Actuals vs. Projected – which to use in underwriting
The actual income and expense numbers the seller provides you for your underwriting should be close to reality, but even if they are, you’ll operate the property differently. Your numbers may be different. A little or a lot. It’s your decision whether to use the real actuals from the seller’s statements, a rule of thumb, or something different.
For actuals, do you use T12 or T3? Remember that the purpose of your underwriting is to project a picture of the future as accurately as possible. If the property had high vacancy for the six month period up to six months ago, then got units renovated, new marketing , or something else improved, and filled those units, it could be safe to say that the next 12 months of rent income will be more like the last three than the six months starting a year ago. So T3 for income. But you have to be able to explain that. Talk to the seller, find out what happened. It should make sense and be a believable explanation.
Look at the big expenses very carefully – insurance, property tax, and repairs. Other big expenses like utilities and management are easier to project so focus on those first three, first.
Insurance – it is okay to use a rule of thumb, but if it is wildly different than what the seller is paying, find out why. Is their policy not very complete? Did they have a fire so their risk is higher? Also confirm your rule of thumb. Surprisingly, a rule of thumb varies by state. Some could be $225/door, others $300+. Talk to brokers, get a referral to local insurance brokers, and call them.
Property tax – this can be very hard to confirm. Will it go up when the sale is recorded? Or three years later? What is the county’s formula for calculating property tax? Go to the assessor’s web site, call the county, and talk to the broker. Experienced brokers know how it’s calculated and when it goes up.
Repairs – So many income statements that are sent to buyers include other things in repair costs, like capital improvements. If an owner is upgrading a unit from laminate countertops to granite, that is not a repair, that is a capital improvement. They didn’t have to do that, they chose to so the unit would look nicer. But they are operators, not accountants, and the expense got thrown into the same bucket as leaky faucet repair and plugged toilets. Look for repair expenses and be sure to include supplies, maintenance, and turnover expenses. They are often broken out separately but for you to decide if they make sense, lump them together. Rule of thumb might be $300- $600/unit but if it’s higher, do a property tour and see for yourself. Is it a very nice property? Then why so much on repairs? Or is the repair expense very low? Does the owner do repairs him or herself? So are they not accounting for his time and expenses? Get answers.
Utilities – there will probably not be much opportunity to tweak these in your underwriting. Don’t try to project a huge savings because you’re going to just start billing tenants for water. If you do, some will move out. It’s a rent increase to them. Maybe they’ll accept it because rents are so low here, or maybe not. You’ll confirm all of these expenses in due diligence when they send you utility statements.
Management – if the owner has one or two people on staff and their payroll is reasonable, it might be a good plan to keep those people after you take over. So just use their payroll numbers. Or they could be significantly overstaffed so you could plan on reducing this number. Again, be careful of your rule of thumb. Is it $900/unit, $1200/unit, or something different? Depends on the area. You’ll pay more in an expensive city than you will in a lower cost of living city. Management expenses vary too. Could be 3% if they have a strong local presence and are putting staff on your property, or 8% or more for off-premises management. Talk to the local property managers. We almost never use the actual management expenses the seller provides in their financials.
Marketing – if the seller’s numbers are $0, that might be a good indicator that they get drive by traffic or the free listings work for them. Still plan on some marketing, at least the basic premium package from Apartments.com. You want strong demand and to build a waitlist.
Landscaping, pest control – these aren’t huge percentages of your expenses but make sure you’re including something. If there’s considerable yard to maintain, snow to remove, trees and bushes to trim, ponds, or storm runoff issues, budget for it. The seller’s numbers here will be very helpful but get good estimates during due diligence.
We will build in increases to income, depending on where rents are, where we think they could be, and the numbers and types of renovations we will do, but we’re not likely to plan for very much reduction in expenses. We’re hopeful we can find savings in utilities, repairs, and other areas, but we’re not typically confident enough to plan on them when underwriting.