The Costly Mistake Most Investors Make When Underwriting Apartment Expenses
The formula for building wealth in the apartment space seems pretty straight forward:
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- Buy an under-performing asset
- Increase the top-line revenue
- Decrease expenses as much as possible
Pushing the top-line and compressing the middle (expenses) increases the NOI, which capitalizes into higher value. That’s the theory, and if you execute correctly, the theory does work.
What’s Hard About it?
On the above list, there is one item that is harder than the rest, one item that is responsible for most failures in this enterprise. It’s item #3.
Indeed, while it takes effort and research to know what rents should be, once you do know, the business plan of driving rents is, at least on the surface, sort of obvious.
Caveat: To prevent the likes of Brian Burke and Serge Shukhat ripping into me regarding the statement above, let me just say that nothing is easy. Rent amount has an inverse relationship to a lot of the economic losses we sustain; therefore, driving rents is a balancing act that is anything but easy. However, for the purposes of this discussion, simply knowing that comparable units are renting for $75 more than the subject does make it easier to underscore the value-add proposition and strategy.
However, expenses—that’s really, really hard. Estimating what to expect in terms of expenses is a multi-step process, and some steps are just not easily accessible to all. Let’s talk about it…
This is What Most People Do
Most people look at the pro-forma provided to them by the seller or the broker—and stop there.
There are several issues with this. First of all, pro-formas can be either based on actual financials or on broker’s projections of financials. If based on actual financials, there is some value to the pro-forma in that we can perhaps glean why the property is being sold. The fact is that most of the time, the reason the property is being sold is because the owner is unhappy with it, meaning it loses money. If so, looking at the owner’s numbers can perhaps underscore where the owner has gone wrong and how we can do better.
However, this requires us to assume that the owner did not lie, which is somewhat of a stretch. And as to broker’s pro-forma, this is always based on pie-in-the-sky assumptions and should be ignored for the most part, aside for this:
We can assume that broker’s numbers result in a suggested price for a reason. That reason is the seller’s expectations. So, by looking at broker’s pro-forma, we can establish a pretty good idea of where the seller’s thinking is, and from here, our job is to see if we can get close enough to be competitive.
This is where most people stop… not good!
Understand, looking at pro-formas of any kind is looking at past performance. While the above paragraphs underscore some reasoning behind knowing past performance, what we really care about is future performance. In steps one and two, we isolated value-add proposition relative to revenue, but what will this thing cost to run—really?!
To underwrite these expenses, we must start with some sort of averages that are applicable across the industry. For example, I can’t tell you how many times I’ve seen a pro-forma that indicates a payroll expense of $19,000 for a 120-unit building. Immediately, if you’ve done any studying up on this, you should know that the industry average is one employee per 40 doors. This varies, of course, but this piece of knowledge on its own should tell you that there is no chance in hell you are employing three people at a cost of $19,000. This means that right off the bat that your NOI is going to be about $120,000 less than the pro-forma, and any chance at a deal hinges on you finding that money elsewhere.
Now, let’s say that the pro-forma is more realistic and includes $950/door worth of payroll. Typically, it costs more than that in even very large buildings, but in a 120-unit I would want to be safe, and personally I’d underwrite $1,200–$1,250/door.
However, the pro-forma at least makes an attempt to be realistic here, and in my effort to get a deal I have to now ask myself, Is there any reason as to why payroll should cost less on this building, and can I bridge the gap of $250–$300?
If I can come up with a legitimate reason, then perhaps I can get closer to asking price. Perhaps the HVAC systems on this building include through-the-wall AC and baseboard heat. These are easy to work on, and on-site personnel can handle them. Furthermore, I neither need an HVAC certified mechanic on staff, which means I can pay less salary, nor will I be outsourcing that work to third party contractor, which means savings on contract services.
Thus, perhaps I can I can knock off my payroll by $100 and be comfortable around $1,150. And perhaps there is now rationale to justify contract services of $100/door less than I would typically use for forced air.
As such, I’ve mitigated $200 out of the $300 gap, which gets me closer to where I need to be. However…
THIS is the Problem
In order to complete this type of analysis, I must have good knowledge of industry standards of what things “should cost,” and I must have good working perspective on “WHY.” The problem with the “WHY” becomes evident via experience—there is just very little that can be substituted for experience.
And if we don’t know why things cost what they do, then we can’t make adjustments to the averages (even if we know what those averages are). And if not, we are just left looking at past performance and flat out guessing at the future.
Not the best way to buy multifamily.
How do you go about estimating expenses when evaluating multifamily investments?
Let’s talk in the comments section below.