Have had brokers wondering why my offer prices are down so much vs. pre-crisis.

After all, rents are only down, say, 15%.

So their intuition is that my offer prices should be down 15%, too.

To understand why they're wrong, we gotta do some math.

(1/n)

2/n

Recall we underwrite every deal using unlevered yield:

(Forecast annual rents / forecast annual opex) / (acq price + rehab cost) = unlevered yield

Price and rents are important, but other things matter, too:

- projected opex; and
-rehab cost

3/n

Re opex:

Recall numerator of yield equation: (Ann. rent - ann. opex) ["net operating income"]

Just bc rents are doesn't mean expenses are, too. Still need to pay prop tax, utilities, insurance, etc.

Assum. no chng in opex, 15% rent decrease equals ~20% decrease in NOI

4/n

But wait, there's more.

Remember denominator of unlevered yield calc: (acquisition price + rehab cost)

We expect construction to get cheaper, but we don't have proof yet, so we're not changing rehab cost under-writing.

So...

5/n

If forecast rents are down 15%, forecast NOI is down 20%, and assuming rehab cost stays the same:

To get the same unlevered yield as before, you need to drop aquisition price by ~30%.

Ouch.

And it gets worse...

6/6

If the present risk environment causes you to raise your go/no go yield hurdle by, say, 10%, then...

... that 15% drop in forecast rents requires a 40%(!!) drop in acq. price to get you the yield you need to move forward.

So, brokers: That's why my bids are way down.

Some notes

- my original equation assumed price is 2/3 of total capitalization, with rehab the other 1/3.

- for simplicity, have grouped holding cost into rehab... Don't forget about it!

- when rents drop, opex does actually drop a little, bc mgmt cost is pegged to rent

@mgirdley rightly points out the unlevered yield equation in 2 contains a typo ("/" instead of "-"):

Should be:

(Forecast annual rents *minus* forecast annual operating expenses) / (acquisition price + rehab cost)