How We Underwrite Rent Growth Without Gambling on the Market

Rent growth assumptions can make or break a pro forma. Aggressive assumptions produce attractive IRRs. Conservative assumptions produce real returns.

Here is how we underwrite rent growth without gambling on the market.

The Three Year Rent Growth Floor

We use a three year rolling average of submarket rent growth as our base case. Pulled from CoStar, ApartmentList, RealPage, or local market surveys.

If the submarket has averaged 3.2 percent rent growth over the last three years, our base case assumes 2.5 to 3 percent going forward. A modest haircut to historical performance.

This produces conservative pro formas. It also produces pro formas that consistently meet projections.

Why We Discount Historical Growth

Most three year periods include some rent growth. The 2020 to 2022 period had explosive growth. Including those years in a backward looking average can mislead.

We use trailing five year data where available. We discount the highest year. We discount the lowest year. We use the middle three to set a normalized assumption.

This produces a more accurate baseline than raw averages.

Loss to Lease Capture

Separately from market rent growth, there is loss to lease capture. The difference between in place rent and market rent that gets captured through turnover and renewals.

On a property with 200 dollars of loss to lease per unit and 35 percent annual turnover, you capture about 70 dollars per unit per year just from turnover. Plus whatever renewals contribute.

Loss to lease capture is not a market assumption. It is an operational outcome. It should be modeled separately from market rent growth.

Value-Add Rent Premium

Renovation produces a rent premium above market. A standard unit might rent for 1100. A renovated unit might rent for 1275. The 175 dollar premium is the value-add return.

This is not market rent growth. It is a one-time step up based on capital investment. Should be modeled separately.

Common error. Sponsors blend market rent growth, loss to lease capture, and renovation premium into a single growth assumption. The combined number sounds reasonable. The components add up to aggressive assumptions.

Downside Scenarios

Every pro forma should include a downside rent growth scenario. What if rent growth is zero. What if rents decline 5 percent in year one.

Stress test the DSCR. Stress test the IRR. Identify where the deal breaks. Underwrite knowing where the breaking points are.

A deal that hits target returns under base case and survives under downside is a real deal. A deal that only works under base case is a bet.

Communicating Assumptions

LPs should see the rent growth assumptions clearly stated in the offering memorandum. Submarket. Historical. Projected. Components.

If the assumptions are not transparent, they are hidden for a reason. Ask. Understand. Compare to your own research. Invest only when the assumptions are defensible.