Are Expense Escalations Causing Errors in Multifamily Real Estate Underwriting Calculations?

In short, the assumptions compound annually vs monthly. Annualized assumptions also multiply based on all 12 months being equally prorated vs a gradual monthly increase.

Most underwriting tools take a percentage assumption and multiply the previous years expenses by a certain increase. For instance, if the expenses were $1,000,000 in the previous year, they'll say that expenses go up by 3%. The underwriter will show $1,030,000 with natural expense increases the next year.

If you take the annual expense increase of 3% and compound it monthly like it actually occurs, you'll have a different number.

Here's an example of monthly vs annual compounding on one line item in the expense category.

Month 13-24 are shown. The annual expense increase is 3%. The expense based on the annual increase is $63,654. Adding up the monthly expenses that increase by (3% / 12) each month = $62,654 for that line item.

If the error is $1,000 each expense category and you use 10 expense categories, that's affecting your NOI by $10,000 per year.

$10,000 per year / .05 Cap = $200,000 Value Difference

The thing that this example uncovers is that accounting is more than just basic math. Most people assume that all accounting is the same like adding and subtracting. There's more to the math when compounding gets involved.

Pros of using the monthly compounding:

1.) The gradual increase in income better represents what will actually happen.

2.) Economic vacancy assumptions will progress from the last year to the end of the next year incrementally. The final month of the year will hit the projection. If it's compounded annually, it assumes you get the % assumption the first month which wouldn't likely be the case.

3.) You can easily separate the time frame assumptions to achievement based on months. If the value add plan is expected to be done in 18 months, you have the option to do that accurately. With the annual compounding, you can only assume in years.

3.) It's easy to separate rental income assumptions, economic vacancy assumptions, and other income assumptions. On my analyzer, separates the time frame assumptions of all three of these categories above. You can implement the value add rental plan in 2 years and the other income value add in 6 months for example.

4.) Overall accuracy is improved, especially in the income category.

Pros of using the annual compounding:

1.) It's simpler and could be easier for investors to understand. They'll likely look at the annual numbers only. If the assumptions are compounded annually it could be easier to see the basic math. 3% times the previous year's expenses vs a number that is slightly off of 3% when the assumption says 3%.

2.) Some major expenses do actually increase annually. Taxes, insurance and contract services fall into this category. In this sense, you would immediately see the increase in the early months.

3.) In underwriting tools, you get quotes on your expenses for the first year. This translates into an annual increase. If you wanted to use the monthly compounding method, you would have the first year an annual increase and the following years be monthly compounded. It wouldn't be a big deal, but there wouldn't be congruency.

4.) Projecting the prorated expenses being the same amount every month sets a baseline. This baseline is ultimately what you're trying to do with underwriting projections–"it should be roughly this amount." You use that baseline to gauge progress and why you're on or off the baseline. Having the same number can make it easier to remember and base decisions off of that.

Conclusion:

Neither method is technically wrong and after all we are dealing with a projection. I wrote this blog partly to make the choice for my own underwriting tool. After writing it, I chose the monthly compounding method because of the control over escalations. It's really awesome to be able to separate the time frames of the income assumptions: rental income, economic vacancy (also separated into physical vacancy, bad debt, and other economic vacancy), and other income. This gives me much more control as to what I can represent in the business model. Also having the incremental shifts in the economic vacancy is totally ideal.

You may have to zoom in, but here is how have the incremental shifts set up. In this assumption, the rental increase through the value add will take 18 months. The economic vacancy reduction assumes 6 months after the renovation, 24 months, and the other income is assumed to be implemented in month 8. The monthly changes move incrementally to the ending month and also account for the natural income and expense escalations during the process (0% in this example). This level of control over the analyzer gives you a huge amount of freedom in what you can do. To my knowledge, no other multifamily underwriting tool has this feature.