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 face recurring questions about what to include on the expense side. The goal is 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 helps determine whether a given property is ‘high abuse’. For example, study the rent rolls and financials carefully.
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. To calculate the annual figures, divide 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 the owner will probably replace in the first seven years. Most often, these are only carpets, window coverings and garbage disposals. Do not take a reserve for the roof, although some lenders require it. However, the final value estimate still considers the roof’s condition. Also include a reserve for the water heaters, especially if the units have individual water heaters.
High Abuse Properties
Today, Southern California apartment buildings fall into two categories. 1) Those operated in an efficient manner 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.
How appraisers treat neglected buildings
Despite the neglect, an appraiser usually estimates expenses as if the owner managed the property properly. First, the appraiser produces a value estimate based on the property operating in a smooth and stabilized fashion. Then the appraiser deducts the costs of getting the property back into shape. These costs might include repairs, replacements, and lost income due to temporarily low occupancy. They also include 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 the owner makes certain improvements and puts good management 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.” Some properties defy smooth and economical operation no matter what actions the owner takes.
Root causes of high abuse
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 with poor construction that are entering economic and physical obsolescence prematurely. The third factor is tenants who bring, along with their beds and sofas, a lack of responsibility and a general disrespect for the landlord’s property. They trash apartments, get behind on rent, and then face eviction in a short span of time.
All three causes appear at high abuse properties. Whatever the combination, investors contemplating the purchase of these properties now compensate by pumping up their expense estimates in order to counterbalance the effects of these factors. As a result, the high abuse building will incur higher maintenance and replacement expense and, quite possibly, higher utility expenses.