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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series – a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.
Each week we air two-part podcast series about a specific aspect of the apartment syndication investment strategy. Typically, these series are four, six, to eight parts, so the entire series is over multiple weeks… But for the majority of these series we offer some sort of document, or spreadsheet, or resource for you to download for free.
All these free documents, as well as the past Syndication School series can be found at SyndicationSchool.com. Today is Thursday, so this is going to be a continuation of what will likely be a six-part series entitled “Breaking down the apartment financials.” In part one and two we broke down the rent roll, and in part three and four – which includes today’s episode – we’re gonna break down the T-12.
Yesterday, or in part three, we talked about what a T-12 actually is, when you use it – during underwriting, and then when you’re executing your business plan. We kind of took a big picture look at how the T-12 flows, how you find the T-12 and what you should do with the T-12 more specifically during the underwriting process and when you’re executing the business plan, and then we actually walked through a sample T-12 from a deal that Joe did, and we got through the first major section, which is the Income section, which consists of the rental revenue and the Other Tenant Income. Below the rental revenue there were 10-15 line items, and then under the Other Tenant Income there were another 13 or so line items that we went through and defined, and mentioned what to look for when you’re underwriting, and what to look for on an ongoing basis for each of those.
In this episode we’re going to move on to the expenses. These are going to be the operating expenses, the non-operating expenses, and really any other expenses that the property incurs. We’re gonna go ahead and go through all those and define those, so by the end of this two-part series you should be able to look at a rent roll and a T-12 and be able to find essentially every single metric that’s on those documents.
Let’s jump right in. For the overall Expense section, the first category is going to be the Operating Expenses. The operating expenses are the variable expenses associated with running your apartment community. These are things that aren’t going to be the same every single month. They’re going to fluctuate based on how the property performs, what happens to the property etc. So when I define each of these terms, I’m going to provide you with a market cost per unit per year for each of these different operating expenses. These dollar per unit per years are going to be for apartment communities that are located in major markets that are 200 units or more.
If you’re working with a smaller property, or if you’re working in a secondary or tertiary market – this probably applies to secondary markets, but probably not tertiary markets. If that’s the case, you’re gonna want to talk to your property management company and the broker to help you determine these accurate market cost ranges for your specific market… But for now, since most of you are likely investing in major markets, we’re gonna focus on that. The grey areas – you’re gonna have to speak with a management company.
Generally, the operating expenses are gonna be broken into nine major categories. These are the nine categories you should have on your cashflow calculator, and in the next series and the series after that, when we start going over underwriting and we give away the free, simplified cashflow calculator, you’ll see that there are nine different categories for operating expenses.
So if you come across a T-12 that is not broken down in these nine categories, then you’re gonna have to do some rearranging, which is why it’s gonna be very important for you to download this and see “Okay, for utilities, what is considered a utility? What is considered a contract service? What is considered maintenance repairs?” Because you might come across a T-12 where all the maintenance repairs, all the contract services and all the turnkey make-ready costs are all within the same category, and you’re gonna have to pull out what is what and break apart that one category into three categories. So this portion of the podcast is gonna be very important to listen closely.
First we’re gonna have the utilities. That’s gonna be the cost of the utilities of the property. You’ll see that there is the electric for the vacant units; if a unit is vacant, you’re gonna have to pay for those utilities. There’s the house electric – that’s mostly serialized electricity for your amenities like your gym, your pool, your lights for your barbecue area, lights for your pet park, things like that.
You’re obviously gonna have the electric for the clubhouse or your office, and then you’re most likely gonna be paying for gas and heating oil overall, for the entire property… So whether it’s gas for the grill, or if you have a boiler, gas for your boiler… You’re paying for utilities and water for the entire property. Cable – cable for the office, or your model unit. Telephone and internet for your office, as well as any waste disposal that you have – kind of a one-off waste disposal if you’re doing renovations… Because you typically have this when you’re doing renovations, or just trash collection in general. So those are gonna be utilities.
When you’re underwriting a deal, again, you’re using this T-12 as a guide to set your stabilized expense assumptions… So when you are underwriting a deal, you’re gonna wanna set your stabilized expense assumption to the same annual cost on the T-12. Right here, the annual utilities are approximately $230,000, so if I was underwriting this deal, I’d be like “Okay, well my annual utilities are also likely going to be $230,000”, and then if total utility cost is outside the range of $750 to $900 per unit per year – so take that total number, divide it by the total number of units, if that is over $750 to $900, outside that range, then just make a note, because likely either utilities are really low, or they’re too high. And for anything that’s outside of this market cost per unit per year range, then you’re gonna wanna mark that down and ask the management company “Okay, why are the utilities really low? Are tenants paying for parts of the utilities?” or “Why are the utilities really high? Are there water leaks somewhere? Is the electric really high for some reason?” And if it is too high, it’s not a deal-breaker, because it is an opportunity for you to add value.
The next category is the contract services. These are the costs or expenses associated with ongoing contracts that you have with vendors… Those are gonna be landscaping, anything related to security – patrols, alarm monitoring, emergency phone… A key maintenance person, pest control, and other upkeep-related contracts that you have. These are contracts that you have with vendors, not one-off maintenance repair issues; it’s going to be things that are on a consistent basis.
As I’ve mentioned, you’ve got your landscaping contract, you’ve got your security patrol contract, alarm monitoring contract, emergency phone contract, key maintenance person contract, pest control contract, and then just a contract with probably a paraservices company which is on-call if you’ve got something small that happens and you need to be able to take care of it, and you don’t wanna have your key maintenance person do it.
As I’ve mentioned, a lot of times these contract services will be lumped in with repairs and maintenance, so make sure that when you’re underwriting you take a look at the individual line items and make sure that something that’s in Repairs and Maintenance isn’t actually a contract service.
So when you’re underwriting, you’re gonna want to set your stabilized expense assumptions for contract services to the T-12 amount, and making note if it is outside $200 to $400 per unit per year. If it’s above that or below that and you’re looking at a 200+ unit apartment community in a major market, then it’s either too low or too high and you wanna make a note to ask the broker why.
Next we’ve got Repairs and Maintenance. These are going to be costs associated with the ongoing repairs of interiors and exteriors, including supplies but excluding capital expenditure. So you do not want to include your cap-ex costs in repairs and maintenance, and when you’re reviewing deals, you wanna make sure that they’re not including those in there. If there’s a line item that says “New roof” and it’s $250,000, that’s gonna throw off your repairs and maintenance.
For Repairs and Maintenance let’s just kind of go through these… There are some that are pretty self-explanatory. You’ve got equipment repairs, you’ve got HVAC repairs and supplies, pool supplies, you’ve got paint service and supplies, you’ve got [unintelligible [00:11:31].00] repairs, supplies for landscaping, supplies and repairs for plumbing, supplies and repairs for electrical, you’ve got general maintenance supplies, small tools, supplies that are broken or replaced, parking lot repair maintenance – again, this is not you going in there and restriping the entire parking lot; these are one-off, smaller repairs to your parking lot.
Same with the roof repairs and building exterior repairs, windows and door repairs – maybe you’re replacing one door, but not replacing every door, every window… Fire safety supplies, new locks and keys, new light bulbs, floor repairs, cleaning for your office or the clubhouse, cleaning supplies, pest control products, appliance repairs and parts, general exterior repairs, water extraction, and fitness room repairs and supplies. So really anything that’s a supply or a repair will go under this line item, but not anything that’s like a brand new cap-ex type of budget.
And when you’re underwriting, you’re gonna wanna go ahead and set Stabilized Expense to the same annual number as the T-12, and make a note if that number falls outside the $250 to $350 per unit per year range.
Next we have the Turnover, or it might be called Turn, or it might be called Make-ready, or Turn Make-Ready… These are gonna be costs that are associated with repairing a unit for a new resident. Again, just like contract services, this might be included in the maintenance and repairs, so make sure that you are, again, looking through the maintenance or repairs line items every single time, to make sure that it’s only including maintenance or repairs and not including things like contract services and turnover.
So this is gonna include things like painting units and cleaning units, and again, it’s not going to include capital expenditures. If a unit is turned and then you are doing your value-add renovation of 6k-7k, you’re not gonna include that here. These are gonna be costs associated with repairing a unit for a new resident, not renovating a unit for a new resident. These are gonna be repainting the units, cleaning the units, resurfacing the countertops or the floors, cleaning the carpets, things like that.
When you’re underwriting, you’re gonna wanna go ahead and assume that it’ll be approximately $150 to $300 per unit per year. So if the current number is $400 per unit per year, then you’ve reduced your assumption to $300, and then make a note to ask the broker why their turn costs are so high. Likely, high turn costs is a reflection of a poor demographic and/or a high turnover, which is kind of also a sign of poor renter demographic.
Next we have Payroll. These are gonna be the costs associated with paying the salaries of your full-time employees. This is different from the contracts that you have. These are gonna be people that are full-time employees at your property, so these are gonna be things like the payroll for your main maintenance person, payroll for people that work the admin jobs in your office – these could be leasing agents, the person at the front desk… You’re also gonna want to account for any bonuses that are paid, or temporary salaries to temporary leasing agents, as well as payroll taxes, any insurance you have… Right here we’ve got group health insurance, the key man life insurance… So health insurance, life insurance, any compensation that’s paid out, and then your payroll processing fees if you have those.
Next we’ve got the taxes and insurance category. On your cashflow calculator these are actually broken into two different categories. First we wanna take a look at insurance — but I’m sorry, before we go to that I’ve gotta go back to Payroll and explain what the market rate is. So when you’re underwriting, you’re gonna wanna go ahead and assume a stabilized expense of $1,000 to $1,200 per unit per year for the payroll. For example, if the current payroll is $800, you’ll set it to $1,000; if it’s $400, you’ll set it to $1,200, and making note that it’s too low or too high, and then ask the management company why that is.
This is one of those things that you might not even see if you’re looking at a building that’s got less than 50 units, because you don’t have any on-site management, you don’t have any on-site people working there. Maybe you just contract out a leasing service to fill the units, so this might be way lower than $1,000 to $1,200 range, and it might actually be zero when you’re dealing with a four-unit, a ten-unit, a 20-unit.
Now we can move on to the Taxes and Insurance. Insurance is the property insurance, pretty self-explanatory. For insurance, the minimum amount that you’ll see is about $225 per unit per year. Typically, you’ll see somewhere around $250 to $300 per unit per year for property insurance, so just set your stabilized expense assumption for insurance to the same as the T-12, just for a good place to start, and then get a quote from someone; you need a ballpark quote for the property, to get a more accurate assumption.
Then for taxes, you’ve got your property taxes, and then on this T-12 there’s also a property tax consultant. You’ll see at the end of the year, in November, they pay about $2,700 to talk to a tax consultant to help reduce their taxes… But overall, this is very important. So when you’re underwriting a deal, you’re gonna see an annual tax on the T-12, but that’s gonna be based on whatever the property was valued last, it’s gonna be based on that number. So if you plan on buying the property, and let’s say you buy the property for five million dollars more than what the current tax rate is based off of, and you use the current tax rate, then you’re gonna be surprised when your tax rate goes up by 100k or 200k. So when you are underwriting deals, make sure you go to the auditor’s site or the appraiser’s site and figure out what the tax rate is. Usually, it will be like 85% of the value, times 0.142435, some random tax rate number… And they’ll determine what your annual taxes will be.
Make sure you calculate your stabilized tax assumption using that method, don’t just copy and paste the current taxes, because they’re most likely going to be different.
Next we’ve got Management Fees, pretty self-explanatory. This is the fee paid to the management company for managing the property. So what you wanna do here for the T-12 – you’re gonna want to divide the annual management fees paid to buy the annual total collected income, because typically the management fee is based on the total collected income. Get a percentage, so you can see what rate the current management company is charging. Then for your stabilized assumption, you want to ask your property management company, “Hey, I’ve got this 200-unit deal in this market. What percentage of the collected rents would you charge to manage this property, and what will I get in return for that?” Then you wanna know if that percentage includes everything, or if there are gonna be other fees that you have to pay, and you wanna know what those are, so you can make sure you add those in, as well.
Next we’ve got the admin fees, or Administrative Expenses. Those are gonna be essentially any administrative legal or office-related costs. On this T-12 we’ve got eviction costs, so whenever you go through an eviction, there’s legal fees associated with that. The utility billing – since you are most likely going to be paying some sort of utility bill, the company might charge you for using an automated service, or mailing you the bills…
Resident screening – costs associated with screening out residents. This could be background checks, things like that. Fees, Dues and Subscriptions – any newspaper or online business article, or any type of group that your company or your property manager is a part of, and they’ve got monthly or yearly fees, or subscriptions, or dues – that’s here.
You’ve got your Banks Fees – these are fees charged by the bank to you for essentially being able to collect rent via direct deposit, things like that. Payment Processing – payment processors might charge you a percentage of the money you collect using their service. Blue Moon – that is actually the property management software that they use, so you’ll see that there’s an annual fee of about $900 to use that.
Office Supplies & Equipment – pretty self-explanatory. Answering Service, Uniform. Payment Reversal Fees – so if your tenant submits a payment, and the payment is reversed and not accepted, then you’re charged for that.
Property Management Software – that’s the secondary software used with Blue Moon. Any IT support, costs associated with maintaining or updating the website. Postage, Courier and Freight – basically, Post and stamps.
Any meetings or trainings that you have for your employees. Training shop – same thing. Any legal services that you use, talking to a lawyer… Permanent registration – if you need to pull a permit from the city, there’s a cost associated with that. Mileage Reimbursement to your employees, and then Meals and Entertainment for your employees.
When you’re underwriting, you’ll wanna go ahead and just simply set your stabilized expense assumption to the same annual expense on the T-12, and making note if that number is outside of the $150 to $250 per unit per year range.
And the last operating expense on here is going to be Marketing. It might also be referred to as Advertising. These will be the costs associated with marketing your apartment community to fill the units. So here we’ve got “Marketing – others”, so really anything that doesn’t fall into the Other categories or what they go over.
You’ve got Printing – printing out fliers to hand out to local businesses… Resident Party and Functions – if you host a Halloween party, Christmas party. Locator Fees – a locator is essentially a company where all they do is they work with properties and they help properties find tenants, so they’re kind of the middle man.
Marketing Events & Gifts – if you make gift baskets and drop them off at local companies. Referral Fees – if you have a referral program, where if your tenants refer someone, they get $300 off their rent. Promotional Fee – pretty self-explanatory. Intermittent Ads & Listings, Web Analytics, Lead Tracking, Office Hospitality… Anything related to marketing or advertising your property to prospective tenants will be included here.
When you’re underwriting, you’re gonna want to set your stabilized expense assumption for marketing to whatever the amount is on the T-12, and making note if it is outside of the $100 to $200 per unit per year range. Similar to Payroll, and probably even Administrative too, those numbers will be much lower, or potentially even zero for those small apartments. And for Marketing in particular, this should be tied to rent, loss to lease, and vacancy loss. So if the market rent is low, or the loss to lease is high, or if the vacancy is high, then these marketing expenses should be going up.
Now, as I mentioned, you have your Total Operating Expense, which is a sum of all nine of those categories. Then you’ve got your Total Expense, which here is the exact same as the Total Operating Expense.
Then you’ve got your Net Operating Income. Net Operating Income is gonna be the Total Income minus the Total Operating Expenses, and this is what’s used to actually determine the value of a property. So when you’re underwriting a deal, the Net Operating Income is as important, although is what your lender will use to underwrite your deal, so that’s what they’ll base the debt they’ll provide on, is what’s the current Net Operating Income.
Typically, what I would do is I’ll take the Net Operating Income and the asking price, or the Net Operating Income and the cap rate that the listing broker claims the market is at or the property will trade at, and that can be found by looking at the recent sales comps that the broker included, just to get an idea of what the owner thinks they should be getting for this property. That will determine, okay, if they wanna get 10 million dollars for this property, and based on the current NOI that’s a 4% cap rate, but I know that the lender is gonna underwrite at a 6% cap rate, then I’m gonna have trouble getting the property at that price.
So it’s something that I personally use just to determine “Okay, is this even worth pursuing, and does the seller have realistic expectation of how much their property is actually worth?”
Then when you own the property, you wanna take a look at that Variance column for the net operating income. Essentially, you compare what’s actually happening to your budget on a monthly basis, and if that variance is high, you wanna work with your property management company as quickly as possible to identify whatever is causing that variance, and brainstorm ways to increase the net operating income.
Above net operating income there’s over 160 different line items, so you’ve got 160 different potential causes for why the net operating income is not what it’s supposed to be, which is why it’s important to know what each of those line items actually mean, as I said earlier. Now at this point you should be a master on all of those.
Below the net operating income you’ve got a few other expense line items that aren’t accounted for in the net operating income. You’ve got kind of miscellaneous expense – this is anything that is not an operating expense, that doesn’t fit into another category. The asset management fee – that’s the fee charged by you, the syndicator, for managing the property. Any professional or legal fees — right here you’ve got Legal Fees and Accounting Services, so consulting with your lawyer, consulting with your accountant, bookkeeping from your accountant, things like that. That will give a total Other Expense, and then the next is going to be the Non-Operating Expense, which typically is just going to be the debt service and the interest. This is the principal and interest paid by you to the lender.
From there, you’ll get your total non-operating expense, and then you’ll get your total net income. This total net income is the total income minus the operating expenses minus the other expenses minus the non-operating expenses. This right here is also referred to as the cashflow. This is going to be at the end of the day how much money is this property actually cash-flowing.
Now, overall, when you’re looking at a T-12, specifically during the underwriting process, one thing I would mention — and that’s why it’s important for this to be broken out by month… So for each of those expenses I mentioned what a market range would be. For example, for payroll a good market range would be between $1,000 and $1,200 per unit per year. Now, let’s say for some reason that the payroll cost ends up being $1,800 per unit per year, which is, again, really high for payroll, unless you’re downtown L.A. At that point, I’m making note and saying “Okay, payroll seems to be very high, so let’s go ahead and look at the individual line items below payroll by month.”
Let’s say I’ve got the line item Payroll Temp, and then let’s say it’s between 0 and $1,000 every single month, but then in one month, for some reason, it’s $6,000; it’s really abnormally high. Now, instead of going back to the broker and saying, “Hey, the payroll costs are high. What’s going on?”, I can say “Oh, the payroll costs are really high, and I looked at the T-12 and saw that for one month the payroll to temporary employees was like $8,000. Do you know what that was?” That way they can respond and say “Oh, we had a really slow month, so we brought in ten temporary employees to bring our vacancy back up again, but it was kind of a one-off thing.”
Then you can look at it and be like, “Okay, well the payroll is not actually gonna be $1,600, it’s actually gonna be a little bit lower”, whereas if you didn’t do that, you might have just set it to $1,600 or $1,800 and might have lost on the deal, because as expenses go up, the net operating income goes down, which means that you need to offer a lower price in order to get the returns that you want.
So multiply that by 160 different line items and you’re talking about a huge difference in how much money you’ll be offering for the property. So if you see anything that falls outside that market range, make sure you’re digging into the individual line items that make up that overarching category. I use that payroll as an example, but it could be applied to any of these categories.
Make sure that there isn’t one line item that has one really high expense for one month and that’s it, because if that’s the case, then you can likely set that to whatever the average is and then say “Okay, well in reality what’s most likely to happen is that payroll will be $1,100 if I take out that random $6,000 temporary payroll cost.”
Besides that, I recommend downloading this T-12 and walking through each of these line items just to make sure you’re familiar with them. I also recommend doing the same thing for the rent roll in parts one and two. From there, we will also be doing parts five and six next week, where we will be diving into the third piece of information that you will need for underwriting a deal, assuming it’s off-market, and that’s going to be the offering memorandum.
Until then, listen to part one, two and three, listen to the other Syndication School series about the how-to’s of apartment syndication, and download your free document this week, which is gonna be the sample T-12 as a guide; but it’s still very helpful, because I’m not sure if you guys have downloaded one of these online somewhere. The document, parts one through three, and other Syndication School series can be found at SyndicationSchool.com.
Thank you for listening, and I will talk to you next week.