Draw What You See, Not What You Think
For anyone who has tried to learn how to draw, the odds are high that a teacher or instructor has repeated those words in some form or fashion. All the instructor is trying to convey is the notion that, at times, there can be a disconnect between what our eyes are telling us we are seeing and what our brain is thinking that we are seeing. Once a student learns to overcome the impulse to draw what they think and rather draw what they see, the odds increase substantially that they will succeed in their aspirations to become better at drawing.
I mention this because it holds true to several exercises in life, but also something I have been considering and thinking about in the commercial real estate world we have been living in for some time. Within the last year, we have seen much of the “free money” evaporate in the commercial real estate sector, especially in the multifamily realm, and most operators and investors who didn’t sell everything by June of 2022 find themselves in a new world order. The paradigm shifted quickly from a mentality of buy high and sell higher 366 days later or so to discussing things like operations, efficiencies, and management. Management? Are we really talking about management? It sounds like we are finally returning to the basics of making money from cash flow and driving performance.
Digressing for a minute, if I were to mention the terminology “modified gross lease,” most astute investors likely think of a lease structure that falls between a NNN lease on one end of the spectrum and a gross lease on the other. In terms of asset class, office comes to mind first for me. Some expenses are passing through to the tenant directly (e.g. utilities), some are probably getting caught up at the end of the year in some form of a true-up or bill-back (property taxes, insurance, etc.), and some are just getting eaten by the landlord with hopes that any rent bumps more than compensate for them, or they can increase rents on renewals (management, G&A, capital expenses). The closer you get to a triple net lease, the more responsibility falls to the tenant, and less on the owner, and the opposite is true the closer you get to a gross lease.
Jumping back to management. When you really drill into how apartment buildings operate, how many investors, syndicators, or even lenders—yes, lenders—understand the full picture of what all those rows of expenses are depicting? The easiest thing to see, and where most of the attention falls, is on the income, which rolls up nicely in a handful of rows. But what are we actually seeing with regard to the expenses? On the fixed expense side, how often are taxes getting reassessed, and by how much? I recently read an article that property taxes in Texas have doubled in the last five years. I wonder how many owners got that right in their model. What about insurance? What formula do you use to determine how much is going up year-over-year? When was the last time you heard someone say their premiums are down year-over-year? Utilities? Are your heating oil/ gas prices changing monthly, quarterly, annually? Contract services? Payroll? Good employees will want to get paid – look at all the negotiations and strikes that have been permeating the news lately. Finally, I am still trying to understand where the $250/unit/year replacement reserve number comes from that lenders underwrite to. Do lenders understand how much turnover happens in certain buildings each year, and what the cost of a patch and paint job at a minimum is?
Where am I going with this? When you lay everything out and draw what you see and not what you think—a lot more moving pieces go into managing apartment buildings. The way expenses play out for multifamily sounds pretty similar to what I described for a modified gross lease structure more than anything else. Taking it one step further, I will assert that, operationally speaking, multifamily and office are much more similar than most people tend to see. Yes, supply and demand metrics are very different now, but we know that supply and demand will, over time, revert and balance out, and when that does happen, operationally, these two asset classes share a lot more similarities than differences.
This brings me back to what I have been trying to make sense of over the last year – is the risk profile associated with office warranted right now, or conversely, is the lack of risk profile not associated with multifamily warranted—especially in the new world order where we are focusing on operational performance cashflow and management?