The Test You Need to Do: Affordability Test

Most of us hated tests in school, but here’s one test you should be doing in your underwriting model: The Affordability Test

The affordability test is something all multifamily underwriters should be doing when modeling a potential acquisition.

Let’s break it down…

The affordability test is a simple, yet extremely valuable test you can use to evaluate if the potential tenants in a given submarket can afford the rents you are projecting by using the household income.

We need 2 things for this:

  • Median Household Income (I like using 1-Mile radius)
  • Pro Forma Rents

Average Household Income Defined:

The term household (HH) income generally refers to the combined gross income of all members of a household above a specified age. Household income includes every member of a family who lives under the same roof, including spouses and their dependents. The incomes of everyone count even if they aren’t all used to support the household. Household income also includes anyone living in that home even if they’re not related.

Lookup Average Income Stats:


The Affordability Test:

Most property managers require a 3x Rent-to-Income Ratio. Meaning, the tenant has to earn at least 3 times their monthly rent amount. A 3x is just a rule of thumb we will use today.

We can calculate the Rent-to-Income Ratio like this:

  • 1-Mile Median HH Income / (AVG Rent x 12)

I’m taking the Median HH Income and dividing it by the annual average rent.


Example:

In this area, the 1-Mile Median HH Income is $45,000. Our company will only rent to tenants that have a rent-to-income ratio of 3x.

The average in-place rent at this property is $1,000/month. Potential tenants can easily afford $1,000/month because the rent-to-income ratio is 3.8x. The household in this area makes 3.8 times the rent amount.

If I were to underwrite to an average pro forma rent of $1,400, this could be a serious problem. The rent-to-income ratio drops to 2.7x, lower than our requirement of 3.0x.

If the median HH income is $45,000 and we have a 3x rent-to-income requirement, the max rent we could potentially charge is $1,238/month.


Good News!

We created a free Affordability Test calculator you can copy and paste into the underwriting model you are using. (Go to File, then Download)

This affordability test is also included in the Next Level Value Add Model!