On today’s show we’re talking about three of the spreadsheet, the most common mistakes I see investors make. The first is the dreaded rule of thumb mistake.
Somewhere along the way, a real estate trainer provided some rules of thumb about what things should cost. In particular, we’re talking about expense ratios.
The logic goes something like this. In a multi-family apartment building, you should allocate about 45% of your revenue to expenses.
Well folks, I’m here to tell you that this approach to analyzing your apartment complex is just plain inaccurate. In fact it’s so inaccurate that it’s not even useful as a tool for quick math.
I’ve seen the exact same product with the same management company experience two dramatically different expense ratios. In one city, the expense ratio was 31% and in the other it was 42%. The rents were basically the same. The difference was in property taxes and insurance. One city had much higher property taxes which accounted for a massive difference in the total operating expenses for essentially the same product. So rules of thumb don’t work.
The only exception to that would be if you had another similar building in the same area with a good bit of operating history. In that case, you can borrow actual expense numbers as an estimate from a similar property in the same area. But you’re not blindly multiplying by a percentage. In that case you’re using real data as a point of reference.
Expenses tend not to care how much you’re getting in rent. If you have a lot of common area, you’re going to need to spend money on energy to provide lighting and climate control for those common areas. How old is the building? How much will you need to spend on maintenance?
How high is your tenant turnover? The higher your turnover, the more you’re going to spend on unit turns.
When a water heater decides that it has reached end of life, it doesn’t care whether you’re getting $700 a month in rent or $3,000 a month in rent. It’s going to cost the same to replace the water heater. But clearly as a percentage of rent, the cost of maintenance is going to be much higher.
I’ve then seen investors take this flawed assumption and build a financial house of cards on top of it.
There are three deadly sins when it comes to underwriting a deal. Excel will give you beautiful reports and charts and graphs. That creates an aura of legitimacy that far outstrips the integrity of the underlying data.
- Push the rents above the market. Nothing too aggressive, maybe just $50 a month above market. I’ve seen so many investors delude themselves using this approach.
- Use the aforementioned expense estimates.
- The cap rate assumption.
The market cap rate is often used to determine the value of a property. But since cap rates these days are so low, even a small change in cap rate can result in a large change in value.
I would have valued a new property in that C class location at about a 6% or 6.5% cap rate. But this investor chose to underwrite the value based on a 4.5% cap rate. That 2% difference in cap rate may not sound like that big a difference. But in reality, we’re talking about a 32% difference in value. Simply by choosing a lower cap rate, this investor had inflated the value of his proposed property by 32%.
This particular investor had accepted another investor’s pro-forma as a good model without digging deeply into the numbers. It turns out that his expense ratio was below 20% which is unrealistic.
When you layer the other sins on top, you find that the cumulative error is a whopping 76% overestimation of the value of the property. But Excel is perfectly willing to dutifully perform the math and show glowing numbers.
In short, proper underwriting requires a deep analysis of all the variables that make up the income and expenses for a project. There is no shortcut.