Understanding where you think rents and rent income will be is one of your biggest challenges when underwriting a deal. In my experience, I pass on more opportunities for this reason than any other. It’s not just that I can’t see rents being increased enough to make this a value-add opportunity for me, it’s how much will income be. There is a difference, and it’s important to understand that difference and what drives it.
Let’s say you find a property whose units are in decent condition and rents are $150 below market. You’ve been taught that you’re not going to get $150 more out of each of those units in the first year. Of course not. Their lease expiration dates are spread out through the year. So you get some increased in year 1 and the rest in year 2.
But what about vacancy? How many will move out because of your rent increases?
And how about renovations? Will you take the unit off line to work on it? For how long?
And month-to-month units? If they are month-to-month does that mean you can increase their rent right away?
I have needed to come up with ways in my underwriting to account for these factors, but the good news is you can make informed assumptions. You can plan for some time to renovate, and the loss of income during that period.
My underwriting has evolved to take as much of this into account as I can, because they are assumptions that might change from property to property.
For example, if the property has a lot of month-to-month units, you can certainly end the tenancy of all those units at once and fix them up right away. But the contractor can only do so much at a time. How long will some sit, un-rented, waiting for the contractor. And then you get a large batch of them renovated and back on the market. How many vacant units will your market absorb in one month?
Think about these variables. Stagger the renovations through the year. Don’t end all of the month-to-month leases at once. Think about the seasonality of lease-ups – who’s looking for new apartments in December vs. May?
And then use that to project your income – month by month, unit by unit. You might discover that given the number of renovations and lease-ups you can accomplish in one month, it will take you longer than one year, maybe more than two years, to complete your renovation plan. It’s better that you know that up front, then maybe the deal got worse, or possibly better.
Earlier in my career I was a computer programmer so more recently I have written some programs to model rents based on a bunch of different variables. If you know a programmer, think about how you might build your own model and partner up (give her/him some of your GP!). It’s a great experience seeing how quickly your assumptions illuminate the strengths and weaknesses of your deal.
I’m a fan of rules of thumb and have used them extensively, but when you can dig deeper and quantify more, your information quality is higher and your decision making is better.