You’re ready to invest in a new multifamily property. Before you get started, however, it’s important to put together a realistic look at what income and expenses you can expect over the first year or two of owning the property. You do this by approaching your deal analysis from a multifamily pro forma budget point of view. In other words, what happens to property income and expenses once you own the property?
You don’t want to get stuck with a property that is a constant drain on your resources; rather, you want a property that will help generate income and improve your financial portfolio. By taking a reality-based point of view as you pursue your investment, you’ll discover that you’re in a much better position to predict expenses once you take over the property.
Start with the T12 (but take it with a grain of salt)
The seller should provide a T12 when you’re considering the property. If not, ask for a copy. A T12 is the 12-month trailing profit and loss statement for the property. It will allow you to evaluate profit and loss—but it won’t provide a perfectly accurate statement of exactly what you can expect.
Listing brokers will likely start by promoting profitability: a clear look at what you could make from the property in a pie-in-the-sky reality. Their offering memorandum will likely show the highest possible income and a low look at potential expenses.
Your ultimate numbers will not look like the seller’s or broker’s. Sure, you may have great results. You may be able to increase income or decrease expenses. That doesn’t mean you should rely on those numbers in your own pro forma budget.
Multifamily pro forma budgeting from a reality-based POV
Review the T12 and the brokers offering memorandum but take both with a grain of salt. Your multifamily pro forma budget should include your numbers, not the ones offered by the seller or broker. Ultimately, this will give you a better look at what you can expect from the property.
To arrive at your offer price, start by projecting your income and expenses through your first 12-24 months of ownership. The goal is to develop an understanding of your cash needs beyond the down payment and closing costs. This is especially important if you plan on having partners throughout your ownership. No one enjoys cash calls!
Ask yourself these key questions to help project and predict your income and expenses.
What rental income can we expect on day one?
Consider the current vacancies—or the ones expected at closing if there are tenants preparing to move in or out. Also review the current rent roll.
Do not use market vacancy to arrive at your numbers. If there are higher vacancy levels in the property, you may find that you struggle to fill those vacancies in a timely manner. On the other hand, if every unit is filled, you may be able to expect a higher level of income. A current rent roll is a critical part of your multifamily pro forma budget and should not be ignored or overlooked.
Will leases renew or expire?
How long do current leases on the property last? Do tenants usually choose to renew, or do tenants in this building often move on after their lease has expired?
Scrutinize the leases that will expire soon after you take ownership. Often, tenants choose to leave under new ownership because they expect rents to increase. Consider how long units will be down during renovations, especially if you have plans for big renovations and changes throughout the building.
You can’t count on the same occupancy numbers that the property currently has, especially if you know that you’re going to make significant changes to the building or to the individual units. Noise and consistent disruptions across the property can also lead to new vacancies.
What property expenses are likely to change?
Some expenses will remain relatively consistent even when a property changes ownership. Others, however, you can expect to change such as the following:
- Liability, hazard, and umbrella insurance: You can’t know when you look at the seller’s insurance expense whether they are over- or underinsured. During your due diligence period, speak with an insurance broker and get a quote effective for your closing date. Make sure that it is based on your specific needs and includes the appropriate riders for your loan: flood insurance, hurricane insurance, earthquake insurance, loss of rents, code changes, and so on. Your insurance is the first line of defense for risk management and asset protection, so make sure you don’t let it fall by the wayside!
- Personal property taxes. Some jurisdictions will tax non-real property that is included with an asset. Make sure you’re taking this into account.
- Utilities. Do you plan to introduce a tenant utility reimbursement program as leases renew or are signed? If so, your utility income and costs will change. Utility usage may change. You may also find that utility costs change if you introduce significant improvements to the building or due to weather differences from year to year.
- Property taxes. Sometimes, sales trigger a tax increase. Contact the assessor’s office to get a better idea of when you can expect from property taxes.
- Property management. Is the seller self-managing? If not, who do they use as a property manager? You might want to continue working with that individual. Chances are, you’ll bring in your own property management company. As a result, management expenses may change drastically. Also, your rates may differ based on the number of buildings you own or a range of other factors.
- Debt Service. Do you intend to pay all cash for the property? Or will you finance a portion of the purchase? If financing, you’ll want to include the debt service expense when arriving at total cash needed.
What are our immediate cash needs?
As you prepare to take on a new property, make sure you have ready cash on hand to handle immediate needs. This might include:
- Unit renovations
- Unit refresh costs (basic repairs and maintenance)
- Addressing common area deferred maintenance
- Additional leasing fees and commissions
- New signage and marketing materials
You’ll also want to be sure that you really know your market before you take over the property so that you can adequately prepare for potential expenses, including giving potential tenants more of what they want. Some questions to ask are:
- What do prospective tenants want? What will they pay for it? And can you give it to them and still be profitable?
- Can you expect to fill vacancies quickly?
- Is your renovation budget accurate?
- How quickly can you turn units? Raise rent?
- How much cash will you need to keep in reserve?
By answering these questions, you’ll get a better idea of what changes need to be made quickly in order to help the property reach its full potential—and therefore put together a better multifamily pro forma budget.
Do you need more help choosing your first rental property or deciding whether a specific multifamily property is right for you? Contact us today to learn more about how we can help you along the way.
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