How to Underwrite a Small Apartment Building

By Gary E. Wilson, President & Designated Broker, Wilson Management, Inc.

Underwriting a building is a different exercise from evaluating a rental house. A house has one rent, one tenant and one set of systems. A building has a rent roll with a distribution inside it, expenses that behave differently at scale, and a capital position that can be worth more than a year of net income.

The offering package will present all of this in its most favorable form. The work is reconstructing it from the underlying documents.

For the general return metrics that apply to any rental property, see how to calculate rental property ROI. This covers what is specific to a building.

Start with the rent roll, not the summary

The summary tells you average rent. The rent roll tells you the distribution, and the distribution is where the value sits.

Read every line. For each unit: the in-place rent, the lease start and end, whether it is currently occupied, what concessions were given, and what the unit is.

Then look for four things:

Loss to lease. The gap between in-place rents and what comparable units currently achieve. A building with substantial loss to lease has embedded upside — but the upside is only real if it can be captured, which in Washington means captured within the notice and increase rules that apply. A seller presenting market rents as achievable next year may be presenting something the regulatory framework does not permit at that pace. See Washington's rent increase cap.

Lease expiry concentration. Leases clustered in the same month create a turnover spike, and a spike is both a vacancy risk and a cash demand for simultaneous make-readies. Staggered expiries are worth money; concentrated ones are a cost you will pay in year one.

Recent leasing. Units leased in the last few months are the most reliable evidence of what the building actually achieves — more reliable than any comparable-property analysis, because they are the same building, same location, same condition. If recent leases came with concessions, the effective rent is lower than the stated rent.

Unit mix and what each type earns. Not all units in a building perform alike, and a mix weighted toward the weakest-performing type is a structural feature rather than a management problem.

Reconstruct the expenses

The T-12 shows what the seller spent. It rarely shows what you will spend, and the differences are systematic rather than random.

Work through each category and ask whether it will be the same under your ownership:

Property taxes. Frequently the largest single change. Assessment may be reset following a sale, and underwriting the seller's tax figure is one of the more common and more expensive errors.

Insurance. Your coverage, your deductible, your loss history — not theirs.

Management. If the seller self-managed, there is no management line in the T-12, and there will be one in yours. If they had on-site staff, establish the burdened cost rather than the wages.

Repairs and maintenance. The most-manipulated line. A seller preparing for sale spends less on maintenance, which improves net income and defers work onto the buyer. A suspiciously low R&M figure is not a sign of an efficient building; it is a sign of a deferred one.

Capital treated as expense, or expense treated as capital. Both happen. Work through what was actually done and classify it yourself.

Utilities and recovery. Establish what the building pays and what it recovers, and whether the recovery method will survive scrutiny under your ownership. See Apartment Utility Billing.

Turnover. Frequently distributed across several lines and therefore invisible. Reconstruct it: what did the building actually spend to turn units last year, and how many turned?

Vacancy and credit loss. Use the building's actual performance, not a standard assumption. Actual bad debt is visible in the ledger.

The output is a normalized expense figure — what the building costs to run under your ownership, at your management structure, with maintenance funded properly. That figure, not the seller's, is what the price should be tested against.

Express it per unit. Per-unit expense is what makes the building comparable to itself over time and to other buildings at all. A percentage of revenue moves whenever rents move, which makes it a poor instrument for comparison.

Fund the capital position separately

This is the discipline that separates underwriting from arithmetic, and it is where small-building acquisitions most often go wrong.

Net operating income assumes a building that keeps working. Buildings only keep working if their components are replaced as they reach the end of their lives — and those components have finite, knowable lives.

Inventory them: roof, siding and envelope, windows, heating plant and distribution, water heaters, electrical service and panels, plumbing supply and waste lines, parking surface, decks and stairs, elevators where fitted, and unit interiors.

For each, establish age and remaining life, then price replacement. Age is knowable; condition requires inspection.

A building with a roof at the end of its life, original galvanized supply piping and thirty-year-old windows carries a capital obligation that is real whether or not it appears anywhere in the offering. Subtracting it from what the building appears to be worth is not conservatism — it is accuracy.

Two items deserve specific attention in this region: water intrusion history, because envelope failure is the expensive one and it hides; and any deck, stair or balcony structure, because those carry both a capital and a life-safety dimension.

See Apartment Capital Planning.

Regulatory diligence is part of the underwriting

Washington's multi-family regulatory framework directly affects what a building can earn, and it is not optional diligence.

Rent increase rules. What can be increased, by how much, and with what notice — which constrains how quickly loss to lease can be captured.

Notice periods and just-cause requirements, which affect how quickly a unit can be recovered and what a repositioning plan can realistically assume.

Screening requirements, which differ by jurisdiction. Seattle's rules are materially different from the state baseline. See Seattle landlord laws and the Washington landlord-tenant law guide.

Local registration and inspection requirements, which apply in some jurisdictions and carry both cost and a compliance obligation from day one.

Energy performance obligations, which apply to multifamily buildings above defined square footage thresholds and carry reporting duties and, potentially, capital implications. See Seattle energy benchmarking.

This article is general information, not legal, tax or investment advice.

Documents to obtain

• Certified rent roll, and the prior twelve months of rent rolls
• Trailing twelve months of operating statements, with general ledger detail
• All leases and amendments, including any side agreements
• Utility bills for at least a full year, covering seasonal variation
• Tax bills and the current assessment
• Insurance loss runs
• Service contracts and warranties
• Capital work history — what was done, when, by whom
• Any inspection, engineering or environmental report
• Permit history, and confirmation the unit count is legally permitted

That last item is worth stating plainly: confirm the legal unit count. A building operating with more units than are permitted is not carrying the income it appears to carry, and the problem transfers with the title.

Test the assumptions that carry the deal

Every underwriting rests on a small number of assumptions that determine the outcome. Identify them and test them individually.

Usually they are: the rent you can achieve, the time it takes to achieve it, the normalized expense figure, the capital obligation, and the exit assumption.

Move each one adversely, one at a time, and see what survives. If the return depends on capturing full market rent across the building within a year, on an expense figure below what the building has ever actually run at, and on no capital surprises — that is not an underwriting, it is a hope with a spreadsheet around it.

A deal that works under reasonable assumptions and merely disappoints under pessimistic ones is a deal. A deal that only works under optimistic ones is a bet on being right about everything simultaneously.

Where to go next

Our Multi-Family Property Management page covers how we operate buildings for owners, and Lease-Up Strategy covers capturing rent after acquisition.

For the operating side, see reducing apartment operating expenses and value-add strategies.

To have a specific building reviewed, contact us or request a free rental analysis.