An Example That Proves Why You Should Underwrite Multifamily Numbers

I keep telling you guys: Underwrite your numbers! Look at the trailing financials, sure. Understand broker’s pro forma, sure. But underwrite your numbers…

Understand this: It doesn’t matter how much income the previous owner brought in or how much the broker thinks you should be able to bring in. What matters is how much income YOU think you can bring in.

Similarly, it doesn’t matter how much the previous owner spent to run the property or how much the broker thinks you should spend. It’s how much YOU think running this property correctly will cost you.

Underwrite to your numbers. Got it?

A Recent Example

I spent a couple of days working up 120+ units in a submarket I know very well. This is a community that just came on the market with a national broker.

Even though the community is listed as “un-priced,” having seen a lot of OMs by this company, I knew just by looking at their pro forma that they were aiming for no less than $4,000,000. Having spoken to them, I realized that I was wrong–they are really pushing $4,500,000.

A Few Things to Note

As I mentioned, I know the market very well; it is in my target area. I also know all of the heavy hitters in this area. There has never been a transaction involving 100+ units that traded anywhere near $40,000/door, ever! Players in this submarket understand that the dynamics there just do not warrant this type of pricing.

You should also know that I had personally contacted the big investors in this sub-market for two reasons: to establish whether anyone would be pursuing this deal and to gauge what people thought the value of it was.

As it turned out, none of the typical players, aside perhaps for me, was interested in playing. And everyone agreed that the price at which the deal made sense was considerably less than that which the broker was peddling this for–considerably less.

My Underwriting

Here are some points of interest:

My gross potential income–this is the total income if I had zero economic losses–is within $5,000 from the broker’s projection. Basically what this says is that I agree with the broker’s estimate of what rents the property can bear.

My other income–which includes income from laundry, pet rent, application fees, late fees, etc.–is lower by about $25,000 than the broker’s projection. But my number is practically identical to the trailing 12 number. This is the broker saying to me, “We know that the current management has only been able to achieve $xyz, but you are better and will achieve $xyz + $25,000…”

This might be, but I am not sure I clearly see where and how. In this case, the trailing number is practically right on in my opinion for this marketplace.

And thus, so far I am only $25,000 below broker’s pro forma!

However, my Effective Gross Income, which is the bottom line income number that takes into account economic losses such as vacancy, concessions, bad debt, LTL, etc., ends up $60,000 lower than the broker’s. At a 10 CAP, this is $600,000 of value, and at a 9 CAP, which is what I think the trading rate for this asset should be (and broker agrees), this discrepancy constitutes $666,000 of value. Suddenly I am not doing so well…

Perhaps I Can Recapture Some Losses in Expenses

Nope, not gonna happen. The broker’s underwriting suggests that it’ll cost about $450,000/annum to run this property, while I think it’ll cost $475,000. Thus, a loss of an additional $25,000, which capitalizes to another $275,000 of value.

All and all, I am $85,000+/year off on cash flow, which means I am $1,000,000 off on the valuation…

And we haven’t even touched the up-front CapEx that the property definitely requires.

Discussion

The $25,000 gap on the expense side can be bridged; we are close enough. The big issue is the $60,000 of income that I lose due to the economic losses. I know this particular marketplace–I target it. I know the tenant class and all of the vacancy, eviction costs, bad debt, and LTL in this marketplace.

Economic losses are what they are, and they are real dollars, and in this case they are about 10% higher than that which the broker’s pro forma attempts to make us believe.

And you know something else? The broker doesn’t even disagree with me. 🙂 He said so while on the phone with me, which means one of two things: Either he is looking for an idiot who wouldn’t know multi-family underwriting if it hit him in the mouth (which most buyers today are), or he is looking for a 1031 buyer who flat out doesn’t care!

Conclusion

I am not one or the other. I respectfully bow out on this one, unless they decide to get real…

Now it’s your turn to weigh in: Do you agree with my decision regarding this deal?

Let me know with a comment!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.