Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
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As part of our multifamily real estate coaching business, we review hundreds of deals each year for our students. As a result, we have a unique perspective on the most common mistakes made when underwriting the potential cash flow of a multifamily rental property.
Below are the five most common mistakes we see and how to avoid them to ensure your multifamily underwriting process is sound.
Mistake No. 1: Overestimating Market Rental Rates And Rental Growth
We coach our students to seek out apartment buildings with good locations and below-market rents. If these commercial properties can be purchased for a good price, the thesis is that rental rates can be brought into line with market rents through a capital improvement program. But there are two common underwriting mistakes with this approach.
First, it is common to be overly optimistic about post-renovation market rents. To avoid this mistake, it is important that this estimate be driven by a data-based comparison of the target property to the competitors in the surrounding area. Are the finishes the same? What about the amenities, unit sizes, layouts and parking capacity? These all factor into whether the newly renovated property can achieve market rents.
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Second, it is common to assume that rents will grow in a straight line over time. This is also overly optimistic. There may be some years where rents don’t grow at all, even some where they decline. These scenarios must be considered when creating the pro forma.
Mistake No. 2: Underestimating Operating Expenses
A property’s income less its expenses results in an important metric known as Net Operating Income (NOI), which forms the basis for the property’s valuation. For this reason, it is critically important to estimate operating expenses accurately.
One common mistake is to simply “estimate” operating expenses (taxes, property management, utilities, etc.) without looking at the property’s previous performance for reference. For example, it would be easy to estimate utilities at $750 per unit. But if a review of the property’s historical utility statements reveals an actual cost of $900 per unit, the cost estimate will prove inaccurate.
This tendency is particularly common when estimating property taxes. This is because a property’s value is reassessed when it is sold, and there is typically a large jump, particularly if the previous owner held the property for a long period of time. As a general rule, the property’s newly assessed value will equal the sales price, to which the county’s millage rates should be applied to estimate post-sale taxes.
In other words, we spot it as a red flag when a pro forma assumes that property taxes will stay the same after sale.
Mistake No. 3: Underestimating Repair And Renovation Expenses
The success of a value-add strategy like the one described above is highly dependent upon accurately estimating the cost to renovate the property.
We have found that it is very common to underestimate the cost and the time needed to complete renovations. For this reason, it is always a good idea to work with an experienced contractor to develop renovation cost estimates, as well as budget for a generous contingency that can be used in the likely event of cost overruns. We’ve found that the contingency line item should be roughly 10% of the renovation budget.
Mistake No. 4: Not Reviewing The Rent Roll
A property’s rent roll provides key information about the individuals who occupy the property at the time of sale. When evaluating an apartment complex for the first time, it is common to focus on the current rent, because it drives the property’s income. But doing so ignores another major detail: lease expirations.
Multifamily leases are typically 12 months in length. When they expire, the tenant will either renew their lease, or they won’t. If they don’t, work must be done to “turn” the rental unit and find a new occupant. This takes time, which means lost income for the property because there is no tenant making monthly payments.
Not reviewing lease expirations ignores the risk that a group of them expire at the same time. For example, if a property has 50 multifamily units, but the leases for 10 expire in the same month, the property could experience a significant income reduction while the units are turned and re-leased. In a worst case scenario, this could lead to a liquidity crunch.
Mistake No. 5: Not Stress Testing The Pro Forma
A pro forma is an estimate of future income and expenses. There is no guarantee that actual performance will track closely with pro forma estimates.
As a result, it is a best practice to “stress test” the pro forma, which is to say that real estate investors, lenders and anyone else involved in the transaction should test pro forma assumptions as a means of considering multiple outcomes. For example, if the pro forma assumes 5% property vacancy, what happens to returns and market value at 7% or 10% vacancy? If closing costs are estimated at 3%, what happens to returns if they turn out to be 6%?
The common theme here is that from my experience, investors tend to take an overly optimistic view as to the potential performance of a property. In multifamily real estate investing, this is a mistake. It is a better practice to take a data-driven approach to underwriting and to consider a range of possible outcomes before committing to a transaction.
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