SS277: How Expense Ratios Kill (or Save) Deals?

SS273: Multifamily Expense Ratio

In multifamily investing, expense ratios are a quick way to gauge how efficiently a property is operating. In this episode, Charles discusses how expense ratios might signal opportunity and also hide a potential problem.

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Talking Points:

    • Previously, in episode SS273, we discussed the basics of what an expense ratio is in the context of multifamily real estate investing, and in this episode, we are going to take that one step further.
    • As a quick recap, the expense ratio is determined by dividing operating expenses by the gross effective income of a property. The rough rule of thumb is that multifamily properties should have an expense ratio of 40%-60%. The expense ratio will be lower for newer A-class properties and higher for older C-class properties. B-class properties should be right around that 50% mark, but like real estate in general, expense ratios are hyperlocal and can differ by sub-market.
    • In multifamily investing, the expense ratio is a quick underwriting metric that gives a glimpse into the operations of a property. For beginners, it can be overlooked, whereas a seasoned investor who understands common expense ratios in their market might notice an opportunity.
  • How Do Expense Ratios Kill Deals?
      • Expenses greatly affect the value of a property. If you are looking at a property with a 5% Cap Rate, every $1 in expenses that is not accounted for reduces a property’s value by $20. 
      • It is easier to verify a property’s income but harder to verify a property’s expenses. If you are reviewing a seller’s T-12 or trailing 12-month statement, you will see the gross income, and you can verify that by cross-checking the property’s bank statements. Pretty straightforward. But, when reviewing expenses, it is harder to see if the seller is making them look “lean” for sale to boost the value of the property and deferred maintenance awaits the buyer, or if they were really fixing a lot of issues throughout the year, and the property has minor deferred maintenance remaining. Additionally, if repairs are higher than normal, it might indicate constant patching, which may require an actual replacement. Reviewing current expenses with the property management team and walking the property will give you clarity on the property’s true condition.
      • Property taxes are a common deal killer, especially if a property has been owned by the same owner for many years. Estimating the new tax bill at the time of purchase will give the buyer a more realistic estimate of the expense ratio.
  • How Do Expense Ratios Save Deals?
    • Normalize the expenses of the deal. Provide an honest opinion of how much it will take to operate the property. What line items can be decreased? If you own similar properties in the area, these opportunities will be more apparent than to a first-time investor. Do all of this without changing the property’s current gross income, and see how the deal looks now.
    • Are there any operational inefficiencies? Is the seller paying for all of the utilities out of pocket? Are they overpaying for payroll or management, which is very common with seasoned owners who are making money and not interested in making changes that could negatively affect the time they devote to the asset?  
  • In multifamily investing, you want to look out for expense ratios that are outside of market norms. Expenses that are not in line with industry averages, and underwriting that has not been adjusted for the estimated new taxes and insurance premiums. Expense ratios won’t make a bad deal good, but they will quickly expose it, and that is exactly why we reference them early in underwriting.

Transcript:

Charles:
One of the biggest underwriting mistakes is underestimating expenses. Small expense mistakes can erase hundreds of thousands of dollars of value in an instant. One thing I’ve noticed over the past two decades is how experienced investors and underwriters utilize expense ratios while some beginner investors simply overlook them. Welcome to Strategy Saturday, I’m Charles Carillo. Today we’re discussing how expense ratios kill deals and how they can actually save them when you know how to read between the lines. So let’s get started. Previously in episode SS 2 73, we discussed the basics of what an expense ratio is in the context of multi-family real estate investing. And in this episode, we’re gonna take that one step further. As a quick recap, the expense ratio is determined by dividing operating expenses by the gross effective income of a property. The rough rule of thumb is that multifamily properties should have an expense ratio of 40% to 60%, and the expense ratio will be lower for newer A class properties and higher for older C class properties, B class properties should be right around the 50% mark.

Charles:
But like real estate in general, expense ratios are hyper-local and can differ by sub-market. In multifamily investing, the expense ratio is a quick underwriting metric that gives a glimpse into the operations of a property. For beginners, it can be overlooked, whereas a seasoned investor who understands common expense ratios in their market might notice an opportunity. So how do expense ratios kill deals? Well, expenses greatly affect the value of a property. If you’re looking at a property with a 5% cap rate, every $1 in expenses that is not accounted for reduces a property’s value by $20. It’s easier to verify a property’s income, but harder to verify a property’s expenses. If you’re reviewing a seller’s T 12 or trailing 12 month statement, you’ll see the gross income, and you can verify that by cross checking the property’s bank statements pretty straightforward. But when reviewing expenses, it’s harder to see if the seller is making them look lean for sale, to boost the value of a property and deferred maintenance awaits the buyer, or if they were really fixing a lot of issues throughout the year and the property has minor deferred maintenance remaining.

Charles:
Additionally, if repairs are higher than normal, it might indicate constant patching, which may require an actual replacement. Reviewing current expenses with the property management team and walking the property will give you clarity on the property’s true condition. Property taxes are a common deal killer, especially if a property has been owned by the same owner for many years. Estimating the new tax bill at the time of purchase will give the buyer a more realistic estimate of the expense ratio. So how do expense ratios save deals? Normalize the expenses of the deal, provide an honest opinion of how much it will take to operate the property, what line items can be decreased. If you own similar properties in the area, these opportunities will be more apparent than to first time investors. Do all this without changing the property’s current gross income and see how the deal looks.

Charles:
Now, are there any operational inefficiencies? Is the seller paying for all of the utilities outta pocket? Are they overpaying for payroll or management? Which is very common with seasoned owners who are making money and not interested in making changes that could negatively affect the time they devote to the asset. In multifamily investing, you wanna look out for expense ratios that are outside of the market norms, expenses that are not in line with industry averages and underwriting that has not been adjusted for the estimated new taxes and insurance premiums. Expense ratios won’t make a bad deal good, but they will quickly expose it, and that is exactly why we referenced them early in underwriting. So 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:

  • SS273: Multifamily Expense Ratio

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