Most bad multifamily deals were not bad buildings. They were ordinary buildings underwritten with six or seven assumptions that each seemed reasonable and were each slightly wrong in the same direction.
Testing operating assumptions means finding those. Below are the ones we see most often in pro formas for Southern California buildings of 5 to 50 units, stated the way a buyer usually believes them, followed by what a careful underwriter does instead. The numbers are hypothetical and attach to a 10-unit building in Anaheim we will use throughout.
“Market rent is what the broker says it is”
The offering memorandum says the 2BR units should rent for $2,600. The comps in the back of the package support it. The number goes into the model as the rent every unit reaches on turnover.
A careful underwriter asks a narrower question: what did this building’s own most recent new leases achieve? If the three 2BR units let in the last year signed at $2,325, $2,350, and $2,400, the achieved rent is about $2,360 and the broker’s $2,600 is a hope with a $240 gap. Underwrite the turnover units to $2,360. Then, separately, look for the reason the building lets below the comps, because it is usually something physical you will have to pay for before the gap closes.
“Five percent vacancy is standard”
Five percent is the number most pro formas carry because it is the number most pro formas carry. On a 10-unit building it implies less than one unit empty at any moment, all year.
What matters is economic loss, not physical vacancy. One unit turning takes three to six weeks of downtime once you allow for cleaning, repairs, and marketing, and a 10-unit building with 30% annual turnover has three of those a year. Add a modest allowance for uncollected rent and the honest figure for a small building is closer to 7% or 8%. On $270,000 of gross potential rent, the difference between 5% and 8% is $8,100 of net operating income (NOI), and at a 5% capitalization rate that is $162,000 of price.
“Expenses scale with revenue”
Many models set expenses as a percentage of income, typically 35% to 40%, and let them rise as rents rise. The building’s costs do not know what its rents are.
Build expenses per unit, in dollars, line by line, and then grow them at their own rate. A careful model for our Anaheim building might carry repairs at $1,100 per unit, turnover at $1,500 per unit turned, and utilities from the actual bills, with each line growing 3% to 4% a year regardless of what rents do. The expense ratio then becomes an output you sense-check rather than an input you choose. A ratio that falls from 40% to 30% over five years because rents grew and expenses did not is a signal that the model has stopped describing a real building.
“Three percent rent growth is conservative”
A flat 3% a year on every unit looks modest. In a rent-capped market it is neither modest nor how rent actually moves.
Under California’s statewide cap (AB 1482), rent on a sitting tenant can rise by 5% plus local inflation, to a maximum of 10% a year, and some cities allow less. Rent on a vacated unit resets to whatever the market will pay. So a careful underwriter runs two rent lines: in-place tenants at the allowable increase, and turnover units stepping to achieved market rent when they turn, at the building’s actual turnover rate rather than an assumed one. On a building where four of ten tenants have been in place for over a decade at $1,600 against a $2,360 market, the model’s answer depends almost entirely on when those four leave, and a 3% blanket figure hides that dependence rather than resolving it.
“Insurance and taxes move with inflation”
Both lines usually get the same 3% escalator as everything else. Neither behaves that way in California.
Property tax after purchase is governed by Proposition 13: the assessed value resets to your price and then grows by no more than 2% a year, so the tax line is high in year one and predictable afterwards. Insurance is the reverse: the year-one quote is knowable, and the trajectory is not, because California carriers have been repricing and withdrawing coverage on older wood-frame buildings. A careful model escalates the two lines separately, taxes at 2% and insurance at a rate well above general inflation, and tests what happens to debt-service coverage if the insurance line doubles over the hold. The year-one figures themselves belong in a separate exercise, covered in our note on rebuilding the operating expense line.
“The exit cap rate equals the entry cap rate”
The model buys at a 5% cap rate, grows NOI for five years, and sells at a 5% cap rate. All of the projected gain comes from the NOI growth, which looks disciplined.
It is not, because it assumes the market will price the building in year five exactly as it did on the day you bought it, with an older building and an unknown rate environment. A careful underwriter adds 50 to 75 basis points to the exit cap rate and looks at what survives. Take our Anaheim building with $135,000 of stabilized NOI: at a 5% exit it is worth $2.7M; at 5.75% the same income is worth about $2.35M. If the business plan only works at the lower number, the plan is a bet on the capital markets rather than on the building.
Run Them Together, Not One at a Time
Each correction above is small on its own. The useful test is to apply all of them at once and see whether the building still covers its debt. A model that goes from an 11% projected return to 7% when its assumptions are tightened is still a model of a decent building; one that goes from 11% to a coverage ratio below 1.0 was never describing an investment.
This is also where leverage decides how much room the assumptions have. At sub-50% loan-to-value on every property, the debt-service coverage ratio (DSCR, net operating income divided by annual debt payments) starts high enough that a few tightened assumptions reduce the return rather than threaten the loan. Our explanation of debt-service coverage in multifamily investing works through that arithmetic.
Want a second opinion on the assumptions behind a Southern California multifamily pro forma? Talk to VisionWise Capital →
This content is for informational purposes only and does not constitute investment, legal, or tax advice. Real estate transactions and private placements involve significant risk, including potential loss of principal. Always consult qualified legal, financial, and tax professionals before making investment decisions.
Related Reading
- How to Review Multifamily Operating Expenses Before Investing
- Debt-Service Coverage in Multifamily Investing
- How to Value an Apartment Building in Southern California
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