16 Jan Underwriting for Reserves / Replacements and High Abuse Multifamily Properties
Estimating expenses is always topical around tax time, when deductions are on everyone’s mind. More broadly, both appraisers and investors find themselves with recurring questions in estimating what to include on the expense side in order to achieve the best possible projections for multifamily property valuations and operations. Below are some basic rules of thumb to keep in mind when estimating reserves and replacements or underwriting potentially high abuse properties. For the latter, due diligence discovery such as careful study of rent rolls and financials would help determine whether or not a given property should be considered ‘high abuse’.
Reserves for Replacements
This category provides for the periodic replacement of short-lived items such as carpeting, window coverings, roof covering, water heaters and appliances. The annual figures are calculated by dividing the replacement cost of an item by its useful life.There are differences in opinion as to whether reserves should be included for newer buildings. For a new building include only those reserve items which will probably be replaced in the first seven years. This is most often limited to carpets, window coverings and garbage disposals. Do not take a reserve for the roof (the roof’s condition is still considered in the final value estimate, however), but some lenders require it. Include a reserve for the water heaters, especially if the water heaters are individual water heaters.
High Abuse Properties
Today, Southern California apartment buildings can be divided into two categories: 1) those operated in an efficient manner and that earn enough income to make the loan payments. 2) Those that were over-financed and haven’t provided enough income to cover payments. Buildings in the over-financed category often undergo a gradual process where:
a) the owner takes any tenant in order to increase income,
b) careless tenant selection results in evictions as well as the loss of many of the good tenants,
c) the owner saves money by cutting maintenance expenses,
d) more good tenants move out,
e) the property goes into foreclosure,
f) the lender ends up with a building that is in poor condition and has low occupancy.
Despite the neglect, an appraiser usually estimates expenses as if the property were properly managed. After producing the value estimate based on the property operating in a smooth and stabilized fashion, the appraiser deducts the costs of getting the property back into shape. These costs might include repairs, replacements, lost income due to temporarily low occupancy, and enough entrepreneurial profit to lure an investor to buy the property. In these instances the operating expense estimation often reflects the property operating in its rehabilitated condition.
The above scenario assumes that the property can, in fact, achieve a smooth operation once certain improvements are made and good management is put into place. Unfortunately, this assumption is not always accurate. Social and economic evolution in Southern California during the past ten or fifteen years has created the “high abuse property.” There are properties that defy smooth and economical operation no matter what actions are taken.
There are several root causes. One is an overpopulation of the building, such as with multiple families in each unit. Another factor is the growing upkeep expense of properties that were poorly constructed and are entering economic and physical obsolescence prematurely. The third factor is tenants who are basically undesirable along with their beds and sofas they bring a lack of responsibility and a general disrespect for the landlord’s property. They trash apartments, get behind on rent, and then get evicted in a short span of time.
All three causes can be observed at high abuse properties. Whatever the combination, investors contemplating the purchase of these properties are now compensating by pumping up their expense estimates in order to counterbalance the effects of these factors. The high abuse building will incur higher maintenance and replacement expense and, quite possibly, higher utility expenses.