How I Deal With Uncertainty When Buying Real Estate

Rent Premiums

The Uncertainty:

I invest in value add properties, making improvements and renovations with the assumption that I’ll be raising the rents and increasing the net operating income (“NOI”) once those renovations are completed. Sounds pretty intuitive, but assumptions equal uncertainties, since there is no way to 100% guarantee you will get those premiums (rent premiums are the difference between the current rent for non-renovated unit and the projected rent that’s expected once the improvements are made to the renovated unit).

How to Deal With the Uncertainty:

It’s always best if the current owner has already renovated some apartments and is already receiving premiums. In this scenario, I am more confident I can renovate the units to the same scope and get similar premiums.

If the current owner hasn’t made the renovations yet, I look at comparables - properties that are in close proximity to the property I’m investing in (usually within 1-3 miles). In addition to proximity, the comparables should have similar amenities and the property should be of similar age (up to 5 years older or newer). I have my team call different properties and ask about rents as well as the scope of the renovation that was done. However, regardless of projections, I always use a conservative estimate on the rent premiums when evaluating deals, so my tendency is to assume lower premiums than the comps are receiving, just to be on the safe side. So, for instance, if comps are receiving $150 premiums, I will assume $120 and see if the deal still works with lower premiums.

Expenses

The Uncertainty:

Looking at expenses and where cuts can be made is critical to increasing income and profits. However, you can’t be 100% sure how much exactly it will cost you to run the property, since sometimes there are unexpected expenses (HAVCs that break, insurance costs go up due to market conditions, etc).

How to Deal With the Uncertainty:

As a rule of thumb, expenses should be about 40% - 55% of income, so that’s a great place to start. You can also take the property’s historical expenses and market expenses into consideration. That will help when analyzing numbers.

Another way to assess the property’s expenses is to have the property manager walk the property and provide us with a detailed operating budget, so we’ll have a good idea of how much it takes to operate the property each month. We also like to have a capital expenditure (CapEx) budget so we’ll know which one time items will require replacement. A CapEx budget can include roofs, HVAC systems, flooring, appliances, driveways and other large ticket items.

As mentioned earlier, even with an operating and CapEx budgets, you still have uncertainty on whether or not you’ll be able to meet the budgets, since there are always unexpected expenses. For example, if you’re purchasing a property where the owners postponed necessary repairs and maintenance, you may be hit with an unexpected repair bill that wasn’t budgeted. The key is to have a budget set aside for “additional expenses,” and to be vigilant about repairs and maintenance once you acquire the property. I often use a 10% budget (10% of estimated budget) as reserves for unexpected expenses.

Another unexpected expense is vendors who raise rates without a prior discussion. Some owners get complacent about vendor rates and fees and begin to accept increases. To avoid this uncertainty, review all existing contracts and get competitive bids if costs continually rise or seem out of line.

Occupancy

The Uncertainty:

Most multifamily property investors and owners would love to have 100% occupancy rates. The reality is that you can never predict exactly how full your property will be. Market shifts, new competitors, and other unforeseeable forces can change the property’s occupancy.

How to Deal With the Uncertainty:

Even if the property you’re looking at is 100% occupied, you should always plan for a minimum 5% vacancy rate to give yourself a cushion in case the market changes. Additionally, you can buy access to professional reports, such as CoStar and YardiMatrix and look at historic and projected market occupancy levels. These reports are not cheap, but many property managers have access to them and if you work with a reputable company, you can ask them to share some reports with you.

Concessions

The Uncertainty:

Concessions are basically the reduction in rent or any specials that owners have in order to attract tenants. They can be in the form of discounted rent, or free rent for a short period of time, usually one month. There are other types of concessions to consider, including a discount on an upgrade to a larger unit, new appliances, painting, etc. At least with an upgrade to a larger unit, you’ll at least have a tenant with a newer, long-term lease.

If you’re located in a market that has an abundance of new multifamily construction coming on line, you will probably have to offer concessions in order to remain competitive. It’s the same with your major competitor - if they’re offering concessions, you’ll find you’ll have to match their offers.

How to Deal With the Uncertainty:

To find out what concessions your competitors are offering, you generally have to use a paid data source to get current information on concessions. We use CoStar and YardiMatrix to get competitive information. Once we have that data, we are able to make informed and calculated assumptions on what concessions will have to be offered in order to remain competitive.

You may find out that competitors are offering one-month free rent, but are allocating it over a 12-month period of time. It’s the same amount of money that is discounted, but spreading it out over 12 months gives the tenant an incentive to stay, versus using it in the first month and then moving out. The term, “Professional Rent Hoppers” use this technique to gain free rent at multiple complexes.

If you don’t have access to professional reports, simply call your competitors and ask them what specials they offer. It’s as simple as that. This is a great way to deal with uncertainty about concessions.

Exit Cap/Price

The Uncertainty:

Of all the uncertainties you’ll face when dealing with multifamily investments, the exit cap is one of the major ones. After all, it’s not easy, and frankly almost impossible to predict what the price of your property will be when it’s time to sell, especially if you have a long hold period (the estimated time you plan to sell, usually 5, 7 or 10 years down the road). 

So, what is an Exit Cap? It’s the actual or estimated price of a property at the time it will sell, and it’s calculated by dividing the expected net operating income (NOI) by the anticipated sale price, shown as a percentage. To give you an example, let’s say your NOI for the year of the sale is $500,000, and the expected sale prices is $8M; your Cap Rate would be 6.25%. ($500,000 divided by $8,000,0000 equals .0625, or 6.25%.

Most often, buyers want to have a higher cap rate, which means that the price is low relative to the NOI.

Also, remember that an Exit Cap is an estimate of what the property might sell for. There are many factors that can impact a cap rate, and therefore, the price. These include the property’s location, the asset class of the property, interest rates, occupancy rates and other factors. The cap rate is simply a guide to use as you weigh whether the investment is sound or not.

How to Deal With the Uncertainty: 

Estimating your exit cap is pretty challenging. The way that I deal with this uncertainty is by assuming that the market will be in a worse shape when it’s time to sell, compared to now. My team usually assumes a higher exit cap rate than the cap rate we’ve purchased the property at. This usually translate to 10 basis points (0.01%) higher for every year I hold the property. So, for example, if I buy a property at a 5% cap, I assume that I will sell it at 5.5% cap after 5 years (0.01% x 5 years).

Summary

As you can see, buying real estate comes with some uncertainty. I’ve found ways to ease that uncertainty and I hope you use some of these tactics when evaluating an investment opportunity. When looking at rent premiums, go conservative and use lower numbers when evaluating your deal. Analyze the estimated expenses and be sure they fall within the industry average of 40% - 55%. Have the property manager provide an operating budget and a CapEx budget so you can analyze where expenses may be reduced and which capital expenditure may be expected. Anticipate having to use concessions in order to maintain or boost vacancy rates, but be sure to use data resources in order to see what concessions the competition is using. Finally, estimate a higher Exit Cap to see if the deal will have an appropriate Cap Rate, but remember these are simply estimates and can be impacted by many factors. Doing due diligence and being conservative will help to minimize the uncertainty you’ll face when investing in multifamily properties.

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