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At a major bank lender. We model it out based on annual increases but we have been conservative lately - 2% growth. Case could be made that isn’t the most accurate way because not all leases turn at the same time every year and essentially, you’d not be counting any rent growth that occurs within 6 months of closing, but it works for us.
As a GP we tend to model 0% growth in year 1 then increase rents at about 3% annually. However, when we look at monthly cashflow over a 10 year hold we do break it down into a monthly growth rate so that annually it still grows at that 3% rate at the end of a given year. We assume 0% growth in year 1 to stay conservative and that way our untrended NOI is our "worst case" outside of negative growth in the market. We assume expense growth at 2% in a similar fashion to rents since realistically we would want to charge higher rents and grow real NOI over the hold period.
I’ve always modeled 0% in year 1 as well. Out of curiosity though, why not model monthly growth if you budget it once you are operational?
whats your rational for 0% in year 1? concessions?
To understand this policy, you need to zoom out a bit.
(1) Most firms generally have a ‘modeling policy’ to be ‘conservative’ and every deal be similar, in a sense.
(2) If you are modeling annual rent increases, it does actually make sense. The thought is, let’s say rents in place are $1,000 per unit but market rents are $1,200 per units. If you close on the deal and add rent growth if 3%, all of a sudden rents are $1,272 at market. Rent probably haven’t grown by 3% on closing. So having no rent growth year 1 makes sense.
However, if you model rent growth monthly, you only reach $1,272 in rent in month 12 (or 13) depending on if you begin rent growth in month 1 or 2. If you model rent growth monthly, I think it makes sense to have rent growth in year 1, otherwise you don’t reach 3% rent growth until month 24/25, which is going to probably undershoot your rents.
Pudding's explanation is the general thought process most firms use. One other anecdote I'll add is that in the real world this is affected by the lease expiration schedule. The WALT (not typically used for multifamily, but applicable here) is going to be 6 months on average, so on average you'll need to wait 6 months to increase rents on your tenant base, so even if you're able to get the full rent increase you were planning, you'll only have it for half the year, in effect making your Net Potential Rent growth for Y1 half of what it should be.
Bank that lends to institutional groups here, we do not actually trend rent. This was new to me when I started here as my previous bank trended rents. And to also make it fair we do not trend expenses (taxes we will underwrite stabilized taxes assuming reassessment and for other expenses we use the sponsor budget) as that would be too punitive if we are not trending rents. So if projected stabilized rents are $1,600/unit, we will underwrite to it only if we have support from renovated rent comps today already achieving $1,600/unit. If that is the case, then is a no brainer as we will not have to rely on and rent growth to get there if renovated units today are already achieving those rents.
The institutional lender I worked for would always run a untrended rent vs trended expenses to see what happened. If it didn’t pass that, deal usually got killed.
Yeah we could do that but we just keep it simple, we just do the as is and untrended as stabilized UW (we dont need to get to into the granular monthly cash UW like the equity groups typically). Our as stabilized UW is super simple, the GPR has to be supported by renovated rent comps today, we start with the sponsor's stabilized GPR and see if it is supported by rent comps otherwise we haircut the rent. Then vacancy, concessions and bad debt will be based on sponsor budget and we check to see if it is supported in the market. Other income and utilities expenses will be conservatively based on T-12 and not sponsor budget. Usually we see a huge lift in other income in the budget but we start off being conservative. Taxes will be based on stabilized taxes assuming a reassessment. Other expenses will be based on sponsor budget. That's it, pretty simple. Total loan proceeds are as stabilized NOI divided by a DY (usually 7-8% depends on the deal and the client). Holdback will be the 100% of capex budget. Initial funding will be total loan proceeds minus the holdback. If the borrower ask is in line, we move forward with a LOI, otherwise we just move on. Especially in this market we are not going to bend over backwards and size to a super low DY or stretch on rents.
Similar to others here, we typically model no growth in year 1 then monthly growth equivalent to 2-3% annually thereafter.
On tertiary market deals where we have high conviction we might start growth in year 1.
I’m also curious as to how everyone models expiries - do you actually use a schedule based on lease turns for each unit, or do you just assume an equal proportion turns over/renews monthly? I’ve seen both, we do the latter but curious to hear arguments to why the former might be important in multifamily.
I’ve seen both and done both. My old firm modeled monthly rent growth and assumed an even amount of expirations, monthly. (Occupied units / 12).
My firm before that had two methods. We modeled rent growth annually and never looks at expirations. Just assumed it was all even. Secondly, on heavy value add multi, we had a tool we would used that looked at the rent roll and expirations, and assuming 12 month leases, used the implied rollover of each successive 12 months to actually renovate the units.
On the AM side of a dev shop - when we are doing internal valuations we'll run our DCF model on a monthly growth, since that's how the acq. shops we sells to do so. Typically on a more conservative look. BOV's I've gotten have always been an immediate step up, so be warry when getting external valuations (as we all know).
Controllable expenses we typically will flatline at 2.75%-3% (focus more so on initial year inputs are driving off of), non-controllables like taxes we'll have more finesse too. Rent growth will be obviously be market specific but we typically peel back whatever the reports are saying (i.e. sub market is saying 5%, we'll be more conservative at 3.5% - where as our dev arm will take the full 5% on a new UW).
Especially with trade outs being stronger (7-10%) we're seeing buyers step into the 6-8%+ in Y1 underwrites.
From what I'm hearing from buyers at 1-1.5% for concessions in Y1, and then 0.5-1% in Y2+. This is for new build stuff, 2021 or more recent.
Turned this comment more into a UW assumptions comment, but interesting to see the mechanics that manipulate the returns. Helps brokers when they're assuming 6% growth immediately versus the more typical gradual growth.
Your dev team is underwriting market rent growth? Holy shit that is gutty. We won't underwrite above 3% regardless of what's happening in the market.
Depending on your market it can be impossible to get a deal to pencil without outsized growth you are an IRR investor with a high cost of capital.
I find a lot of the overly granular modeling to be overkill since the actual performance of the deal never matches the initial model exactly anyway, and whether you do a high-level model or get extremely detailed you're going to end of throwing on some conservative tweaks to the assumptions before final valuation anyway and end up in the same place.
I've been with firms that do 0% in year one, half the annual rate in year one, or do the full 2-3+% in year one but also include a line item for loss-to-lease at half the rent growth rate under the theory that units will turn throughout the year so only half the rent growth will be realized on average. I personally wouldn't bother modeling monthly or using actual turnover/expiration dates from the rent roll, would rather just eyeball it and if units are mostly turning late in the year then use low/zero growth or high LTL in year one. Actual turns never match initial UW anyway because things like early terminations and renewal rates can be unpredictable (unless you're non-renewing intentionally).
Spot on here
Large construction lender.
We look at untrended rent/ expenses to see if the deal passes the sniff test.
For some extremely competitive deals where we really need to massage the underwriting we sometimes use trended rents to juice our metrics a little. This is pretty rare and only use it when the deal is otherwise brain dead safe and we just need it to look a little sexier for committee.
I'm at a national multifamily developer and we underwrite monthly rent growth, the place I was at before was a family office and we did the same. We assume 3% annual rent growth, 2.5% opex growth.
Do you grow opex monthly as well? Or assume it increases 2.5% once per year?
Opex grows monthly as well. That makes less sense to me conceptually, but it's out of my control.
Traditionally we grew rents a 2 or 2.5% and opex at 3%. Will have to revise both of those upwards given inflationary trends but I imagine the relative numbers will stay consistent
This honestly explains so much about you.
Yep. It's why my firm isn't going to go bust because expenses are shooting through the roof. Nice to be conservative!
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