I see posts on BiggerPockets all the time advertising deals with low operating costs as percentage of effective income. Folks are smart to recognize that at its core premise, income property is less about the income and more about the cash flow and that as much as anything, this is a function of controlling the operating costs.
Armed with this notion, everyone seemingly tries to make an impression on the community — and perhaps on themselves — by presenting deals with apparent “low” operating costs. As in, wow, see how good this deal is… it only cost 35% to run?!
Let’s chat about this for a minute…
The Way You Underwrite
Let’s say you are analyzing a 100-unit building. You’ve received the OM containing a Pro Forma underwriting and 12 months worth of trailing financials. (In reality you will rarely get the latter, at least not on deals that are worth the paper financials are written on, but let’s have fun, shall we?)
You analyze the data, and you think that you have a good idea of what things cost in this building based on the information at hand. You come up with an NOI, and from there capitalize a value. Furthermore, you think that you can hike rents by like $125/month. All and all, you figure you’ll make out like a bandit…
Realities of Engagement
What’s important to understand is that someone who understands the form and process of the multifamily dance intimately is able to stack the numbers on the page to paint the story any way they want. Truly, you could have 10 people put the numbers for the same exact building on paper, and all 10 will look different and will imply a different story of the position of the asset.
The Way I Underwrite
With this in mind, my approach to the underwriting process is somewhat different in that my aim is less to underwrite the trailing financials. Instead, I focus on underwriting the numbers that I think are realistic for me, which often diverge from the trailing information presented to me in substantive ways. Why? I used to think it’s because people who prepared the OM were all stupid. And while, to be fair, a lot of them are indeed stupid, many are very smart and understand how to manipulate numbers so as to paint a positive and seemingly reasonable picture.
So, I look at the same building as you. I plug the numbers into my spreadsheet, which has two columns (actually it has more, but let’s just say two). The column on the right is to enter the numbers provided by the Pro Forma, while the column on the left is for my projections of what the numbers are really going to be, which take into account my strategy for the asset.
I enter the information as it appears in the Pro Forma (OM – Offering Memorandum) into my underwriting first. Nine times out of ten, there will be a few line items in this column that remain empty. Not everyone knows how to track all of the moving parts. And as you can imagine, it is not always in everyone’s best interest to track all of the moving parts… just sayin’!
Which is why, having completed the transfer of information from the OM into the left column of my underwriting, I move onto the right column. Based on the information I have, what are the reasonable income and expense figures for an asset such as this?
What Information? The Only Information is the OM, Isn’t It?
Not at all. The OM is the guidance that the seller/broker wants me to have. It may or may not contain any honest to goodness information. The OM is a story, for the most part fictional. I need facts!
For example, while I’d like to know what rents the seller gets, but I NEED to know what rents are reasonable. While I want to know what expenses the seller is paying, I NEED to know what expenses are reasonable for the type of systems that are utilized in the asset.
In other words, if I look at data across 30 communities (5,000 doors) and realize that the payroll expense averages $1,100 – $1,400/door, but the OM schedules $40,000/year for 100 units, am I going to use $40,000 in my underwriting, or am I going to use $110,000+? This happened just last month by the way, and I don’t mind telling you that the OM indicated payroll expense of even less than $40,000/year for a property of over 100 units!
Here’s another example. One thing that almost every OM includes is the property tax expense. This item is so expected and mundane that it’s silly not to include it.
However, most OMs simply include the property tax expense as per the most recent year. Most do not attempt to project this expense past the sale… as if!
Every county in these United States has its own formula for calculating property taxes, and while these formulas vary dramatically in form and style, one thing is the same: they are based on the most recent assessment of property value in some way, shape, or form.
The notion that the current year tax bill will survive the sale is just stupid; it almost never does. And yet, I’ve seen people get into deals assuming their tax bill will be $70,000, only to be stuck two years later with a $105,000 bill — happens all the time! This is an instance where the OM is not lying or trying to mislead; it indicates honest to goodness current tax bill on the property. It is the buyer’s responsibility to understand local customs and costs and to anticipate changes, which sometimes happen rather immediately and other times take a few years.
I do not underwrite the income and expenses of specific assets. I underwrite averages. It’s my job to know how much income per square foot to expect. I may be able to outperform, but I am going to be safe and expect to be average. It’s my job to know how much laundry income to expect from “X” number of units. It’s my job to know how much management will cost on the average. I need to know how much contract services run per door on the average.
The thing is, this particular subject property that I am underwriting certainly has some specific efficiencies or inefficiencies relative to the averages. It is those efficiencies/inefficiencies that I must “catch,” as they are the key to placing value on this asset relative to what it is and what it can be.
Are you getting the gist? Do you have questions regarding my underwriting process?
Leave me a comment below, and let’s discuss!