Tuesday, September 09, 2014

Shadow Incentives: How new Multi-family builders fake pro-forma Rents

Builders of multi-family apartment properties want to get as much money as they can, of course, for their new projects.  They don't want to buy and hold.  They want to move to the next project.

The price of a new building is fundamentally based on gross rents.  The buyers think they are sophisticated enough to gauge ongoing expenses better than a builder - who is only operating the building till they can sell.   So the top line gross is everything and the net is kind of ignored except for immutable expenses like property taxes and utilities.

So how do they pump rents in advance of a sale?

The conventional wisdom is that new construction will offer incentives to get butts in the seats - and that's true.  Full buildings make money.   But with the general build & sell (fast) pattern followed by multifamily developers now, things are tweaked a little.   The object now is NOT to maximize near term cash flow

It is to boost the pro-forma top line of the building.

So, yes, there are cash incentives like "free rent," which is traditional for new buildings.  But there are also "shadow" incentives that won't be as obvious to a buyer.   Extra services - like free concierge or dog walking or cleaning or free etc. that may not be obviously an incentive on the books jack up the rent on the apartment.  You might think a savvy investor would recognize these higher expenses and lower net, but, especially with a new building, an investor is more likely to assume the operating expenses would be more similar to their own experience in running that type of building (and write off the higher apparent costs as "start up" or just the inefficiencies of a builder vs property management company running the building.)

These shadow incentives are yet another way of gaming the system.   If you talk with tenants at these new buildings (instead of the sellers/buyers/builders), you get a clearer picture of why they are paying these higher rents and which of those amenities are likely to appear as incentives to a prospective buyer of the building.   These extra services will disappear when an operator with the bottom line in mind is running things - and rents can be expected to drop.

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