The underwriting looks good, the submarket dynamics are favorable, and the value-add component is realistic. This short list of investment criteria help explain the 10,000-foot view and possibly even the 5,000-foot view, but what happens when we get into the details? The details are where the deal turns into a home run or a dreaded write-off, so where can investors look beyond the numbers and read the words between the lines? There are two ratios that play an important role in investment profitability, and both concern the way a property is running: (1) tenant turnover ratio, and (2) property manager turnover ratio. Both of these numbers account for the hidden cost of investing in multifamily real estate, and both are often overlooked.
Tenant turnover ratio is a function of voluntary and involuntary turnover. Residents have a variety of reasons to move out of a facility and some things are out of the owner’s hands, but the opportunity exists to limit voluntary turnover. People choose to leave because they are disgruntled or feel poorly treated. More specifically this could be poor facilities, lack of maintenance, or unfair treatment and so far this has been quantified as vacancy rate and loss-to-lease when underwriting a property. To put this in numbers it equals somewhere between 8% and 11% of effective gross income. However, what about the average length of tenancy or average length of vacancy for a property? Both of these metrics contain cost or opportunity and many management groups collect this data by default, but few management groups we have seen use it to their advantage. If a property has historically been 90% occupied with tenancy lengths of 18 months or greater and it takes less than 2 weeks to find new tenants, that’s a solid property in terms of monthly cost of ownership. If a property isn’t performing like this then how can management make it better?
A much more hidden cost of owning multifamily properties is the cost of manager turnover. Managers truly are the lifeblood of a property and can make or break the investment. The manager is the employee and as billionaire Richard Branson has indicated: “Clients do not come first. Employees come first. If you take care of your employees, they will take care of the clients.” If a property has had several managers over a short period of time, this is usually evident through increased vacancy rates as simple duties such as following up for renewals are forgotten. However, this becomes much more detrimental than just reduced occupancy. It will create an environment of voluntary tenant turnover lasting into the coming months. If management hasn’t been steady, then who is there creating strong communities? For example, what happens to outstanding work orders that were told to the old manager? All of these instabilities will influence the likelihood a tenant vacates the property. A recent study by Witten Advisors showed that attention to community and conscientious management can make it 5 times likelier a tenant renews its lease. One renewal for one unit has profound impacts on NOI that aren’t initially easy to quantify. Multiply this effect on the percentage of units up for renewal each month and suddenly the investment starts to look like a home run.
Currently, the data for this discussion is mostly qualitative. Also, this isn’t the silver bullet of analysis. What it should help to convey is investment opportunities exist that may seem “risky” might actually be solid investments. A rural market scares several people, but it might be important to ask what the average length of stay for that complex is. If it is longer than 16 months, it might be worth digging a little deeper into the numbers. Furthermore, if an affordable housing complex shows that vacancies fill within 2 weeks, maybe another try with the financials unlocks a diamond in the rough. The key takeaway here is good management with a stable tenant population leads to a great property, and a different perspective might be all that is needed to uncover that home run opportunity.
