Projecting Income that is below market rent

[NachoPerito]

I am wondering your take on this situation that comes up a lot.

For example. In my experience for a lot of apartment complexes the rents aren't kept at market rent for existing tenants. I appraise the property and note that PGI based on market rent is 5% higher than actual rents.

The published cap rates for local apartment sales are on actual income (average rents at 5% below market).

In this type of scenario would you go through the whole process of projecting market rent and discounting for getting the one-year leases up to market rent then subsequently adjust your sales to cap rates based on market rents? Or do you say that 5% below market income is typical and future rent upside is reflected in the cap rate correlation?

I struggle with this because what I learned in class was 'market rent' market rent' market rent', but in real life buyers care more about actual income as long as it is reasonably close to market.

Thanks for your input.

 

[Michael P Jacobs MAI]

<SNIP>In my experience for a lot of apartment complexes the rents aren't kept at market rent for existing tenants. I appraise the property and note that PGI based on market rent is 5% higher than actual rents.

You're good if you're "good enough" to spot a 5% difference in market rents in an increasing market. That's $50/month on a typical $1,000 3-bedroom here.

Loss to lease (that 5% you are talking about) is very common here in SE Florida - in this case landlords taking a discount on market rent (mostly on renewals) in the interest of tenant-retention while an identical complex across the street is getting that 5%. So it's "real" and not just puff marketing to appeal to the "value-added" apartment investor that's been told it's a good idea to look for "below-market" rents. We have to be careful about the puff, though - that is very very very common.

The results on 5% loss to lease, if not compensated in your proforma, result in a higher percentage difference in NOI from stabilized so it's important.

Two ways to look at it - first, everybody is caught in the rent-increase market so everybody to some extent has some loss-to-lease on their rollovers in their rent roll (if they're otherwise stabilized and the proforma is based on rents-in-place). So, apples to apples, your OAR is consistent. It's already reflected in the market. This works here in SE Florida because it's very difficult to spot a 5% difference in market rents.

The other way to look at it is that in a 3% V&C market - very tight - an investor's loss-to-lease could last no more than 12 months with negligible increase in V&C, with the average of the 5% (2.5%) actually the loss. Deduct this from your capitalized value.

 

[nstanbru]

I struggle with this because what I learned in class was 'market rent' market rent' market rent', but in real life buyers care more about actual income as long as it is reasonably close to market.

Michael gave a good answer specific to his market and it may also be reasonable for your market. The last sentence in your post says quite a bit about your market. IMO, consistency is the key. Maybe its using actual data for the sales and the subject. If not, then market rates would be ok as long as its market rates compared to market rates for the sales.

 

[leasedfee]

Two ways to look at it - first, everybody is caught in the rent-increase market so everybody to some extent has some loss-to-lease on their rollovers in their rent roll (if they're otherwise stabilized and the proforma is based on rents-in-place). So, apples to apples, your OAR is consistent. It's already reflected in the market. This works here in SE Florida because it's very difficult to spot a 5% difference in market rents.

What Michael says. Had an appraisal department gripping about our cap rate and they forwarded a brochure from the LO from the borrower (despite supposed independence, sigh). Looking at the brochure's income, there were three cap rates that could be extracted -- 1. last 12 month's income, 2. stabilized PGI, and 3. rolling 12 months. Consistency is key. If you only have data on one of the three incomes from your comp, then understand the relationship and basis-point magnitude between the three. Stable properties like yours won't have that wide of spread. If 7% cap is for PGI, then the 5% rolling rents suggest a cap rate of maybe 6.32% (= 0.07 x 95% rolling rent difference x 95% occupancy). A mere 68 BP, but given the size of the NOI, such a small variation will have a noticeable value impact as far as trying to reconcile to the right opinion.

 

[Michael P Jacobs MAI]

<SNIP>Looking at the brochure's income, there were three cap rates that could be extracted -- 1. last 12 month's income, 2. stabilized PGI, and 3. rolling 12 months. Consistency is key. If you only have data on one of the three incomes from your comp, then understand the relationship and basis-point magnitude between the three. Stable properties like yours won't have that wide of spread. If 7% cap is for PGI, then the 5% rolling rents suggest a cap rate of maybe 6.32% (= 0.07 x 95% rolling rent difference x 95% occupancy). A mere 68 BP, but given the size of the NOI, such a small variation will have a noticeable value impact as far as trying to reconcile to the right opinion.

Ah, nice, you're getting into the nuance of valuation. This is where we live! It's also why it's important to understand the six different ways to develop cap rates, the strengths-weaknesses of each, and how they relate to what price per door and the GIM are telling us. After looking at something three or four different ways a pattern emerges that speaks clearly. It's funny... I'm not naturally a numbers-wonk but these interrelationships in an appraisal report are like snack food. As conscientious appraisers most of us can take an analysis to the extreme just to see where it will lead (can't stop). To survive we've learned not to "fall in love with the process" and remain profitable but sometimes it's just fun, self-directed continuous ed.

 

[NachoPerito]

thanks for the replies. Consistency is key I know, but I feel like I have an obligation to project market rent rather than use actuals. Maybe it is misguided, but I feel an obligation to do that and it seems like a futile exercise when market participants aren't doing it. Maybe 5% is within the ballpark of market rent and can be utilized as is if the comps are similar.

 

[leasedfee]

No, your obligation is to determine market value. To that extent mirror the market -- easier said than done -- but don't force a round peg into a square hole if you don't have to -- note I'm not saying don't use PGI in this instance -- don't force numbers and you'll be surprised how often and nicely the market guides you to the correct number. When numbers are being forced in one part of the report it often bubbles over into forcing an error into another model or approach.

 

[Michael P Jacobs MAI]

Do market rent then and deduct 2.5% of EGI as loss to lease from the reconcililed value (or each approach) as a stabilization adjustment. Other lease up costs are unwarranted if you are in a high occupancy environment and nobody would do profit.

In other words just deduct half of the below market difference from the indicated value at market rent. EZ.

 

[Michael P Jacobs MAI]

That's half of year 1 egi... sorry, doing this from a smartphone.