Rental Property Investor · New York, NY · Member since 2017 · 300 posts · 168 votes
Hi everyone,
I would like to survey the crowd as to what everyone is using for organic rent growth and expense growth assumptions. What are your baseline numbers and how do the idiosyncrasies of a given deal affect these numbers (if at all) and do you adjust these assumptions for different submarkets/markets?
Additionally, I'm finding it difficult to reconcile the fact that when you project 3% rent growth and 2% expense growth for 5 or 10 years, your expenses as a percentage of EGI (which should be around 50-55%) get way out of wack (40% or less). Does this low of an expense ratio ever become a reality? If not, how does strong rent growth over a number of years play out in these numbers?
@Rob Beardsley Your ratios go out of whack because of compounding. 3% vs 2% compounding results in big gaps. This isn't as big of an issue in the deals I've done because our expense ratio (non-stabilized) was in the 55-58% range. Expense optimization was one of the reason why the asset was being acquired.
All things being equal, in a value-add project, your expense ratio should be in the 55% range in the first 1-2 years because you will be going through a rehab (units will be down but fixed costs will continue). At this level, in 3-5 years, you should see your expense ratio fall to the 48-50% mark.
From a purely modeling POV, if that is not the case, it could mean 2 things:
Incorrect modeling; OR
You have an amazing property manager who's killing it!
Personally, I have not understood the expense growth rate of 2%. That doesn't really work in primary and/or secondary markets. E.g. payroll costs have shot through the roof, but a multiple of 2%, in Texas over the past 3 years.
Alternatively, you might also consider not being aggressive on rehab time frame, renovated rent premium and rent growth. Most markets are slowing down. The high growth rates that worked over the past 3-5 years might not work in the coming few years.
Great saying I heard which helps me: "It's better to be approximately right than precisely wrong."
@Rob Beardsley Your ratios go out of whack because of compounding. 3% vs 2% compounding results in big gaps. This isn't as big of an issue in the deals I've done because our expense ratio (non-stabilized) was in the 55-58% range. Expense optimization was one of the reason why the asset was being acquired.
All things being equal, in a value-add project, your expense ratio should be in the 55% range in the first 1-2 years because you will be going through a rehab (units will be down but fixed costs will continue). At this level, in 3-5 years, you should see your expense ratio fall to the 48-50% mark.
From a purely modeling POV, if that is not the case, it could mean 2 things:
Incorrect modeling; OR
You have an amazing property manager who's killing it!
Personally, I have not understood the expense growth rate of 2%. That doesn't really work in primary and/or secondary markets. E.g. payroll costs have shot through the roof, but a multiple of 2%, in Texas over the past 3 years.
Alternatively, you might also consider not being aggressive on rehab time frame, renovated rent premium and rent growth. Most markets are slowing down. The high growth rates that worked over the past 3-5 years might not work in the coming few years.
Great saying I heard which helps me: "It's better to be approximately right than precisely wrong."
The answer depends on the market and market cycle. I am in markets that grow 2-4%/year. I underwrite at an average in 5 years at 2% rent growth and 2% expense growth.
@Rob Beardsley when I look at financials for a syndication I'm evaluating or any other pro-forma, it's a big red flag for me if they assume organic rent growth higher than expense growth. Because both of those numbers are just guesses and because the rent growth multiplies a bigger number it naturally has a larger affect and it compounds the more years they show.
So my advice would be just to be conservative and assume the same low growth rate for each number. 2% is reasonable.
Note, though that I said organic rent growth, if you are driving rent growth through value-add rehabs you have to show that in the numbers.
I’m a fan if the 2% rent / 2% expense growth assumption as well. This reconciles with the Fed’s goal of 2% inflation. There will be periods of higher and lower inflation but since I’m a long-term buy-and-hold investor in the long run this should play out close enough to reality, if anything conservative based on where my properties are.