Biggest Underwriting Mistakes Incurred by Novice Investors

[Richard McRae]

I see many properties advertised these days with unrealistically low expense ratios. Inexperienced investors that are excited to make that first acquisition need to be aware of and understand how to accurately evaluate expenses. As a commercial real estate appraiser for over 18 years, I have analyzed hundreds of income statements for multifamily properties. Institutional and investment quality properties seldom have supportable expense ratios below 40% (typically in 45% -50% range), but most 1-4 unit properties have advertised expense levels at well below these levels. Bear in mind that if a large project cannot be operated below this range, you should be skeptical of a one or two unit property that is advertised as such.

One of your best guides is recent expense comparable data. Most small-scale investors skip this step, but acquisition analysts and appraisers are religious with the collection of expense comparable information. If you will email me, I will be glad to forward an excel template.

It is imperative for investors to adequately understand current expense levels and estimate pro-forma levels with some level of confidence. I have included a brief discussion of some of these problem line items: vacancy/collection/loss to lease (VCL), management, administrative expenses, maintenance, and reserves.

VCL expenses are notoriously under-represented:

• Vacancy is relatively straight forward and should not be difficult to ascertain. As a check, divide total rents collected during the past year by the gross potential income and see if there is a difference. You may be surprised!
• Collection loss is a different story. For example, owner-managers typically do not collect or record late penalties or the cost of the non-payment. Attorney fees may be accounted for, but the income loss may not be recorded, particularly if the tenant remains in place.
• Loss to lease can also be extreme and must be considered in your underwriting. If one unit is rented at $500 and is supported by market rents (assume a GPI of $60,000), and the other nine similar units rent for $450, your loss to lease is $5,400, or 9%! It will be a costly process for you to increase rents as vacancy levels will potentially increase, or you may be need to incrementally increase rents over time for those nine tenants. Budget for this expense in your overall V/C/L estimate.

Owner-managers often do not pay themselves the market rate for managing and leasing their property. Management expenses are often seen as profit. Assume that you will have to hire a manager and pay lease-up commissions.

Administrative fees can also slip through the cracks. Often-overlooked expenses include: tax preparation fees, licenses, bookkeeping, finance related fees (will an appraisal be required every 3 – 5 years for asset monitoring, checking fees, account expenses, etc.).

Maintenance and re-let expenses fall under the same category as management: ownership will often make repairs and not charge the property for their time. Be realistic!

Lastly, the cost of capital expenditures can quickly add up. Depreciate the cost of your appliances, roof, driveways, etc. over their useful life and you will be surprised at the actual cost. Lenders typically require $200-$300 per unit for reserves for replacements.

Take-away: Start an excel file to record operating expenses from every property you underwrite. As the data mounts you will see a more accurate picture of what operating expenses should be for the type of asset you seek to purchase. Be realistic in your assessment of the potential for increases or decreases in the advertised level. Understand as well that the seller may not be trying to hoodwink you, but may have just not understood and recorded all expenses incurred.

Good hunting!