Multifamily Post Renovation Market Rents in OMs

Something to keep in mind when reviewing offering memorandums (OMs) for multifamily deals is how market rents are being forecasted. 

Sometimes, brokers will show "post-renovation market rents" and while that may be achievable after upgrades, it doesn't reflect what the property can earn today on an as-is basis, meaning its current condition and quality.

If you compare pictures of a classic unit vs. a renovated one, the rent premium makes sense.  It might look like new vinyl wood flooring, quartz countertops, shaker cabinets, stainless steel appliances, and maybe in-unit laundry. 

But what’s missing from the OM is the cost of getting there.  The renovation costs and time required to reach stabilized occupancy are not considered.

This becomes especially important when selecting the appropriate cap rate to determine value.  The difference between in-place and market rents is considered in the selection of the overall cap rate, such that the first-year return should align with what is supported by recent comparable sales.

Ideally, you will have a full set of sale comps with financial data from the OMs to support your analysis.  If you have a comp that forecasts post-renovation market rents, assuming all other underwriting factors are equal, the proforma cap rate for this comp would be inflated and the rental upside would be overstated on an as-is basis.

Rental upside refers to the potential to increase rents above the in-place rents to market level.  And it’s a key factor in what cap rates investors are willing to buy multifamily properties at.   

For example, if a property is significantly below market rents, it’s possible that an investor would require a yield premium (a higher going-in cap rate) to compensate for the execution risk of bringing those rents to market level which could be especially difficult in rent-controlled markets.

Analyzing cap rates can be a bit nuanced.  Learning how to read the story the comps are telling is a valuable skill in commercial real estate whether you’re an appraiser, broker, investor, or lender.