Today is another AMA episode (Ask Me Anything) John from New York asks:
With states, cities and towns possibly being under financial pressure due to decreased business during pandemic, how would you underwrite the purchase of a multifamily asset? How much of the increased tax can be passed along in a rental increase?
John, this is a great question. If you look at most cities, they get their cash from one of several sources.
1) Property Taxes
2) Service Fees
3) Other Levels of Government
Despite the pandemic, I don’t expect property tax collections to go down very much. Eventually, the city will get the property taxes, whether it means a tax lien on a property, or an outright tax sale, the city will get their money.
Service fees are the area that have been hit the hardest during the pandemic. Services fees include everything from the revenue collected when a someone rents a meeting room for an event, to parking tickets, to library fines. This is where cities have experienced the most impact during the pandemic and it’s also the area where the cities have reduced staff. You don’t need to hire life guards if the swimming pools are closed this year.
Transfers from other levels of government have been largely unaffected.
Borrowing is restricted to capital projects in most cities. Most cities are prohibited from borrowing to fund day to day operations. The only way to cover the shortfall is to either raise property taxes or to beg another level of government for more money. How each city will deal with the problem will vary from one to another. Nashville increased their property taxes by 34% in their most recent budget. Hopefully most cities don’t experience that kind of increase.
One problem in your question is how can you pass on these costs to tenants and recover some or all of the income lost to higher taxes? Some jurisdictions have rent controls. Where you’re from in NY is famous for its complex web of rent control regulations. Where I live in Ontario Canada, the province limited rent increases to zero % for 2020, arguing that the pandemic has caused enough pain for tenants. In most communities, taxes, utilities, insurance, have all increased rates in the past year. A zero percent rent increase is basically legislating landlords to lose money.
So back to your question which is how to underwrite a new project?
When there is uncertainty, you need to build safety into the project. That means increasing the debt coverage ratio to ensure you have a higher profit margin and lower debt service.
Most lenders require a debt coverage ratio of 1.2. Let’s look at a simple example. Let’s say that your project generates 120,000 in profit before debt service. In that scenario you would have $100,000 in debt service and $20,000 in free cash flow. But that’s the minimum your lender would allow and it doesn’t leave much margin for things to go wrong. For example, if your property taxes went up $10,000 and your occupancy dropped, and you had some unplanned maintenance, you could find yourself in a negative cash flow situation.
I would urge you to borrow a little less money, and bring more equity to the table. You might lower your borrowing from 80% loan to value to something lower, like maybe 65% or 70%.
You would want to target a higher debt coverage ratio like 1.5. In that scenario you might take that same $120,000 profit and target $80,000 of that to go towards debt service and $40,000 in free cash flow. The stronger cash flow on paper makes the project more resilient towards surprises. You could need that extra buffer. In our projects we are targeting higher debt coverage ratios above the minimums in order to bring that extra level of safety into the projects.