Trending Income vs Expenses

[Anonymous]

I see this a lot in practice, but how can you justify trending income at 3% and expenses at 2%. Isn’t this essentially saying that inflation has a stronger effect on future income? Or is it suggesting a stronger future management will be able to control the variable expenses?

Thanks

[Spencer Burton]

Let me first say, you’re absolutely right that this is common right now! I think it’s more a reflection on where we are in the cycle, than on those sponsors knowing something the rest of us don’t. But remember, sponsors have capital to deploy. And at this point in the cycle, without outsized rent growth many deals just don’t pencil. So they drop in an overly aggressive and unsupportable rent growth assumption, use an unrealistically low vacancy assumption, assume little to no capital expenditures over the hold, layer in all IO debt, and voila – the deal works!

With that said, I think it is important to remember that the growth (or decline) of one line item is wholly distinct from the growth (or decline) of any another. I know in practice that we usually only assign an income growth and an expense growth assumption. But really, when sharpening your pencil, each line item should be considered independent of any other.

Property tax is likely to grow at a different tick than property insurance, which is likely to grow at a different tick than payroll. Similarly on the income side, rent is likely to grow at a different pace than parking income, which is likely to grow at a different pace than pet income. And so it goes for all line items in your model.

So at the end of the day, for most line items how much to assume for growth (or decline) is a matter of understanding the balance between supply and demand (imagine that!). If a market is underbuilt and rental demand outstrips the number of units available, rent will grow faster than average. Thus, you might be justified in using a more aggressive assumption for rent growth.

Similarly, if the local labor market is struggling and wages are flat, you might be able to support a payroll growth assumption below the long-term average. Or if parking is scarce in your CBD location and job growth in the submarket is robust, you might get comfortable with an above average parking income growth assumption.

Etc, etc etc.

Lesson for the day – and I’m not telling you anything you don’t already know. There is no wrong assumption, so long as it is supportable.

Thanks for the great topic!

[Author]

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