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How to Underwrite Expenses on Multifamily Properties (from the Multifamily Millionaire)

1. First Evaluate Actual, Historical Expenses

• Examine trailing T-12 expenses side by side from two previous years if possible.
• Analyzing longer periods of time more important for expenses than income, since expenses more easy to manipulate.

2. Separate the Expenses into the Following Categories.

• Payroll
• Property Taxes
• Insurance
• Utilities and Trash
• Property Management
• General and Administrative
• Professional Fees
• Marketing
• Contract Services
• Repairs and Maintenance
• Turnovers

3. Divide Each of the Annual Expense Numbers By the Number of Units to Evaluate in Terms of Dollars/unit.

4. Normalize the Expenses

• Normalizing means taking taking the information you’re given and making adjustments to bring them in line with what is historically reasonably or expected.
• Properties that are self managed will have low expenses if you plan to use a property management company after purchase.
• properties that are poorly managed often have abnormally high expenses.
• Some property financials will include interest expense or capital expenditures, both of which can throw off your valuation and should be removed from your underwriting.

5. Budget for Replacement Reserves

• A cash requirement defined by the lender usually calculated based on the results of the property condition assessment. (PCA)
• Fannie Mae sets the minimum reserve requirement at $200 per unit per year.
• can be up to $300/unit for aging properties.

6. Calculate Your Expense Ratio

• For most properties, annual expenses should be between $4000 and $6000 per unit.
• Now use your total income and expenses to calculate your expense ration, which is total expenses divided by your effective gross income.(EGI)
• Expense Ratio = Total Expenses divided by Effective Gross Income
• a 50% expense ratio is standard for the industry.
• A High Expense ratio might indicate that the property has value-add potential.
• A Low Expense ratio often indicates under-reported expenses and limited value-add opportunities.

7. Calculate your Pro Forma Expenses

• Project your expenses forward based on the same timeline as your income.
• Model annual expense increases to 2 to 3 percent per year.

8. Use Good Judgment to see Investment Opportunities

• Closely analyze historical expenses and note any trends, omissions, or anomalies.
• use good judgment to normalize expenses, which involves estimating what expenses are most likely to be post-acquisition.
• Expense ratios are an important metric that experienced investors will use to get a quick, high-level indication of how efficiently a property is operating. Just remember: it is a crude and broad-brush measure.
• The single most important element of underwriting is good judgment, because underwriting can be as much of an art as it is a science.