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What are Rental Property Risks?

In today’s highly competitive, low cap rate environment, it’s vital to get the underwriting correct. For example, at a 5 percent cap rate, every dollar you miss in net operating income translates to $20 in price.

So, if you underwrite $10,000 in income you shouldn’t have, you just lost $200K in value. Pretty serious stuff!

Larger multifamily deals and the added complexity of the transaction create more opportunities to get tricked or to miss something.

In smaller deals, it’s pretty simple. You’re really just looking at the stated rents and applying a vacancy factor.

On bigger deals, to truly get a handle on income you’ll need to understand the interplay between market rents, loss to lease, concessions, bad debt expense, and marketing expense. Then, there are a handful of other income line items, as well.

Maybe you come across a deal where rent increases appear to be red hot over the past three or four months and vacancy is tightening. But along with that, you see a spike in concessions, bad debt expense, and marketing expense. Maybe utility reimbursements dip, as well.

If you’re focused on the rents, you may underwrite those numbers and lean on your property manager to get expenses more in line with a typical property. Then, you acquire the property and watch your rents decline.

Sure seems like those sly foxes on the other side of the transaction bought up rents and lowered credit standards to drive income for the sale. And you fell for the shenanigans! Bummer.

Before I continue, here’s a quick word on brokers. This article is not about broker bashing. Brokers are generally hardworking, good people trying to do their job. And it’s the broker’s job to get the highest price for his or her client.

The good brokers do an excellent job of presenting their properties in the best possible light. In this game, there’s no one to go crying to if you get it wrong. (Well, maybe your mommy.) But unfortunately, you have no one to blame but yourself if you overpay and lose money.

Getting upset at a broker for convincing you to pay too much would be like me giving my two-year-old paint and then getting upset when the cat is purple. (Side note to my wife: That’s on me, honey. I’m sorry.)

Here are a few areas where a less experienced buyer may be convinced to pay a higher price than they should.

Gross Potential Rent Shenanigans

One of the most common things we see is a sudden increase in market rents before a sale.

The seller raises their market rent by $100K, but the actual rent charged hasn’t changed, so loss to lease goes up $100K and the gross potential rent is unchanged.

However, it isn’t easy or intuitive to see that on a raw rent roll. You’ve got to break down the rent roll and do some analysis to find out what is going on.

It would be easier to see the market rents and assume they’re achievable—especially when the broker cherry picks the very best comps.

When you ask about the loss to lease, the reply might be, “All you have to do is burn off the loss to lease and you’ve got a real winner!”

Sure, there are deals that are slightly under-managed. Nonetheless, do you really think the seller is just leaving $100K in rent ($1.5 to $2 million in value) on the table?

Value-Add Shenanigans

Many value-add deals come from a seller who has done a number of units already to prove the concept. At my company, we look into it further. When we do, we’ll often see the offering memorandum (OM) suggest that the units that have already been renovated still have meat on the bone because the current owner didn’t maximize the renovation.

To set our expected renovation premiums, we look to three different data sets. The first and most accurate numbers will come from the renovation premiums the current owner has achieved. Even if you plan to do a few things differently, the market won’t drastically improve with a few new finishes.

After that, we look at similar vintage, recently renovated comps with the same ceiling height as the subject. I think a lot of investors overlook the importance of ceiling height. A unit with eight-foot ceilings will just never feel like a premium unit even with a great renovation.

Ideally, we’d like to be able to underwrite to the lower end of the rent spectrum relative to these comps. And if we execute a great reno, the additional rent is gravy.

Last, we take a look at deals at least 10 to 15 years newer than ours. These deals are just designed better. They have better amenities and floor plans.

No matter how good your renovation is, these deals will always look and feel a little better. We want to make sure our rents remain a good $100 or more below these properties so we maintain the value proposition to renters wanting a nice unit at a fair price.

Negotiating Shenanigans

It’s great to have a good relationship with brokers. It can definitely help you in a competitive bidding process. But let’s not forget who the broker is working for.

It’s not uncommon to hear something to this effect: “If you can come up another $500K, the deal is yours.”

What they’re not telling you is that you’re already the highest bidder, and they’re just trying to squeeze out a little more for their client. The broker is trying to give you the old “sugar-me-do.” (Bonus points for the first person to identify that reference in the comments.)

We’ve bought a number of deals where we thought we might need to come up, decided to stand pat, and then had the deal awarded to us.

To be fair, we’ve lost more deals than we’ve won when they tell us we need to come up. But the takeaway here is to commit to your number and don’t fall for the temptation to stretch juuuust a little more than your max.

When stepping up into larger multifamily deals, you’re going to be dealing with more sophisticated real estate professionals. There is an implied understanding that if you’re playing in that space, you’re capable of swimming with the sharks.

To be sure, most people I’ve come across are honest, good people. But they’re pros for a reason. Expect them to do everything they can to get a better deal than you. They expect you to do the same. And at the end of the transaction, when the dust settles, only you are responsible for the deal you’ve got.

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