larger percentage of income.

Worked example: 50-unit multifamily with refi stress

Original loan:

• Amount: $600,000 at 5% fixed for 30 years
• Annual debt service: ~$38,000

Year 1–5 base case:

• NOI: $100,000 (growing 3% annually)
• Debt service: $38,000
• Cash flow to equity: $62,000 annually

Year 5 refinancing stress:

• Remaining balance: ~$550,000 (after 5 years of paydown)
• New rate: 7% (5% + 200 bps)
• New term: 25 years
• New annual debt service: ~$42,000

Year 6–10 in stress scenario:

• NOI: continues at ~$116,000 (year 5 NOI × 1.03^5)
• Debt service: $42,000 (new refi rate)
• Cash flow to equity: $74,000 (higher than years 1–5, because principal was paid down and rents grew)

At first glance, the refi doesn't seem fatal. You're paying $4,000 more annually, but NOI has grown, so cash flow is still positive.

But combine it with occupancy stress:

Year 6–10 combined stress (90% occupancy + 200 bps rate shock):

• NOI (at 90% occupancy): ~$104,000 (10% lower than base case year 6 NOI of $116,000)
• Debt service (at 7%): $42,000
• Cash flow to equity: $62,000 (vs. $62,000 in years 1–5 at base case)

Still positive, but no improvement. The combined shocks cancel out any rent growth benefit. If occupancy drops further or rates spike even more, the deal turns negative.

When refinancing shocks hit hardest

Refinancing stress is most dangerous when:

1. You're near the break-even point: If your base-case year 5 NOI is $48,000 and debt service is $46,000, a refi bump to $50,000 debt service (200 bps shock) turns year 6 cash flow negative.

2. You have an explicit refi plan: Many deals are underwritten with a two-step strategy: buy, stabilize for 3–5 years, then refi and hold longer or sell. If refinancing rates have risen, the refi plan fails.

3. Your LTV is high (70%+): The remaining balance after 5 years is still substantial, so a 200 bps shock impacts debt service significantly.

4. Rates are already elevated: If you're buying at 6.5% and stress to 8.5%, you're modeling a worst-case environment. More realistic: buy at 5%, stress to 7%.

Debt Service Coverage Ratio (DSCR) as a check

Professional lenders check DSCR = NOI / Debt Service. Most loans require DSCR ≥ 1.25 at origination.

In the stress case, recalculate DSCR:

Base case year 5:

• NOI: $116,000
• Debt service: $38,000
• DSCR: 3.05 (very healthy)

Stress case year 6 (refi + occupancy):

• NOI: $104,000
• Debt service: $42,000
• DSCR: 2.48 (still strong, but lower)

If DSCR falls below 1.25 in the stress case, you can't refinance. Lenders won't approve a loan where debt service exceeds 80% of NOI. This is a hard constraint.

The "no refi" scenario: what happens if you can't refinance

If rates spike and your property can't refinance (DSCR too low or loan terms unfavorable), you're forced to:

1. De-leverage: Sell some assets or use reserves to pay down debt to achieve acceptable DSCR.
2. Hold and hope: Keep the property, hope rents grow and rates fall, and try to refi in 2–3 years.
3. Sell: Exit the property early, potentially at unfavorable cap rates.

The cost of "forced" refinancing or early sale can be substantial. If you were counting on a refi to fund a capital improvement or distribute equity, that plan falls apart.

How to structure refi stress into the pro forma

1. Mark year 5 as refi year in your pro forma.
2. Calculate remaining balance at year 5 (from amortization schedule).
3. Assume new term: Often 25 years (the original 30-year term minus 5 years elapsed).
4. Assume new rate: Entry rate + 200 bps. If you entered at 5%, refi rate is 7%.
5. Recalculate debt service for years 6–10 at the new rate and term.
6. Keep all operating assumptions the same (rent growth 3%, occupancy 95%).
7. Calculate new equity cash flows for years 6–10.
8. Compare levered IRR of base case vs. stress case.

Sensitivity: what if rates are only 100 bps higher at refi?

Build a sensitivity table:

Refi Rate	Year 6 Debt Service	Year 6 Cash Flow	Levered IRR (full hold)
Entry + 0 bps	$38,000	$78,000	14.2%
Entry + 100 bps	$40,000	$76,000	13.8%
Entry + 200 bps	$42,000	$74,000	13.4%
Entry + 300 bps	$44,000	$72,000	12.9%

If your required return is 13%, the deal survives up to ~200 bps of rate shock. Beyond that, IRR falls below target.

This tells you: you're comfortable with rates rising 200 bps, but not 300 bps. That's a reasonable risk boundary.

Refi stress in context of current market (2024–2025)

In 2024, mortgage rates are at 5.5–6.5%. If you originate a loan at 6.0%, stressing to 8.0% at year 5 refi assumes rates continue rising or stay elevated for five years.

This is plausible: if inflation remains sticky (3–4% annually) and real rates rise, 8% mortgages are realistic by 2029.

Alternatively, if you believe rates will fall back to 5% by year 5, you might stress to only 5.5% (a 50 bps increase), which is less severe.

Your rate forecast (or lack thereof) determines the stress assumption. If you don't know, use 200 bps as the conservative default.

When to fail the interest rate stress test

Walk away (or dramatically reduce leverage) if:

1. Stress case DSCR < 1.25: You can't refinance. The deal is trapped.

2. Stress case cash flows become negative: You're paying debt service from reserves, which is unsustainable.

3. Stress case IRR < 6–7%: Returns are too low to justify the risk.

4. Combined stresses (90% occupancy + 200 bps rate shock) turn the deal deeply negative: The deal is vulnerable to cascade risks.

The interest rate bet: recognizing it

Many overleveraged deals are implicitly making a bet: "Interest rates will not rise materially, or if they do, I'll exit before refinancing."

That's a market timing bet, not an investment. If you recognize you're making it, decide if you're comfortable with it. If you're not comfortable betting on rates, reduce leverage.

Interest rate stress flowchart

Related concepts

• The Pro Forma Spreadsheet
• The 50 bps Stress Test
• Rent Vacancy Stress Test

Next

You've now stress-tested cap rates, occupancy, and interest rates. The go/no-go criteria bring these together into a single decision framework: when to bid, and when to walk.