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Financial Modeling•7 min read

Rent Growth vs Expense Creep: Avoiding False IRR

Most pro formas assume 3% rent growth and 2% expense growth. The reality? Expenses often grow faster than rents. Here's how to model it correctly.

Educational content only: This information does not constitute legal, tax, financial, or investment advice. Always consult qualified professionals before making investment decisions.

The Problem: Optimistic Assumptions

Most underwriting models show beautiful IRRs: 18%, 22%, even 25% levered returns over a 5-year hold.

Then you own the asset for three years and realize: insurance doubled, property taxes reset upward, payroll crept up 20%, and you haven't been able to push rents like you thought.

Your actual IRR? 11%.

The root cause: Most models assume rent growth outpaces expense growth. In reality, the opposite is often true — especially in the first 3 years of ownership.

Common (Wrong) Assumptions

Typical pro forma:

  • • Rent growth: 3% annually
  • • Expense growth: 2% annually
  • • NOI margin expands every year
  • • Exit at a 50-75 bps cap rate compression

This setup guarantees NOI grows faster than operating costs, inflating exit value and IRR.

Reality: Expense Growth Often Wins

Here's what actually happens in the first 3 years of ownership:

  • →Property taxes reset: If you bought at a higher basis than the previous owner, expect a reassessment increase (10-30% is common).
  • →Insurance increases: Climate risk, reinsurance costs, and market cycles can drive 15-50% increases in a single year.
  • →Payroll and benefits: Minimum wage laws, benefits inflation, and turnover costs compound at 3-5% annually (or more).
  • →Deferred maintenance surfaces: The previous owner deferred repairs. You're paying catch-up CapEx disguised as R&M.

Example: You underwrite 2% expense growth. Year 1: property taxes jump 20% due to reassessment. Year 2: insurance renews at +35%. Year 3: you're forced to raise wages to retain staff.

Actual expense growth over 3 years: 7-9% annually. Your model assumed 2%.

How to Model It Correctly

1. Model Expense Growth by Category

Don't use a single blended expense growth rate. Break it down:

  • Property taxes: Model a reassessment scenario (10-25% jump in Year 1, then 2-3% thereafter)
  • Insurance: 5-10% annually (or more in coastal/high-risk areas)
  • Payroll: 3-5% annually
  • Utilities: 3-4% annually
  • R&M: Front-load in Years 1-2 (deferred maintenance catch-up), then normalize

2. Be Realistic About Rent Growth

3% annual rent growth sounds reasonable. But ask:

  • • Are current rents already at market? If yes, growth is capped at market rent inflation (2-3%).
  • • Do you have near-term lease rollovers? Can you actually push rent or will tenants churn?
  • • Is the market adding supply? New competition can suppress achievable rent growth.

Conservative approach: Model 2-2.5% rent growth unless you have a specific value-add plan (below-market rents, contract renewals, etc.).

3. Run a Downside Scenario

Downside assumptions:

  • • Rent growth: 1.5-2% (below inflation)
  • • Expense growth: 4-5% (blended, with tax/insurance shocks)
  • • Exit cap rate: 25-50 bps higher than purchase cap (no compression)

If your downside IRR is under 10%, the deal is too risky. You're banking on everything going right.

Example: Base vs Realistic Modeling

Deal: $5M purchase, $400k NOI, 5-year hold

Optimistic Pro Forma

  • Rent growth: 3%
  • Expense growth: 2%
  • Exit cap: 7.5% (50 bps compression)
  • Projected IRR: 19%

Realistic Pro Forma

  • Rent growth: 2%
  • Expense growth: 4% (tax reset + insurance)
  • Exit cap: 8.25% (25 bps expansion)
  • Realistic IRR: 11%

Practical Takeaways

  • →Model expense growth by category, not a single blended rate.
  • →Front-load property tax and insurance increases in Years 1-2.
  • →Don't assume rent growth exceeds expense growth unless you have proof.
  • →Run a downside scenario. If it doesn't pencil, the base case is too aggressive.
  • →Use our investment calculator to stress-test your assumptions.

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