Utilities: More that a crappy space in Monopoly
Updated: Jun 10, 2019
We’ve gone through two fixed expenses for a multifamily property - real estate taxes and insurance. Now we’re going to look at the first of the variable expenses…utilities.
When doing an initial review of an opportunity, your first pass, especially in a new market, will be a smell test of the numbers in the Offering Memorandum. If the utility numbers in the package don’t appear to be egregiously off-base, you may elect to use them for this initial review. However, every market, municipality, property will have their own utility rates. There is not be a universal rule-of-thumb so it’s best to understand your particular market or talk to other owners or property managers to get the expected rates for the property you’re underwriting.
Regardless of the specific numbers, however, one important detail you will want to determine in this initial review is exactly how the utilities are being paid. Are they paid by you, individually metered to all tenants each month or reimbursed by the tenants WITHIN the lease? Knowing this will be critically important when figuring out your proforma and how to adjust the one presented to you.
However the utilities are paid, once you go under contract, you NEED to get the last twelve months of all utility bills.
Don’t let them only pass over last month’s bills or the last three months’ bills. Utilities are more seasonal than any line item in the P&L. The electric bill in July while the air conditioners are on full-blast will be drastically different than the bills in December. The gas bills in Decembers with the heat running will be different than the bills in July. You’ll be owning this property year-round so you need to know what your annual expenses will be. Once you have this information, we can dig into the numbers and see exactly how you should account for this variable cost.
We’re going to quickly touch on four different ways you may see the utilities being paid.
If the utilities are paid by the landlord (you), this expense item is fairly straightforward. Get the last years worth of bills, verify them with the various utility companies and you should be good to go. I would caution you to confirm that the last twelve months are going to be similar to the next twelve however. If the current owner has added any amenities or if the property had unusually high vacancy, these bills may be lower than then will be going forward. Otherwise, you’ll be paying a similar amount unless your plan involves improvements such as low-flow toilets, filling in a pool or other capital expenditures that could creating expense savings in the future.
If the utilities are completely individually metered, which you may see in new properties or complexes originally built as condominiums, this expense line item will be substantially lower. In these properties, the tenants themselves set up the utilities and receive the bills. This is a huge benefit for the owner. First, it avoids issues of tenants overusing utilities as they are the one on the hook for the payments. Second, it smooths out this expense item as future utility rate increases don’t fall too hard on your shoulders. I will leave one word of caution. I see a lot of presentations in which the seller agent puts a big “$0” in for expenses because "the tenants pay all utilities”. This is never true. Even in a 100% occupied property, the owner will have common area charges. You have to pay for the lighting of the parking lot, filling the pool, the laundry area, the leasing office etc. Additionally, while utility usage in vacant units is minor, it’s not zero. You’ll be covering all these costs so make sure you have a reasonable expense budget for utilities even if “tenants pay”.
If the utilities are under a master meter, a property owner can also cover this expense by submetering the units. In this case, the owner would have submeters installed unit-by-unit behind the meter as the individual utilities enter the unit. It essentially creates individual metering. You can pay upfront for this installation yourself or you can contract this out on a monthly basis. The advantage of this is similar to the individual metering section. However, note the differences. First, the utilities themselves are still in your name. If the tenant doesn’t pay you for their usage, you can default their lease but you can’t necessarily go after them for these charges, nor will the utility company fight for you. YOU have to pay the water company. They don’t care about your submetering. Second, there is a cost to this. Whether you’re paying $800-$1,000+ upfront to install or $10/mo for a contract, you need to account for this. You’ll also have to monitor and read these meters each month and bill accordingly. They are not nearly as beneficial as individual meters but they are substantially cheaper than the $8,000+ for the meters and solve 90% of the same issues.
Finally, if the utilities are paid by the landlord, you can elect to charge them back to the tenants. This is typically known as RUBS (Ratio Utility Billing Systems). With this, a landlord will simply add some amount to each monthly bill. This could be determined by a straight per-unit charge or a variable charge based on usage, room count or square footage. This is the simplest way to recover expenses without meters. There are a few drawbacks however. First, having a preset charge does nothing to encourage tenants to limit utility usage. They’ll pay the same whether they’re running the hot shower all morning to de-wrinkle a shirt or they are conserving. Second, you may create conflict if you’re using a variable charge each month based on usage. If tenants start policing each other for over-usage while they’re covering their percentage, you could create tenant-to-tenant problems. Finally, as with the submeters, these charges aren’t looked at the same as “rent” by the courts. You may not be able to recoup these so you may be better off simply baking it into the actual rental rate.
Regardless of how you’re charging or paying for utilities, make sure you understand how to handle the P&L.
If tenants are paying 100% of the utilities, make sure your rent comparable properties are doing the same. Utilities are a big expense for a renter and they will not pay the same rental rate for a unit that charges utilities as one in which that cost is included.
Renters look to the absolute cost of the unit.
This is especially important if the Offering Memorandum is proposing a “value add” component in which you start a RUBS program or submeter the property. This is an excellent value add opportunity but you need to look at the whole picture. If they are proposing that current rents are “$100 below market” and proforma’ing rents $100 higher in the future and THEN proposing a utility reimbursement program of $50/unit/mo, you may well find yourself underwriting rents well above what will be tolerated in the market. You may be able to do one or the other, but make sure those “market rent” comps are also charging-back utilities or you’ll miss the mark.
Another underwriting aspect to focus on is the vacancy factor. If you’re charging back $50/unit/mo, that will most likely show up in the Other Income line item. I see way too many packages put this line item below the vacancy calculation. If a unit is not occupied, it is not reimbursing you for utilities, it’s as simple as that. There is literally no reason why this item would not take vacancy into consideration. Please move this above the vacancy line for all opportunities you review.
A third and final underwriting consideration to look for is a revenue item with no matching expense. I know this seems unlikely but, believe me, I’ve seen it. A proforma P&L will place a large Other Income line item in for utility “reimbursement” but they’ll still zero out the utilities or leave a nominal expense amount. The definition of reimbursement implies that it’s offsetting an actual expense. It can’t be in place of that expense. If you see a RUBS program or submetering in the package, please make sure you still see the expense for these items. I know this sounds intuitive but just humor me and check when you see it.
There are many ways to account for the utility expenses. There are ways for a landlord to lower these costs and there are ways for a landlord to enact a value-add program to significantly improve their cash flow. However, you need to know how to underwrite these different scenarios and how to project this expense out into the future regardless of your plan. Keep an eye on the big picture to make sure nothing is glaringly wrong and be sure to dig into the actual numbers as you move through diligence and you’ll be properly covering your ass.
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Next Week: You may manage this yourself, but I’ve got places to be!