SS275: How to Spot Over-Optimistic Rent Growth

SS275: How to Spot Over-Optimistic Rent Growth

Over-optimistic rent growth is one of the fastest ways a great-looking deal turns into a disappointment. In this episode, Charles talks about how to compare pro forma rents to actual market rents.

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Talking Points:

  • When an investment offering memorandum or a broker package is sent to me, one of the first things I always review is the current rents in place at the property and the true market rent comparables. This delta in actual versus market rents is where the investor can protect their downside. If you are purchasing a property with $1,300-per-unit rents and the market is $1,600, you have a $300-per-month buffer.
    • Problems arise when the current property’s rents and market rents are very close, and the investor is considering a value-add business plan, where they will be investing a large amount of money to upgrade units and the property in general to increase the property’s rents.  Furthermore, in these situations, it is common for investors to become over-optimistic about future rent growth to make their underwriting pencil. This is what we want to spot early on.
  • Over-optimistic rent growth is one of the most common ways multifamily deals look great on paper but often fail to materialize. Here are a few things we do to spot unrealistic rent growth.
    • 1. Review underwritten growth vs. historical market reality. Review the last 5-10 years of local rent growth. This is a mistake investors made in 2022: they relied on the double-digit rent increases of the last 1-2 years and thought they would last, even though that was just a snapshot in time.
    • 2. Avoid the standard straight-line 3% rent increase. When I see this, over several years in underwriting, I know the investor or broker just phoned it in and usually did no real research. The investor needs to dig into these numbers to see where they came from.
    • 3. Renovation premiums without real proof. This is a common trait among syndicators looking to raise capital for a deal or brokers looking to sell a deal. The underwriting shows that rents are well below market, and for the right investors willing to make some renovations, they can unlock hundreds of dollars in rent increases per unit. Any respectable underwriting proforma like this will include some rent comparables, and this is where the work for the investor begins. We want to break down the comparables they list and find our own.
      • How close is the comparable property to the subject property?
      • Are they the same vintage? I would really like to see the comparable property being older than the subject property.
      • Are the sizes of the properties and the amenities similar?
      • How big are the units? How high are the ceilings? How is the parking?
      • Find the comparable properties online and review the unit finishes.
      • How well-located are the properties? Yes, they are ½ mile apart, but one is right next to a nice shopping plaza. Maybe one is on a busy street, while the other is next to a building in disrepair.
      • Is there a highway, train tracks, water feature (lake, pond, river), or main road between the 2 properties?
      • What type of commercial properties are located around each property? One property with a wine shop next door and one with a check-cashing store will signal a difference in neighborhoods.
      • What concessions or deals are currently being offered by each property?
    • 4. Ignoring new supply in the pipeline or coming online. New apartment supply disrupts rents for Class A, B, and C apartments. Classes A and B are most affected, but this can trickle down to Class C as tenants move up in class as new Class A properties offer fantastic move-in deals and concessions. These concessions will quietly cap rent growth. Additionally, multifamily construction usually takes 24-36 months from groundbreaking to lease-up, so it should not be a surprise to new investors that new units will be coming online. How many units are coming online over the next 3 years in your local area? For years with high deliveries, is the underwriting still showing that rent growth is happening?
    • 5. Underestimated expense growth. If an underwriting model shows that rent growth will always outpace expense growth, look again. This is rarely the case, and expenses are usually harder to estimate than rents. Be wary of any underwriting model that assumes rents are increasing while expenses remain stagnant.
  • Rent growth is hyperlocal. Yes, the market can give you a trend, but you really want to rely only on comparables very close to the subject property, with a similar vintage, condition, and amenities.
  • It is important to understand that rent growth being just 1% or 2% lower or higher than your underwriting can have a massive change to the profitability of your deal. 
  • Another important point is that people with jobs and wages need to pay the rent. If rent growth is outpacing wage growth or if other factors like inflation are squeezing local renters, it is going to make it that much harder to raise rents, and other landlords will start discounting rents to get people into their units, a trend that will continue throughout the market, eroding all rent growth.
  • In multifamily investing, it is best to err on the side of conservative rent growth and rather focus on solid deal execution. 
  • If you are interested in learning how to raise rents without losing tenants, check out episode SS236.

Transcript:

Charles:
Over optimistic rent growth is one of the most common reasons. Multi-family deals look great on paper, but fail in real life. I regularly review investment offering memorandums and broker packages, and the very first thing I look at is current rent versus true market rent, because that gap is where downside protection lives. Welcome to Strategy Saturday. I’m Charles Carillo. Today we’re breaking down how to spot over optimistic rent growth before it costs you real money. So let’s get started. When an investment offering memorandum or a broker package is sent to me, one of the first things I always review is the current rents in place at the property, and then the true market rent comparables. This delta in actual versus market rents is where the investor can protect their downside. If you are purchasing a property with 1300 per unit rents and the market is $1,600, you have a $300 per month buffer.

Charles:
Problems arise when the current properties rent and market rent are very close, and the investor considering a value add business plan where they’ll be investing a large amount of money to upgrade the units and the property in general to increase the property’s rents. Furthermore, in these situations, it’s coming for investors to become over optimistic about future rent growth to make their underwriting pencil. This is what we want to spot early on over optimistic rent growth is one of the most common ways. Multifamily deals look great on paper, but often fail to materialize. Here are a few things we do to spot unrealistic rent growth. Number one is review underwritten growth versus historical market reality. So review the last five to 10 years of local rent growth. This is a mistake investors made in 2022. They relied on double digit rent increases of the last one to two years and thought they would last even though that was just a snapshot in time.

Charles:
Number two is avoid the standard straight line, 3% rent increase. When I see this over several years in underwriting, I know the investor or broker just phoned it in and usually did no real research. The investor needs to dig into these numbers to see where they came from. Number three is renovation premiums without real proof. And this is a comment trait among syndicators looking to raise capital for a deal or brokers looking to sell a deal. The underwriting shows that rents are well below market and for the right investors willing to make some renovations, they can unlock hundreds of dollars in rent increases per unit. Any respectable underwriting performer like this will include some rent comparables, and this is where the work for the investor begins. We wanna break down the comparables they list and find our own. A few of the ones we’re gonna be looking at is how close is the comparable property to the subject property.

Charles:
Are they the same vintage? I really like to see the comparable property being older than the subject property are the size of the properties and the amenities similar? How big are the units? How high are the ceilings? How is the parking? Find the comparable properties online and review the unit finishes. How well located are the properties? Yes, they are a half mile apart, but one is right next to a nice shopping plaza. Maybe one is on a busy street while the other is next to a building in disrepair. Is there a highway train tracks water feature like a lake, a pond, a river or main road between the two properties? What type of commercial properties are located around each property? One property with a nice wine shop next door and one with a check cashing store will signal a difference in neighborhoods what concessions or deals are currently being offered by each property to rent their units.

Charles:
Number four, ignoring new supply in the pipeline or coming online. New apartment supply disrupts rents for class A, B, and C Apartments. Class A and B are most effective, but this can trickle down the Class C apartments. As tenants move up in class, as new class A properties offer fantastic moving deals and concessions. Now these concessions will quietly cap rent growth. Additionally, multi-family construction usually takes 24 to 36 months from groundbreaking to lease up, so it should not be any surprise to new investors that new units will be coming online. How many units are coming online over the next three years in your local area for years with high deliveries? Is the underwriting still showing that rent growth is happening? Number five is underestimated expense growth. If an underwriting model shows that rent growth will always outpace expense growth, look, again, this is rarely the case, and expenses are usually harder to estimate than rents.

Charles:
Be wary of any underwriting model that assumes rents are increasing while expenses remain stagnant. Rent growth is hyperlocal. Yes, the market can give you a trend, but you really wanna rely on only the comparables of very close to the subject property with a similar vintage condition and amenities. It’s important to understand that rent growth being just 1% or 2% lower or higher than your underwriting can have a massive change to the profitability of your deal. Another important point is that people with jobs and wages need to pay the rent. If rent growth is outpacing wage growth, or if other factors like inflation are squeezing local renters, it’s gonna make it that much harder to raise rents and other landlords will start discounting rents to get people into their units. A trend that will continue throughout the market eroding all rent growth In multifamily investing, it’s best to err on the side a conservative rent growth and rather focus on a solid deal execution. If you’re interested in learning how to raise rents without losing tenants, check out episode SS 2 36. That’s SS 2 36. I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentoring programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Links Mentioned In The Episode:

  • SS236: How To Raise Rents Without Losing Tenants

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