Unless you own several multifamily properties already, underwriting operating expenses for a new property can be daunting. Here's a beginner's rule of thumb.
Unless you already own multifamily properties or have experience in the industry, underwriting operating expenses can be a monumental challenge for new investors. Thankfully, you can incorporate several strategies into your analysis that should get you close to real numbers without profound expertise. As a professional multifamily and commercial real estate analyst, I would recommend a few rules of thumb that you can utilize on your next property analysis.
Most of the time, you will have historical financials to work with. Typically, an owner or broker will provide potential buyers with one to two years of profit and loss (P&L) statements. But what if this isn’t the case? What if you are dealing with an unsophisticated owner who kept poor records? Or they kept good records but didn’t break out non-recurring items such as capital expenditures, amortization, depreciation, and mortgage interest?
I’ve even seen the other end of the spectrum, where expenses are just too low, and no reasonable owner could replicate such efficient operations.
You’ll undoubtedly come across investment opportunities where historical financial information is dicey. If you don’t have ample experience underwriting properties, this could prove frustrating. Let’s talk about some strategies you can integrate to accurately forecast expenses for an apartment investment and feel good about making a competitive acquisition offer.
The operating expense ratio is defined as the following:
Expense Ratio = Total Operating Expenses / Total Operating Revenue
The lower the expense ratio, the higher the net operating income (NOI).
When you’re analyzing a property, the owner or broker should provide you with at least a rent roll to build your revenue assumptions. Assuming you have good historical revenue information, underwriting expenses relatively accurately should be doable regardless of the expense data available.
A good rule of thumb for a fledgling underwriter is an expense ratio of 50%. This could be your starting point.
So, if the total property revenue were $65,000, you could underwrite expenses as $32,500 and feel confident your estimate is reasonable.
The number of units, quality of the apartment building, and submarket will all play into where this ratio will likely settle.
I would expect a 30-unit garden-style “Class C” apartment building in a cold climate to have a much higher expense ratio than a 250-unit “Class A” high-rise in the south.
Start at 50% as your expense benchmark (this excludes capital improvements and other capital expenditures). Then think through it like this:
Smaller buildings enjoy fewer economies of scale. Peg a higher ratio.
Older buildings typically come with higher maintenance costs, plus inefficient heating and snow removal during the winter months. Peg a higher ratio.
Several factors will keep the expense ratio at or above that 50% benchmark:
If you want to be incredibly conservative, you could solve for a 60% expense ratio. I have seen properties operating like this in the past, and there is usually potential for the next ownership group to improve operations drastically.
At the other end of the spectrum, you could adjust your 50% downwards if the property exhibits:
While I have seen larger, well-managed properties operating as low as a 35% expense ratio, for underwriting purposes, I wouldn’t recommend going any lower than 40%, even in the most optimal of conditions.
If you are new to commercial real estate investment and are interested in getting an agency loan such as Fannie Mae or Freddie Mac, the lender may require you to partner with an experienced property manager that knows the ins and outs of the business.
This could provide a great opportunity to review operating costs with your property management company of choice. You could include them in the due diligence process and go through your underwriting line items for each expense to get their honest feedback. They should have a great feel for the projected expense load and how you should underwrite a particular building.
Management fees are a typical expenditure for multifamily owners, so make sure you understand what you will be paying your property manager each month to operate the property. Typically, fees will start at 5% of total revenue on smaller properties and go down to 2.75% of total revenue on larger ones. This percentage is negotiable, and there is no hard rule.
If the manager is involved in other properties in the same submarket, they should have a strong pulse on occupancy, rents, and concessions as well.
While some of the expense items will be estimated, other expenses can be investigated and determined exactly.
Property Taxes — There is a lot of risk with tax underwriting as it tends to be one of the largest expenses, and there can be a lot of exposure if you are paying well above current assessment levels. If you are unsure how property taxes will be affected post-purchase, I recommend calling the local assessor and requesting that they talk you through their reassessment protocol (without mentioning the actual property you’re interested in). You can also get intel on tax assessment trends from a strong sales broker.
Insurance — You can get insurance quotes before owning the property. If the current owner provides you historical financials, don’t expect the historical property insurance expense to remain the same. It will likely increase once you take over. One of the fastest ways to get an accurate insurance quote quickly is using online property insurance brokerage Obie:
Marketing — For a smaller building (under 40 units), you could potentially get by with free marketing using websites like Zillow, Trulia, or Craigslist. For larger buildings, you can get quotes from paid marketing sites such as apartments.com or apartmentlist.com.
Contracts — Contracts for snow removal, landscaping, pest control, grounds, cleaning, etc., can all be priced out before you even make an offer.
Note: Elevator contracts can be a huge burden on newer deals with few units. Ensure you are vetting all assumable contracts and making sure the operations can sustain hefty contracts. One bad contract can really kill the cash flow.
Utilities -Forecasting future utility expenses is nearly impossible because you don’t control the cost of natural gas, electricity, and water. However, you could potentially pass off these expenses to the residents. If other submarket properties are charging their residents for water, sewer, and trash, there’s a strong case to be made that you could likely chargeback for these items too. Hedging against utility expense creep should be of utmost importance, potentially even more so than raising rents.
Management Fee -Management expenses will usually be a percentage of total revenue collected.
Other expense items such as repairs, turnover, and administrative costs will need to be investigated thoroughly. Repairs and turnover will depend on the property’s condition and the tenant quality (are they taking care of their units). Administrative costs will include rental licenses, inspection fees, banking fees, and other technology-related expenses.
Doing as much upfront research as possible and verifying that the overall expense ratio is reasonable should get your expense underwriting very close to finalized.
As you can see, underwriting expenses for a multifamily property can feel patchy. During initial underwriting, it’s important to forecast conservative operating expense assumptions that you can hopefully beat them when you officially own the property. As they say, “under-promise and over-deliver”.
The rules of thumb I laid out above should get you close to an accurate proforma and allow you to feel comfortable making an offer on a multifamily investment. Always verify your assumptions with an expert. Early on, it’s wise to consider partnering with an experienced operator who can offer guidance and expertise. Once you learn from more seasoned investors, underwriting will become exponentially easier, even in instances where deal data is murky.