In this article we want to cover one of the most important parts of underwriting: Comparing “market rents” to actual rents. We have underwritten several properties over the last couple of months. However, in order to protect our investors’ capital in these volatile times, we continue to be highly selective on properties we are willing to offer on. 

When a broker lists a property in a hot market, the sales price (or “whisper price” as it’s known in the industry) is determined by where they think the property’s net operating income (NOI) can go within the next year along with the market cap rate. This is a pro forma version of the “Income Approach” to apartment valuation (for an in-depth explanation of apartment valuation, see the 2-part video series here). 

The traditional Income Approach to apartment valuation looks at the NOI over the previous 12 months, then divides that by the cap rate to determine what the property is worth. But in a hot market, buyers are willing to pay more for future/potential NOI increases. Hence cap rate compression. This has become quite accepted as of late due to the high demand for apartment investing. The important part is making sure these assumptions are realistic.

Let’s look at a case study of a recent property we underwrote, and ultimately why we did not pursue the opportunity. A lot of this information is confidential until the property is sold, so we’ll be general. 

This was a 200+ unit property built in the 1980’s, located in a market that is on fire in the South. We pulled the Offering Memorandum (OM), Rent Roll (RR), and Trailing 12 financials (T12) and dove in. We called the broker and got the whisper price, which was well over $150k per door. Come to find out, some of the units had been renovated to an “Elite” level, some were minorly upgraded, and some were standard or classic units. We were told that if we upgraded the remaining to the elite level, we could get $300+ rent bumps. 

The whisper price was largely based on this assumption, so it was up to us to determine the accuracy of these rent increases should we renovate to the elite level. There are two main ways of going about this. The first is by doing an in-depth analysis of the rent roll and looking for proofs of concept, where other units are already obtaining the higher rents. Or at least close to them. Below is an edited chart of a portion of the rent roll. 

You can see the “Market Rent” column in the middle. These are the rents set by the property management company for what they think the units should be getting and are often increased prior to a sale to make it look juicier. In this example there are 4 vacant units, so we are unable to use those as a proof of concept as we don’t know if these will be rented at the claimed market rent. 

Notice “Tenant A” is only paying $907 in rent despite the market rent claiming to be $1,250. This $343 difference is known as a loss-to-lease and can be a great opportunity to increase NOI, as long as the market rent is realistic. “Tenant B” is paying $20 more than “Tenant A” for the same unit type, so we can already see a trend that these units are not renting for what they claim they should be.

When looking at a complex this big, the rent roll can seem overwhelming. We like to reorganize it by breaking it up by unit type then by rent amount. This enables us to clearly see how many units (if any) are achieving the market rent, as well as when their leases started. We particularly want to see what the newest leases in the pasts few months have been getting as this will give us the most accurate data of what is currently happening at the property.

The chart below shows the highest current rents of this unit type. Notice there are actually several units with recent leases achieving the market rent of $1,250. This gives some reassurance that this market rent is realistic. However, the two elite units with market rents of $1,550 are vacant, so we have absolutely no clue if someone will be willing to pay $300 more for the same type of unit just because it has granite counters and fancy finishes. 

In this next chart of a different unit type, the 4 units with the highest rents are not achieving the purported market rent of $1,300. Granted these leases were signed in 2021, so perhaps they can get to $1,300 with new leases. But this does not show a proof of concept that this particular unit type can actually achieve these market rents.

In this last example, this unit type is actually achieving the market rent of $1,350 in the top 4 units, which again gives us some certainty that this market rent is reasonable. But what about that lone market rent of $1,700? That is actually a certain 2-bedroom unit that has been upgraded to the elite level and they are claiming the market rent for that upgraded unit is $1,700! 

Since there is only one of these such units upgraded to that level and it is vacant, to assume that we will get $1,700 if we upgraded all those types of units to that same level is overly aggressive and a good way to get yourself (and more importantly your investors) in trouble. We have no proof of concept that this property, built in the 1980’s, will ever be able to attract a tenant willing to pay that much for a 2-bedroom unit. No matter how many bells and whistles it has. 

Without a proof of concept at the subject property, the other way to determine if these higher post-renovation rents are realistic is to do an in-depth market survey, where we look at comparable properties with similar amenities and unit types to see what rents they are getting. We do this by “secret shopping” the comparable properties. We always complete this step whether we have a proof of concept within the subject property or not. The last thing we want to do is over-project where we can take rents. This is why we always dive deep into several of the greater market and submarket indicators, including job growth, population growth, median household income and more.

This is ultimately why we did not pursue this property. There were just too many aggressive assumptions that would have had to been achieved to support the whisper price. Our offer price would have been in the low $120k’s per door based on our underwriting, so we passed. But we’ll keep looking for the right opportunity for our investors!

On behalf of all of us at Guardian Multifamily, thanks for taking the time to educate yourself on this important step to ensure your investment is sound. If you have any questions, please feel free to reach out at any time.