Rental Projections - What People Get Wrong
Over the past few years I have looked at thousands of proformas. They have varied by number of units, location, age, but they all (well at least 95%) have one thing in common - their rental projections are too aggressive. So where are most people going wrong?
1. Comp Set - Not all properties are created equally. From one property's amenities versus another to being on the “right side” of a particular street, rents vary drastically. That is why it is really important to know your market! Another common example is not accounting for school ratings. Even defaulting to “The comp has the same high school”, can be problematic as elementary schools vary in desirability. Desirability translates to demand, demand translates to, you guessed it, higher premiums - both on home sales and rents. There are numerous factors impacting the appropriate comp set, however, a good rule of thumb is if you were a prospective tenant, which properties would you be going back and forth about deciding where to rent. At the end of the day, that is what your prospective tenants will be doing, so choose wisely!
2. Accounting for Concessions - It’s one thing to look at advertised rents on a comparable property’s website; it’s another to account for the concessions they are running. Often concessions are not advertised on the property's website, but when you go to lease on site the leasing agent mentions a special. Knowing the discount tells you the effective rent you should be comping. In other words, let's say the advertised rent is $1,200/month, but they are running a special with the first month free. The rent you should be using to comp is actually $1,100. How did I get $1,100? Take $1,200 * 11 months (because of the one month free) = $13,200 annual collected / 12 months = $1,100. Too many people only account for the rent and not the concessions. This leads to an immediate deficit of achieving the target rents.
3. Absorption Rate - I have saved the best for last. Occasionally people account for #1 & #2 above, however, I RARELY see someone account for absorption. Most people would agree that if all things are equal, it is easier to lease 3 units than 60. Most people would also agree that when demand stays constant, having less supply drives price. For some reason when those two statements are put together and applied to forecasting rents, people forget they believe in those two underlying principles. The most common example is when someone uses rents achieved by a small subset of renovated units to forecast the same rate for all remaining unrenovated units. The second most common example is taking the rents achieved from the same unit type at a comp property to forecast the rents at the subject property when the number of units between the two properties varies significantly. Here is a real life example. The subject property has 200 units split 50-50 between 1 bedrooms and 2 bedrooms. A comp property down the street has the same square footage in their 1 bedroom units and is achieving $950 a month. The interested buyers underwrite the subject property’s 1 bedrooms to $950 once the value-add is completed. The problem is, the comp property only has ten 1 bedrooms, while the subject property has 100. In other words it is going to be a struggle to even get $900/unit.
So what’s the big deal? You can make it up in other areas right? Well, it depends. Continuing with the example above, let’s for argument sake say that they were only off by $50/unit across 100 units. The first problem to contend with is cash flow ($50/unit*100 units*12 months = $60,000/year)! The bigger hit comes with the sale price. Let’s assume the market cap is 4.5. That is a hit on the sale price of $1,333,333 ($60,000/.045)!! I think it is safe to say, being off by $50 on just 100 of the units is a pretty big deal!