Budgets are Looming

As we enter the “dog days” of summer, it’s time for pricers to look ahead. Things are usually good right now—we have a strong tailwind from seasonality so rents and occupancies are trending upward nicely. And with various summer vacations going on, the pressure isn’t quite as high as it usually is—most operators and executives are happy with the trends, and some of them aren’t even in the office today anyway.

But as anyone who’s been doing multi-family pricing for any length of time knows, beware the coming of the 4^th quarter. For though the kingdom seems at peace, we know that ill winds are about to blow. Come September/October, two things will conspire as we face what is often our biggest enemy:  the BUDGET; and it’s almost equally evil sidekick, the operator’s bonus.

One of the first things I noticed when I came into this industry in 1999 was that fourth quarter budgets tend to show flat occupancy and flat (or worse, slightly increasing) move-in rents through 4^th quarter (Oct-Dec). When I asked around, everyone agreed that rents and occupancy always go down in the 4^th quarter, especially in “seasonal” (aka northern) markets.

So why did we budget for a behavior we knew wasn’t going to occur? It was as if there was an 11^th Commandment—“Thou shall not budget for decreases in occupancy or rent.”

It may not seem like a big deal, but when the pricing system I was using was lowering prices to protect occupancy, it sometimes sent operators into a “but I’m budgeted for…” tizzy. It took me three years, but we finally slayed that dragon and began budgeting based on actual historical patterns. We didn’t budget for steep declines in rent or occupancy, but at least we budgeted for realistic behavior. What does your company budget for in 4^th quarter?

The issue with operators’ bonuses is much more pernicious. If you’re like every other company I know of, then at least a part (often a majority) of the operators’ end of year bonus is tied to revenue growth vs budget.  The trouble is that my pricing system was trying to maximize the next twelve months revenue while the operator’s bonus is based on an arbitrary period (the calendar year). In first quarter, we’re quite aligned—optimal revenue for the next 12 months is essentially lined up with the operators’ bonus.

But by late 3^rd/early 4^th quarter, we’re hopelessly misaligned. If the operator is far above (or below) budget, there’s no worries. They make (or miss) their budgeted revenue bonus no matter what. But if they’re close, it’s a whole different story. My pricing system may want to sacrifice a small amount of occupancy for rent growth, but the operator takes all the hit for vacancy in their performance this year and gets very little credit for the revenue growth since most of that rent will show up next year.

To make matters worse, if the MI is pre-next year’s budget, they won’t even get credit for the extra yield next year since that will be baked into the forecast/budget. A double whammy! All the pain of vacancy this year and none of next year’s gain of rent for bonus calculations.

The reverse is also true. If the operator insists on lower rents for higher occupancy, she gets credit for the extra occupancy and feels no pain for the lower rent into next year as that will be included in the baseline budget.

It’s a wonder that pricing and operators get along at all in the 4^th quarter. What we really need is an independent benchmark for operating performance budgets. Those of you who know me have probably heard me mention that the hotel industry has exactly that—micro-market competitor aggregate benchmarks of revenue performance. Now that’s a metric that aligns operators and pricers!