How to Create a Sound Rental Housing Pro Forma (Budget)

Being overly optimistic doing the numbers for a planned rental housing investment is like taking off for a trans-atlantic flight with too little fuel in the tank.

Rental housing is a long-term investment. Once you’ve built it or bought it, you’re committed. If you didn’t budget realistically at the outset, when you discover that fact your alternatives won’t be good. This is a detailed how-to article for developers or investors.

As we go through the steps below, bear in mind that the pressure to cut corners will be immenses from the worser angels of your nature and from people you deal with in connection with the transaction. I’m going to be the angel sitting on your right shoulder saying “scale back your revenue assumptions,” and “increase your expense projections” and “don’t underestimate future capital needs.”

Your own eagerness to do the deal, the broker trying to sell you the building, and/or the public funding sources you seek subsidy from (if applicable) will be whispering in your other ear: “Don’t listen to that old fuddy-duddy. This baby is a gusher. Your numbers are too conservative. Increase your debt level.”

The goal of doing the numbers is to predict your bottom line. To know your future annual profit or loss, you need to predict your potential gross revenue, and then subtract:

  • vacancy loss,
  • collection loss (deadbeats),
  • promotional discounts on rent (“concessions”),
  • operating expenses (accounting, admin, legal, repairs, maintenance, cleaning, utilities, taxes,  etc.) ,
  •  mortgage payment and
  • recurring capital expenditures.

And then each of the above have to be projected far into the future,  going 15, 20 or even 30 years out.   With each step in this process, there is the opportunity to sow the seeds of your own destruction.   The opiate of excess optimism will be urged upon you at every turn.   Don’t smoke that stuff!

Gross Potential Rent

The top line in your pro forma is the revenue you would earn in the nirvana world in which every apartment was occupied every month, you gave no concessions (discounts) to entice tenants in,  every tenant paid the rent and every rent subsidy source paid the subsidy.   (This article is for both subsidized and unsubsidized housing projects.)   That world does not exist, but we’ll subtract the vacancy and collection losses and discounts in the next 3 steps.   Right now, let’s focus on getting a realistic projection for potential.

The arithmetic of calculating gross potential rent is easy:  Just add up the rents on every apartment.   But what will those rent levels really be?  Here is your first opportunity for self-deception.

[More to Come -- This is a Work in Progress. One of the issues I will address is the chronic underestimating of future capital needs -- big expenditures for things that last more than a few years, like carpet, roofs, counter tops, etc. Throughout the rental housing industry, and indeed throughout commercial real estate, this is a prime area for self deception. During my 27-year career the rule of thumb for budgeting capital needs, sometimes called replacement reserve, went from $275 per unit per year to $360 per unit per year. In other words, from one inadequate figure to another inadequate figure and even if you believed $275 was right in 1983 how could you then believe it would be only $360 27 years later given what has taken place with inflation in that time period? Every responsible actual study of the future capital needs of an actual housing project that I have seen has returned an estimate above $600 per unit per year. And, wall street analysts have finally caught onto this issue now that there are a substantial number of publicly-traded apartment owning companies. Wall Street calculates a figure called "adjusted funds from operations" which, roughly speaking is cash flow available to support dividends or expansion of the company after meeting all expenses and deficit and doing everything you should to maintain and update your existing properties so they don't lose value. The apartment companies had always suggested a figure in the $300 area for recurring capital needs, and then every year was an exception. Capital needs just happened to exceed $300/unit because bla, bla, bla but that won't happen again. The analysts caught on and started coming up with their own allowance for routine capital needs based on the actual spending history of each firm and they tend to be in the $600 area or even higher, as of last time I checked. I have seen perfectly good housing development where the right figure was north of $1,000 per unit per year, based on a careful analysis done system by system and building by building. The drivers of this high figure were the fact that the development has large units, with carpeting rather than more durable floor finishes like wood, and exterior siding and trim that required periodic repainting, which is very expensive.]

If you are eager to see the completion of this article, give me a nudge using the comment box below or my direct email address at Jim@SailboatsToGo.com. Thanks for your interest.

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