When to Gross Up "Other Income" Items

[Anonymous]

During the lecture in 2.7 you divided all our “Other Income” items in Year 1 by the occupancy to create their value at 100% occupancy. In the Foles DCF I repeated that calculation because we again were accounting for the vacancy at 5% later in the model, but I reversed that calculation when I read in the notes our NOI should match our direct cap NOI less the capital reserves. Can you please explain to me when and why we would divide the other income items by the occupancy rate?

[Spencer Burton]

First, let me explain grossing up for those unfamiliar with the concept. Most often properties have some vacancy each year. This is especially true of multifamily, where keeping a 300+ unit complex 100% occupied is quite the task.

[As a sidebar, it’s also worth mentioning that at a market rate apartment property, 100% occupancy is usually a bad thing. It generally means the operator is not maximizing rents. Most operators will target a 96% or 97% occupancy such that they find the right balance between max occupancy and max rent.]

But I digress.

So if the historical income statement of a property has vacancy in rents, the Other Income line items will have embedded vacancy as well. Meaning, the Other Income line items would have been higher had the property been 100% occupied. So for instance, imagine a property with average occupancy of 95% over the year. And imagine during the year that the property earned $95,000 in Other Income. The logic goes than, that had the property averaged 100% occupancy throughout the year =, Other Income would have been $100,000 (95,000 ÷ 0.95).

Thus, the process of adjusting a line item so as to be equal to some amount were the property 100% occupied is called ‘Grossing Up’.

So the question is, when to gross up Other Income line items. From a real estate underwriting perspective, there aren’t hard and fast rules for when to gross up Other Income. It’s a matter of what is the other income line item, and what is the incentive of the underwriter.

If you’re trying to maximize income in your pro forma (i.e. get aggressive), you can support grossing up Other Income when:
1) The line item is 100% positively correlated with occupancy. So mandatory cable income, for example.
2) The General Vacancy line calculates vacancy on Potential Gross Income, inclusive of Other Income. This is not always the case. A lot of professionals will only include rent in their General Vacancy calculation, in which case it would be necessary to include vacancy in the Other Income line items individually.

It becomes more difficult to support grossing up Other Income when:
1) It’s unclear how impactful property occupancy is on a specific other income line item. For instance, parking income can be 100% positively correlated, or completely uncorrelated. So parking income in CBD office buildings may be uncorrelated while parking income in a suburban apartment complex is.
2) Vacancy is taken on rent but not on Other Income. Again, if the assumption is that the Other Income line item is positively correlated with occupancy, and you’re taking vacancy on rent. Than, it’s difficult to justify grossing up Other Income without taking vacancy on that Other Income.

With that said, if you’ve read many of our Forum responses you’ll notice a common theme. How aggressive your underwriting depends on who in the transaction you are. If even you can support grossing up a line item, doesn’t mean you would/should.

So what you’ll find in real life is that:

The seller and selling broker are more likely to gross up Other Income (i.e. get aggressive), as their incentive is to maximize value.

The lender will be less likely to gross up Other Income (i.e. be more conservative), as they’re more concerned about the downside risk.

The buyer can go both ways. On the one hand, the buyer doesn’t want to overpay. And so they’ll push back against the seller for being too aggressive in the seller’s underwriting. At the same time, the buyer wants to win the deal and so will often have to find ways to justify the price to their investment committee. Grossing up Other Income is one way to justify more income to an investment committee, even if the realities are not quite so cut and dry.

Thanks for the great question!

[Author]

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