Probably the most important part of our renovation projects comes at the very beginning, when we need to estimate the rents.
Why? Because we think about deals backwards:
- Start with the estimated rents at completion
- This allows you to estimate both the stabilized yield (for a buy-renovate-hold play) and of the exit valuation (for a flip)
- Subtract the costs of repositioning the building
- What remains is the price you can pay and your profit in the deal (the lower profit the you’re willing to accept, the more you can pay for the building)
If you think about the above calculation, you will see how important rent is. If you guess low, then you will pass on projects which actually would have worked for you. If you guess high, then you can talk yourself into doing projects which won’t end up working.
In fact, at a conference I attended yesterday, Jerry Fink of the Bascom Group told a story about a conversation with a fellow developer, where the guy revealed that he works the other way around… he figures out what the deal will cost to build, then forecasts rents that make the numbers work for everyone.
So, given that the temptation exists to inflate your rent estimates, how do we maintain discipline internally?
It starts with a conversation between Jon and me, where I ask him a question like this: “I gotta a live one here. What can we get for renovated [unit type], with parking and private outdoor space, at [address]?”
I don’t tell Jon the price of the building or what I think it will cost to reposition. That way, he can’t back-calculate the numbers to make them work.
If Jon isn’t familiar with the building, then he goes and drives it and then calls me back with his estimate, which is based on what we’ve got for similar units in properties nearby, adjusted for the particulars (more parking, less outdoor space, whatever).
I always have my own number in mind when I call Jon and I can tell you that it’s rare that we’re more than $100 apart. If we are, we have a debate. And we don’t sign off on a proforma rent roll unless / until we both agree.
It ain’t perfect, but it’s served us well so far.