Using range of expenses in your profit / ROE estimates?

Using range of expenses in your profit / ROE estimates?

J. MartinPro Member
Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes

I know many members on BP use the 50% rule as a screening technique.. I was curious if anyone uses a range of estimates for expenses to estimate potential profit, rather than strictly 50% - either while they are prospecting, or after purchase..

For example, do you look at what your profit and ROE would be if your expenses sucked up 60% of your revenue? 40%? Decreased or increased rents? ("Stress testing") I think this is a more realistic way to assess the likely range of outcomes, rather than some "overly precise", but less informative calculations, where I see people estimating they will be earning $129.72/door this year, with a ROE of "approximately" 17.25834%..

I use a spreadsheet with 5 different columns and some have higher than expected expenses/vacancy, or reduce the rents by 10-15% to make sure I can handle less than ideal scenarios while still making a healthy return. For example, I may estimate an ROE of 8-12% (or whatever they might be) before principal paydown and appreciation, but after a plausible range of expenses. And I think my results will fall in that range a good majority of the time.. (approximately 82.7643% of the time.. just kidding!)

I used to only model my expected scenario and the downside risk. But I also do 1 or 2 to the upside now to estimate longer-term returns for some increased rents, which I also think is plausible. I learned years ago that if you only look at the negative, you may miss the boat on opportunities also.. If you don't price in your potential upside, you may lose out on lots of deals to others who are taking into account everything..

But this also gives you the ability to ask yourself, Am I comfortable with returns on the low side of that range if expenses are higher, or rents a bit lower, than I thought originally? Or if the market changes? Am I dependent upon increased rents to make healthy returns? Can I reasonably expect my returns to fall within that estimates the majority of the time? Thoughts? I think @Account Closed if he's got time for the forums..?

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Johnson H.Pro Member
Investor · San Francisco, CA · Member since 2010 · 910 posts · 889 votes
12y

@Bill Gulley - Ironic that you chimed in here as both J and I are bank examiners as well. =)

See this reply in the discussion

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  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Account Closed , good stuff..

    Nice, tight DSCR. Good for you. MF is favored out there, plus you're in a prime location (I assume down there), and I'm sure they take into consideration the strength beyond the subject property DSCR... (I'm assuming recourse beyond standard "bad boy" carveouts).

    I'm with you on the timing.. Could have been better; could have been worse. But I am very happy with what I have. Even if I had gone BK in the crisis and was living in a cramped studio, I could be happy. There's a lot in life to enjoy :) Even poor, I could take a beautiful free hike through the Presidio, Land's End, & Sutro Baths like I did last weekend... Honestly though, the CF doesn't hurt either lol

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    @Bill Gulley ,

    I'm not one of you. I'm an engineer. When I was taking my graduate courses in 1999-2001, my favorite professor said something that struck a nerve. He said "if I look at your nightstand, I know what you should be doing in life." Guess what I saw on my night stand? Real estate books.

    I've always love real estate, but how can you buy a $500k house at 8% interest rate to rent out for $2,000/month? At least my engineering side kept me out of trouble during those years. I left engineering on September 11, 2009 and never looked back. I've been a stay at home dad and do real estate part-time, or full-time, or no time. I seriously have no clue, but I bring home more money than my wife. That keeps her happy.

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    J,

    Believe it or not, the loan is non-recourse with Chase. Interest rate was kind of high when we locked it. 4.0% for a 5/1 ARM amortizes over 30 years. It would have been 3.9% for recourse.

    First Republic Bank offered us 3.7% recourse, with 30% down though, so we went with Chase at 75% LTV.

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Bill Gulley , as far as I can tell, Minh examines everything financial I believe, including probably more real estate deals than our loan review team! lol But he's not a bank examiner. Just me and Johnson. But I would be really interested to see how many there are.. I'm going to search around and see (sometime!)..

    I've heard about the 90's, I've heard about SNL's - have had some great fraud speakers and heard some of the greatest swindles around.. But in all honesty a lot harder to find than as many as are likely out there.. Seen some go down in the crisis. Closed a few banks, unfortunately. But I think most are just trying to make a living and and deposit/lend, especially in our community banks.. Bankers and I/B, etc aren't all evil or fraudulent. Just like all examiners are not overzealous or out to punish.. But it has happened..

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Account Closed , they say that they'll usually do non-recourse as long as you're strong enough to make your signature worthwhile.. then you don't have to sign! ironic.. Nice pricing though.. Did you ask how much more for a 10yr fixed rate on a 30yr am? (Not sure if you plan on holding on to these properties that long..) The yield curve has a decreasing steepness as you go out on the curve right now past the first few years. I have a feeling you've seen this link before, but if not, this is a "dynamic" chart that shows how the S&P performs next to a constantly changing "dynamic" yield curve over the years. How accurate is the inverted yield curve? How does the steepness foretell gains? hmmmm

    http://stockcharts.com/freecharts/yieldcurve.php

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    ...

  • Johnson H.Pro Member
    Investor · San Francisco, CA · Member since 2010 · 910 posts · 889 votes
    12y

    Bill, don't you miss borrowers with cash based businesses that have DSCR's of less than one but are always paying as agreed? =)

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    @Bill Gulley ,

    I see a common theme here. It seems like bank examiners are deep thinkers, but pretty chatty. However, the old guy can get cranky sometimes compared to the young guys. It must be the age thing. Unfortunately, we all will get there eventually. I'm not looking forward to it though. Sigh........

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y
    Originally posted by @J. Martin:
    @Account Closed , they say that they'll usually do non-recourse as long as you're strong enough to make your signature worthwhile.. then you don't have to sign! ironic.. Nice pricing though.. Did you ask how much more for a 10yr fixed rate on a 30yr am? (Not sure if you plan on holding on to these properties that long..) The yield curve has a decreasing steepness as you go out on the curve right now past the first few years. I have a feeling you've seen this link before, but if not, this is a "dynamic" chart that shows how the S&P performs next to a constantly changing "dynamic" yield curve over the years. How accurate is the inverted yield curve? How does the steepness foretell gains? hmmmm

    http://stockcharts.com/freecharts/yieldcurve.php

    J,

    I haven't seen those two charts. I'll study them when I have a little more time. Gotta go pick up food for my daughter's class Christmas Party, then pick wifey up to go there. After lunch, we go sign loan docs. There goes 3/4 of my day. 5:30pm, I hit the tennis court and probably won't be home till 8:30pm. :)

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    12y
    Originally posted by @Account Closed:
    @Bill Gulley ,

    I see a common theme here. It seems like bank examiners are deep thinkers, but pretty chatty. However, the old guy can get cranky sometimes compared to the young guys. It must be the age thing. Unfortunately, we all will get there eventually. I'm not looking forward to it though. Sigh........

    Hey, you call'n me cranky?

    LOL

    You just made me think of a senior examiner, the oldest too, all of us in loan review sitting there talking about anything, then someone would come in and he'd almost bite their head off for disturbing our work. I don't know, it might be age, that or it's out of frustration! You do get frustrated easier as you get older I guess. Dang kids! LOL :)

    Deep thinkers? Not all, I recall one who burned a hole with a cigarette in my seat in my new LTD, smoking with the widow down and reading the paper, he turned the page and knocked it out of his mouth it went flying into the back seat. He couldn't think his way out of a paper sack! But, yes, logical, analytical types for sure.

    I wanted to be an engineer in high school, my counselor said "no, you don't have the math for that!" So later, I chose finance and accounting! That's after they invented the financial calculator. LOL :)

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y
    Originally posted by @Account Closed:
    @Bill Gulley ,
    I see a common theme here. It seems like bank examiners are deep thinkers, but pretty chatty.

    Minh, Guilty as charged! lol I was going to take it to PM with Bill on the banking talk so we didn't bother you too much, but wasn't sure if Johnson wanted to hop in.. On the charts, just click 'animate' or read the instructions, and turn on the trail.. Never seen one like it.. Cool way to present this data.

    speaking of cash businesses and tax returns Johnson, I might see you at our special little SF bank and be discussing just that..!

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    @Bill Gulley ,

    I'm glad I made you laugh. My culture has a saying that laughing is the best medicine for your health. I was going to send you a bill for my secret health medicine, but you returned the favor with your clever response. Thanks for the laugh.

    J,

    Thanks for those graphs. If my interpretation is correct, the yield curve were flattened the last two times the stock market peaked and steepened as we get into a recession. As we recovered from the recession, the yield curve gradually became less steep and eventually flattened out.

    If history is any indication, we're no where near the top of the stock market at this time. Are you suggesting that the stock market and housing market have more room to run? Gasp!!!

    I would love to see the yield curve between 1929 to at least 1937 to give me something to compare to.

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    "If my interpretation is correct, the yield curve were flattened the last two times the stock market peaked and steepened as we get into a recession. As we recovered from the recession, the yield curve gradually became less steep and eventually flattened out."

    @Account Closed Yes, oftentimes at a peak, the FOMC is raising short-term rates quickly to cool things down, bringing up the short end of the yield curve. The long end often rises for a while, but when businesses and investors get less confident about the economy, the demand for long-term loans and investments drops, it decreases the long end of the curve, while the FOMC still has short term rates high, creating a flattening, and then inverted yield curve.. A classic predictor of a recession or retracting stock market (although I have heard the joke that an inverted yield curve has predicted 15 of the last 5 recessions lol).

    Then, as the Fed realizes what's going on, they slash short-term rates by 50-100bp/meeting to prevent a collapse, rapidly decreasing the short end of the curve, and causing an artificial steepness to the curve because of all the QE going on. But a healthy economy should show some level of natural steepness as long as investors and businesses are still investing long-term, keeping a healthy demand and higher rate for longer-term financing. But I think the current flatness says we're still not there. Look at cash on corporate balance sheets, and there seems to be some confirmation.. A lot of corps are even issuing long-term debt just to pay dividends because it's so cheap and they have no real economic investments to plow their cash into..

    Here's some yield curve talk on the great depression if you're interested.. Biggest difference then was deflation.. A whole different problem..

    http://www.economicpopulist.org/content/economic-indicators-during-roaring-twenties-and-great-depression-iv

  • Banker · Dallas, TX · Member since 2013 · 158 posts · 129 votes
    12y

    Very interesting thread! You guys know your stuff! @Account Closed You got a great deal on your financing. If I was competing against those terms on a daily basis, I think I would be out of a job. I've never been an examiner but I was on the credit admin side of the bank until a year ago. When I made the switch from credit admin to loan production, the first message I received from a colleague was "welcome to the dark side." Seems to be a universal term for us CRE lenders. I have to admit, the dark side is pretty darn fun but the folks highest up the food chain in our bank are former examiners.

  • Johnson H.Pro Member
    Investor · San Francisco, CA · Member since 2010 · 910 posts · 889 votes
    12y

    Ex bank examiners high up the food chain @Waylon Themer? Funny you say that as some of my coworkers have been examiners for 30+ years. They are too risk adverse to leave! lol

  • Banker · Dallas, TX · Member since 2013 · 158 posts · 129 votes
    12y

    Well you know how it goes. Give us a "2" and you can be on the C level of our bank next year.

    I'm kidding of course. Most of them had short"-ish" careers as examiners and levered that education and wisdom along with hard work to get toward the top. I guess they are of a riskier breed.

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Waylon Themer , welcome to the lion's den! So care to chime in on using a range of expenses to estimate profitability or DSCR over in your neck of the woods? Or at least what you did when you were back in credit.. Breakeven vacancy? 200bp rate shock? Or using 40% expense ratio average if they come in showing 15% expenses w/ no maintenance for last year..?

    I'm at 5 years now as an examiner, and working for the State, the pay is not crazy, but it's flexible and lots of vacation ;) Gives me what I need to get the real estate portfolio built on the side.. I'm taking risk on the real estate side, so I figured I'll lay low on the job risk for a while..

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    @Waylon Themer ,

    What a unique name. Yeah, this is a bank examiners' party. I was just happened to be a guest. I was surprised myself when we got quoted those interest rates. J confirmed the reason why we were able to get those rates. Everyone in the team has his strength and weaknesses. You just have to use everyone's strength to your advantage.

    What crazy was that we got quoted even lower interest rates last month, a 3.7% from Chase and 3.4% First Republic Bank, when we submitted a couple of offers on an 8- and 10-units. Of course, interest rate was lower in November compared to a couple of months ago. For a value-add play, Chase would do a cash out refinance up to 85% of purchase price + improvement. Seasoning requirement is about 3-6 months. The lender hit you pretty hard on pre-payment penalty though, 3% for the 1st year, 2% for the 2 year and 1% for years 3-5 although he said they might be able to waive the pre-payment penalty after year 3 if we refinance with them.

    @J Martin ,

    Thanks for the link. It was informative and confirmed my thesis. It seems like every time the Fed raising short term interest rate in 2-3 consecutive years to cool down the economy, we go into a recession. The data for the 1937 recession was very interesting to me. Given we were coming out of the Great Depression, the Fed barely raised the short term interest rate, and boom we were in a recession again. The Fed then immediately cutting its short-term interest rate to even lower than pre-1937 period. After the 1937 recession, it was back to the normal routines again.

    People look at me like an idiot when I say that I wouldn't be surprised to see 30-year fixed mortgage goes as low as 2.75% when hit the next recession, and this housing market run-up has a decent chance of topping out when the 30-year fixed mortgage hit 6.0-6.5%. Time will tell. Understand history is so critical to one's success in my opinion. We are living in an interesting time of history no doubt.

    This discussion reminded me of what a good friend of mine said when it comes to economics. "Some people understand some of it, and most people do not. Unfortunately, when making economic forecasts one is always working with only partial and imperfect information." Great discussion gentlemen.

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    12y

    Minh, then it certainly looks like banking is more aggressive in CA, I've not asked lately but refi's were at 1 year here, not as to end loans out of construction but from properties held.

    Ha, the food chain, it's the natural progression for examiners to go to bank management. I had a short stay at a state bank in compliance while I tried moving into commercial securities in a brokerage. I was introduced to a client that owned a mortgage company and decided that loans would be more profitable, the rest is history. I feel that I lucked out along the` way as the stepping stones just appeared, I didn't plan much of it at all.

    Economics was a favorite subject, so Minh, I like that "some people understand some of it and most do not". I'd bump your estimate up to 8.5%, the 90s were rather strong floating in the 8s and 9s. I'd say too that if the obstructionists in congress would knock it off, 2014 could take off. :)

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Bill Gulley

    "Most local banks have balloons in five years actually. Some regional banks have 7 to 10 year balloons if you search for it.

    The 5 year loans have the lowest interest rates typically but the most risk. There is more time with a 7 to 10 year loan term to pay down the payoff balance."

    Here's Mine:

    "In CA, if you call around, common loans for multifamily are 25% down, 30yr am (on MF, 20-25yr am on other CRE), 1.25 DSCR (some wiggle room), a 5/1 ARM is often due in 10 years, with resets from 5-10 years and 3/2/1% prepayment penalties for first 3 years. This can vary a bit though too.. Know when your rates reset and potentially how far.. The 30yr bull market for bonds and ever-decreasing rates is over :( Doesn't mean we'll be at 6% LIBOR next year. But there is a full economic and interest rate cycle ahead of us in the next decade. Hopefully rents will keep pace or beat ;) "
    http://www.biggerpockets.com/forums/12/topics/110054-commercial-loan-balloon-payments

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Account Closed , I like your quote regarding "working with only partial and imperfect information." It kinds of brings this conversation full circle, as my first post was trying to acknowledge that we can't precisely calculate any of this, whether it be expenses, profit, interest rates, economic cycle etc... so you have to make some reasonable estimates of the range of outcomes you can expect and be reasonably ready for them.. From my first post on this forum:

    "I think this is a more realistic way to assess the likely range of outcomes, rather than some "overly precise", but less informative calculations, where I see people estimating they will be earning $129.72/door this year, with a ROE of "approximately" 17.25834%.. "

    The data and the returns are estimates, made with only partial and imperfect information.. Let's not kid ourselves that our pencil is so sharp, or spreadsheet macros so powerful, that we overly focus on one outcome, or today's returns, that we lose sight of the range of outcomes we may experience.. That doesn't mean that we can't learn a lot from history and make a lot of money off of it! But be ready for some of these variables to steer off course from time to time. I guess that's what reserves and not getting over-leveraged are for!

    Glad you got something out of the yield curve graph. Interesting history lesson, and interesting way to present the information. I'm with Bill though, I wouldn't be surprised to see Fed Funds at 4-5% sometime over the next decade, putting prime at 7-8%. When and for how long? Your crystal ball is as good as mine. Look at the 40yr chart of fed funds and add 300bp. Even if you just take the last 20 years, it's hard to see how it could stay below 600bp prime forever.. But I also agree with you that there will be another recession and rock-bottom rates at SOME point. 2.75% 30yr? I don't know if I would say the MOST likely scenario in the next decade, but I would not be surprised to see it someday either. I'll be waiting at the Bank's door at opening hours when we get there! lol

    PS @Johnson H. and @Bill Gulley, I'd like to grant Minh honary examiner status for all his contributions to this forum, his deep, ever-questioning intellect, and love for all things economic and real estate. There's no pay, and rarely is anyone greatful, but it's fun and interesting, and someone has to do it! lol

  • Banker · Dallas, TX · Member since 2013 · 158 posts · 129 votes
    12y

    @J. Martin sorry for the slow reply. We run a spreadsheet that shocks vacancy, rental rate, interest rate, and cap rate. For some reason we don't mess withe expenses too much. We take actual property tax, actual insurance, and actual expenses as long as they seem reasonable and we underwrite a management fee even if one doesn't exist. At the end of the day we are looking for a minimum of 1.25 dscr on 20 year amortization. based on historicals. If a property is 100% occupied we will underwrite a market vacancy. In today's lending environment we are rather conservative and the credit guy in me prefers it that way though it makes my job as a producer harder.

  • J. MartinPro Member
    OP
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    12y

    @Waylon Themer , that sounds about right based on most of what I've seen. Maybe they don't tweak expenses because they figure the rest of those stresses adequately gives you an idea of the range of risks they face..

    Sounds like your terms are even tighter than out here in CA though.. Multifamily can often get 30yr am with 1.15-1.20X DSCR. Little less cash flow out here and competitive market, so that might be one reason why...

    Seems like lots of Houston/texas investors on here (many from CA), so you might be able to drum up quite a bit of business if you connect with them.. (if you are not already).. You can start with Johnson, above. lol

  • Investor · San Jose, CA · Member since 2012 · 2k+ posts · 3k+ votes
    12y

    @Waylon Themer ,

    Do you want to compete for my business? I just got a quote from my lender, FRB, for an apartment building in my neck of the woods.

    Purchase price: $2M

    Max LTV: 70%

    Loan program: 5/1 ARM

    Loan amount : $1.4 M

    Min. Payment: Fully amortizing over 30 years, loan due in full in 10 years.

    Rate: 3.25%

    Points: 1.0% (my guess is 3.5% for 0 point)

    Payment: $6,092.89

    Prepayment Charge: 4 year prepay at 2% for years 1 & 2, and 1% for years 3 & 4. Allowed to pay 20% of original loan amount every year without charge.

    Index: 1-Month LIBOR

    Margin: 2.25%

    Floor: 2.85%

    Life Cap: 10.95% (Ouch)

    @J. Martin , do you think the quote above is reasonable? :)

  • Banker · Dallas, TX · Member since 2013 · 158 posts · 129 votes
    12y

    @Account Closed Thanks for the opportunity! Unfortunately our bank only lends in Texas. Looks like you have a heck of a deal as long as you don't mind putting 30% down. If I were financing it, you would be looking at 75% LTV at 4.50 fixed for five years. 20 year amort. 1% origination fee. No prepayment penalty. At the end of five years the loan would either mature or it would go to an annual adjustable rate at Wall Street journal prime plus 1.25%. I would rather have the deal you are being offered. I would accept the terms as offered without blinking.

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