In the Tom Cruise movie, The Last Samurai™, the lead Samurai’s hobby is to find the perfect cherry blossom. In the end, he concludes they are all perfect. Unfortunately, this is not true in rent roll analysis; few are accurate, and most are flawed.
The purpose of a rent roll is to act as a record of rental revenue based on valid in–force leases.
The reason its so hard to get an accurate rent roll is varied, from incompetence to criminality. Most people are fair and honest, but it is still important to verify; trust but validate. Connecting the dots, from the rent roll to bank deposits to leases, completes a circle that builds confidence in rent roll accuracy. There are no short cuts.
Standing behind a record of rental revenue is the payment history of the residents. Payment history is the tail that wags the dog. The rent roll reports the amount of income you can anticipate for a given period, usually a month. The rent roll’s further reach conveys the stability, quality, and longevity of projected income in black and white.
A Rent Roll Measures Change Over Time
Income property is often purchased to own for an extended time horizon: one year, five years, ten years, or longer. Thus, while it is essential to know the current income, it is equally, if not more important, to understand the viability of the asset and its income stream going forward.
As they say in baseball, catch the ball, hit the ball, and throw the ball. A great hitter hits the ball 30% to 40% of the time. When making decisions on placing millions of dollars of equity into millions of dollars of hard assets, you must have a perfect record when validating income. Anything less is a financial disaster.
You are looking to see if the monthly income statement matches the rent roll. Said another way, the income statement and rent roll should tell the entire world the same story. If not, why not?
There will be discrepancies, but differentials should be small and easily explained and documented in notes. If differences are vast, like the proverbial “Mack truck,” there is cause for concern and reason to require more in-depth due diligence to determine actual income.
A Rent Roll Should Deliver True Numbers
Many government agencies require a certified rent roll as part of annual monitoring. For government programs, the rent roll conveys an affidavit on collections. The presentation of an inaccurate rent roll can be considered a criminal act.
Following is an example of a document required from an affordable housing program. The manager/owner must sign this document on an annual basis with the rent roll and financials delivery.
“This rent roll, (being delivered to a governmental agency) is made, presented and delivered to influence an official action of the Department of Housing & Urban Development and may be relied upon as a true statement of the facts contained herein.”
In affordable housing, the rent roll ensures that HUD pays the correct rental amount to the property owner and the resident residing in a subsidized apartment.
Rent growth comes from new and existing leases or units vacated and upgraded to create freshness or differentiation to capture additional rent.
To measure rent growth requires first knowing Gross Potential Rent (GPR). In my book Rent Roll Triangle: The Ultimate Rental Property Grading System, I describe the not-so-subtle differences between GPR, Collections, and stated lease rents. There is and always will be a difference between these three measures of rental revenue potential.
Gross potential rent, or GPR, calculates the maximum rental income that a landlord could generate from a property. GPR assumes that a property has a 0% vacancy and that there are no rental payment issues. Besides, gross potential rent is a take-off on market rent, the average rent that tenants pay for similar properties in the same geographic area. Multifamily.loans
Rent Growth is the Fuel of Property Appreciation
Rent growth is like compound interest: it grows from a baseline (rental) income already in hand but requires an upfront investment. There are dozens of potential income sources with income property, but at the end of the day, with any income property, more than 90% of revenue comes from rents.
Thus, growth in rents drives higher revenue the fastest. For example: Is there a big difference between current rents and potential rents if you were to perform complete remodels? If the answer is yes, you will want to know and measure the investment return before making this redevelopment investment.
Rent growth measures take into account dramatic occurrences or intentional causes that management or ownership implement on a property, allowing you to measure potential significant changes in rental income based on changes in operational events.
Consider the following cost versus benefit example: if a $100,000 investment in property upgrades will generate $120,000 in annual rent growth, that is a significant payoff at that level of investment (this pay off says: DO IT NOW – DON’T WAIT). If a $500,000 investment in upgrades will only garner $20,000 in increased annual rent, there is little incentive (limited as in YOU SHOULD NOT DO IT) to invest in upgrades.
One method to assure lower turnover is to eliminate rental rate increases. Removing rent growth is a terrible business strategy, however, and will result in rental income deterioration in rapid fashion.
Often, increasing rents will create some turnover, but with this (sometimes), intentional turnover comes an opportunity to upgrade facilities and charge higher rents for upgraded amenities.
Consider the more prominent the gap between current rents (stated lease rents) and Gross Potential Rent. The higher the incentive to upgrade interior space to capture this additional rent and close the gap between current rents and Gross Potential Rent (GPR).
With Rent Growth, What You Measure is What Improves
In my book, How To Read A Rent Roll, two full chapters are devoted to metrics that outline rent growth strategies for converting rent and revenue growth into a single measurable number per calculation. Having the capacity to identify rent growth allows you, the property manager or owner, to determine appropriate levels of investment, estimate Return On Equity (ROE) and Return On Investment (ROI).
- Measure quarterly rent growth for the last four quarters for each asset in your portfolio.
- Determine the primary source of rent growth for each asset.
- What is the investment necessary to accelerate rent growth? Does the investment make good business sense?
With permission, this article excerpts from the book: How To Read A Rent Roll: A guide to understanding rental income by John Wilhoit, Jr.