Another source of value that’s easy to manipulate and mess with is the pro forma expenses. The current operations are what they are, and typically all of that information is released early in due diligence so it doesn’t make much sense to try and cover it up. The proforma operations, however, can be easily manipulated to show a big year one cap rate spread that may not actually be there.
What’s going on with the pro forma expenses?
Let’s say the value-add proposal on your desk is for a 200-unit workforce housing deal. Perhaps there will be some minor updates to the units, but the bulk of the value in this deal is through operations. The broker explains the current situation: the owner liked to cut corners on maintenance and management, the amateur property manager was unmotivated to perform, deferred maintenance were given a blind eye, etc. The neighborhood is good overall, offers easy commutes to job centers and there are low vacancy rates at other comparable complexes.
So, in the proforma, it would make sense that vacancy rates and collections losses at the property decrease with a new owner/manager. But oftentimes, all the other expenses will stay the same. That is, the proforma will show the same $25,000 management fee as the incompetent property manager, when really a professional management company will likely charge 3% of effective gross revenue (“EGR”) which would result in much higher management fees. The current contract services, which includes a biweekly mowing of grass and snow plow “as needed” are doubled over (or better yet, escalated at a 3% rate of inflation) when really they should be upwards of $100K. Sure, income at this property will increase significantly, but so will expenses, and what looks like a huge gap in net income quickly fills and destroys your cap rate spread.
Bottom line: Be suspicious of pro forma expenses that closely resemble the current ones on a value-add deal. Find out what you can expect for various line items in the income statement, and when the proforma is significantly off it’s a good indicator that the sale price is too.
The asymmetry of information in the real estate industry is one of the things that attracts people to it. Whether brokers trying to get the best price for their clients, or investors trying to leverage their market knowledge to outperform other investment vehicles, the secret sauce of real estate is often, in fact, the secrets. As the market becomes saturated with “value-add” deals, savvy investors will be more cautious when examining opportunities that present themselves.
The key to underwriting any deal properly lies in making logical, data-driven assumptions. Utilizing financial benchmarks for operating expenses and accurate comparables will help to make stronger underwriting assumptions. Moreover, questioning the broker or seller’s assumptions and comparing against an independent data source will help to determine the merits of any opportunity.