How Will the Property Run Once it is Built? The Operating Assumptions Section

The Operations Assumptions section pertains to the more micro details of the apartment complex: income, expense, unit mix, and payroll assumptions. This is the second part of the model that I began learning about. Many of the aspects of this section are abstract finance and real estate concepts that are hard to visualize or understand without experience in the business. As a result, many of the assumptions in this section are based off past results and altered as needed based on new macro and micro economic conditions and other factors that relevant to specific markets and types of developments.

Income assumptions are important to the model. Rent growth decides how your current rents will grow in future years; having this around the rate of inflation is generally a safe assumption. Loss to Lease is the real estate term for renting apartments below market rents. If Market rents are $1,000 and you rent an apartment for $990 then your Loss to Lease (LTL) is 1%. 1% is a safe assumption considering you price your market rents correctly—meaning, you do not make your rates too expensive. The LTL is a direct reflection of your confidence in both the development (its location, and general draw to tenants) and the property management’s ability to accurately price and effectively lease units. Vacancy Loss refers to how much of your property you think will be vacant; rarely is an apartment community 100% occupied, because people are constantly moving in and out. Researching the average vacancy for the area in which you are developing the property can give you a guide of what vacancy loss should be. 6% is a safe number in this case.

Bad debt is a small figure which refers to tenants not paying their rent. Rent concessions are specials offered when apartments need to be leased; if you believe you are building in a good area and pricing your apartments correctly, large concessions should not be necessary to lease a property. Non-Revenue units are usually models to show prospective tenants on tours because you cannot rent those out to tenants; office/staff units are usually prorated units for property management employees. Other income is made up of utilities and cable reimbursement, and anything else like mentioned in previous blogs, including parking.

Expense Assumptions 

This is where you estimate the amount of expenses your property will have. This is a little easier than income assumptions because data can be used from previous developed properties. Starting out with inflation, 3% is a safe number. The expense categories will grow at the rate of inflation.

The following assumptions are yearly figures and mainly based on comparable data from existing assets. Administration and General includes legal counsel, accounting work, insurance, office supplies, etc. Grounds refers to landscaping and keeping up the property in good shape. Management fee is how much the property management company charges you to run the apartment community from leasing to maintenance and everything in between. 3-4% is a normal rate for property management. Maintenance and marketing are self-explanatory; there are going to be maintenance issues with units over time and through use, and the apartments must pay for marketing to make customers aware of the property. Redecoration includes costs after a tenant moves out and is a mixture of the turnover rate—what percentage of tenants leave after their lease expires—and the cost per unit of redecoration. Utilities are mainly based off of historical data in a similar market. The same is true for insurance, and taxes. Replacement reserves run similarly to previous properties and act as an “savings account” in case something does not go as planned.

Unit Mix Assumptions

This is a major aspect of a development because it helps decide how many units you will have in the property and how many bedrooms the units will have. This can change how big the building is and how much rent it brings in. One bedroom units tend to be the most desirable to build, with two bedrooms behind ones, and three bedrooms behind twos. Deciding on the size of the apartments (Square footage) and the rent depends on market research. Looking at what comparable apartments charge and what their unit mix and sizes are will inform the decisions made in this section. This is an estimate and will be continually refined up until construction.

Payroll Assumptions

Payroll assumptions are the last piece of the puzzle. The rule of thumb is that there will be one in, one out for every 100 units. One in means a property manager or leasing agent who works in the leasing office, and one out means a maintenance employee. The salaries for these positions are generally taken from looking at market rates for these positions.

Summary:

·       Operating Assumptions: How you expect the property to operate once construction is finished

·       Income Assumptions: Higher level estimates of aspects that affect a property’s income

·       Expense Assumptions: Deal mainly with the ground-level assumptions of expenses necessarily to running an apartment complex

·       Unit Mix Assumptions: How many units of each floor-plan do you expect to have

o   Important to pay attention to Square Footage and Rents!

·       Payroll Assumptions: 1 in 1 out for every 100 units; how much are you going to spend on the people needed to make the property run smoothly

My next blog will cover the Development Budget, the final assumptions section of the model. I had no clue about any costs pertaining to construction of commercial properties before going into this learning goal experience, so it was very interesting learning about this part of the development process.