Investing in apartments can be overwhelming. The purchase price is usually extremely large and the debt service is more than you can service on your own.
However, I firmly believe there isn’t a safer investment.
Unlike the vast majority of other commercial investments, people have to have a place to live. Thereby obviously making it less risky.
Additionally, unlike single family housing, apartment investing scales-up very easily. Single family houses will wear you out and is very hard to scale.
- 1 Benefits of Apartment Investing
- 2 Negatives of Apartment Investing
- 3 Class of Apartment Buildings
- 4 Metrics of Apartment Investing
- 5 Financing Apartment Complexes
- 6 Summary
Benefits of Apartment Investing
The biggest mistake with apartment investing is believing you don’t qualify. It truly is easier (with the right deal) to get a million dollar loan for an apartment complex than a one hundred thousand dollar loan for a single-family residential house.
When you own a single-family residential house and a tenant moves out – you have 0% occupancy. If you own a 100-unit apartment complex fully occupied and a tenant moves out you have a 99% occupancy rate. Which sounds better?
Diversified Tenant Base
I know we already talked about diversified revenue, but having a diversified tenant base really helps. If a certain company moves out of town – this might greatly affect someone who owns a portfolio of single-family houses, but it doesn’t hurt an apartment owner as much because his tenants probably work in different industries.
You would think that having a large apartment complex would cause higher maintenance issues. However, because apartments are extremely similar, maintenance costs are standardized and therefore easier and cheaper to deal with. It also makes makes preventative maintenance easier since there is only one complex.
Simplicity or Economies of Scale
I know several real estate investors who have a portfolio of hundreds of single-family houses. They are always exhausted from property maintenance issues, insurance policies, tax-issues, financing issues. Even though they have a team that manages most of this – it’s still exhausting for the owner.
I don’t know any apartment investor that is exhausted – they simply have a team that is dedicated to each apartment complex. Having one insurance policy versus hundreds.
Having one site for your maintenance guy to be in-charge of versus hundreds and having to drive around looking for different fittings for each property. The issues quicly spiral out of control with a portfolio of single-family houses.
Brandon Turner from BiggerPockets.com had this to say about his first apartment complex:
When I bought my apartment complex, I didn’t realize how important systems were for making things function well. In other words – get all the various tasks (lawn mowing, caulking windows, cleaning windows, etc) out of your head and onto paper so that the tasks don’t get forgotten. Checklists are a great way to do this! We have weekly checklists, monthly checklists, quarterly checklists, and annual checklists. There are simply too many things going on at once to try and “wing it.”
Generally speaking (as in if you are not in San Francisco or Detroit – two outliers on opposite ends of the spectrum) rent increases along with inflation. If you are able to secure fixed-rate financing, you are benefiting from inflation while also growing your net worth.
A vacant single-family house is far more likely to get vandalized and broken into than a vacant apartment unit. By having a multitude of neighbors it makes crime far less likely. It’s also easier to install an alarm system and security cameras in an apartment community.
Yes, the apartment investing costs are actually cheaper than single-family costs. I have found that relative to the revenue you are receiving the overall costs are significantly lower than with single family houses.
As I said earlier, it’s easier to get a loan for an apartment complex than a single-family house. This is obviously just my opinion – which has been formed from personal experience.
When you are getting a loan for an apartment complex they are going to be looking at the apartment complex financials and focusing on that. They will obviously focus on the other invested parties financials – but this will not be a focus point.
If you want to look at a multifamily underwriting spreadsheet that I built when I underwrote apartment investments for banks you can get it here:
Negatives of Apartment Investing
Obviously, no investment is a perfect investment. Below are the negative attributes of apartment investing.
Sophisticated Buyers and Sellers
Because of the size and scale of apartments you have very sophisticated buyers and sellers. This makes it very hard to achieve a higher rate of return than the cap-rate you are buying. Although this is a negative don’t let this overwhelm you. There are still way’s to achieve significantly higher rates of returns:
Upgrading the units and charging higher rents
With a single family house there are renters that will sometimes rent from you for over 10 years. This rarely happens with apartments. Generally, apartment tenants stay in their units for 1-3 years.
Water costs are generally not separated in apartment complexes and therefore the owner has to pay this fee. They also have to pay sewer and trash fee’s as well. These costs are of-course past through to the overall rent you charge. However, these costs are burdensome nonetheless to apartment owners.
Although I stated earlier it is easier to get financing for apartments than single family homes, I don’t mean it’s a 20-minute trip to the bank. At the end of the day, you need at least a million dollars to get started in apartment investing. Now, this can come through a variety of ways:
Private Equity Investors
The property taxes on apartments are generally very high. Additionally, municipal governments also like to charge very high rates for sewer and water fee’s to apartment owners because they know they can get a way with it.
The property insurance rates on apartments can be astronomical and can actually be the single-factor that kills a deal.
I was once looking at buying an apartment complex and the deal looked too good to be true. There was basically 100% occupancy. A maintenance guy lived their at a discounted rate and fixed everything. The property didn’t need any major repairs. Yet, this property was selling for a very high cap rate and I heard the owner was “very motivated” and willing to look at all offers. It turns out the property had been rezoned for the flood zone and the flood insurance had taken this property to a point where the owner was now facing foreclosure! Always do your due diligence!
Class of Apartment Buildings
Apartments are defined by “class.” There are only 3 classes – A, B &C. Which type of apartments you invest in will determine what kind of risk and return you will receive.
Importantly, you can buy one class of apartments and renovate that apartment complex to upgrade it into a higher class.
I will go into this further below.
Class A Apartment Buildings
These apartment buildings are in great locations and are usually very new. Everything is updated and rents are at a premium due to location and quality of the property.
Rent tends to be significantly higher for Class A Apartments. Additionally, occupancy tends to be very high and most true Class A Apartments have wait list.
Generally, Class A Apartment buildings sell for very low cap rates and there is a significant amount of competition for them – due to their location, income and occupancy.
Class B Apartment Buildings
These apartments are in good locations as well, but tend to be a little older than the A locations. These apartments tend to be older but they have been maintained.
Rent for Class B tends to be average for the area and occupancy tends to be whatever that given area is.
Class B Apartment Buildings tend to sell of average cap rates – for your respective area. There is competition however, not as much as you would think.
I personally like investing in Class B Apartments because you can generally buy them if they are in A locations, update them and now they are Class A Apartments with higher rents and you have created a significant amount of equity.
This takes on a lot of complexity in financing of-course and there is more risk since there will obviously be vacancy time during the renovation.
Class C Apartment Buildings
These apartment buildings are generally not in good locations. Additionally, these apartments have not been updated and there tends to be excessive deferred maintenance.
Rent for Class C Apartments is usually subsidized with some version of a Section 8 program. The occupancy rate tends to be very low with plenty of vacancy.
There is usually very little competition for Class C Apartments. Since the apartments are located in undesirable locations and there tends to be a significant amount of deferred investment, investors usually avoid these areas.
However, Class C Apartments generally sell for significantly higher cap rates than Class A and Class B Apartments.
Metrics of Apartment Investing
Net Operating Income (NOI)
Net Operating Income is the one metric that most investors use to analyze a property. Unfortunately, it’s also the one metric that is the most manipulated by brokers to get someone to buy a property. This is why it’s important for you to do your own math. Here’s the formula for NOI:
Potential Rental Income
Effective Rental Income
Gross Operating Income
= Net Operating Income
Unlike other cash-flow metrics, NOI excludes financing and tax costs. Therefore, investors are able to determine the cash-flow of a specific property.
Paula Pant from AffordAnything.com had this to say when calculating cash-flow:
My #1 tip is to invest for the sake of cash flow, rather than making projections about potential appreciation (market or forced). As long as you follow that simple principle, you’ll be protected from a lot of risk.
The occupancy rate is the number of units filled divided by the total number of units. For instance, if there are 95 units occupied out of a 100-unit apartment complex the occupancy rate is 95%.
Some investors prefer to use the vacancy rate instead of the occupancy rate. The vacancy factor is just the reciprocal of the vacancy. For instance, in the example above if there was 5 empty units out of a 100-unit apartment complex the vacancy factor would be 5%.
This is an extremely important factor that you need to learn how to calculate – especially if you are investing in a growing market. First, determine the total number of apartment units available in the market.
For this example let’s call it 3,000 with a 95% occupancy rate (2850 units rented). Use a time-frame of 12 months.
Then find out how many units were built or demolished during this time frame. For this example, let’s say a new apartment complex was built with 300 units so the market now is at 3,300 units with a 90% occupancy (2970 units rented).
In this example, even though the size of the market grew 10% to 3,300 units the absorbtion was extremely high because the total number of units rented actually increased. Occupancy rate slipped slightly however, this is the sign of a healthy market.
Capital Expenditures (CapEx)
This is an easy metric to mess-up. Basically, just think of capital expenditures as an expense. However, capital expenditures improve the life of the asset.
A new roof would be an example of a capital expenditure.
Mowing the lawn would be an example of an expense.
Because a new roof improves the life of the asset you want to spread the cost of this new roof over the life of the asset. For a roof, you would need to estimate the life of the roof. Accountants call this “capitalizing the expense”
For a deep dive on this topic go here: http://www.duprescott.com/articles/articlePDF.cfm?ArticleId=215
Reserves for Apartments
Reserves are a very big deal when investing in apartments. I was completely unaware of this term before apartment investing. However, when you forecast your return (especially your initial investment) you need to account for reserves. Ok, what are actual reserves? Well, there are multiple kinds of reserves such as:
Interest Reserves – That your lender might make you make. These payment reserves gives the lender a margin of safety knowing that there is always a certain amount of payments held in a reserve account, in-case you have some negative cash-flow for several months.
Cash Reserves – Investors, lenders, business partners or whoever else might be a stakeholder might want to require some cash reserves or liquidity reserves. This simply ensures you will have the money to pay for any unforseen expenses.
Maintenance Reserves – If you are buying an older property, maintenance reserves are absolutely essential. Instead of relying on cash-flow you will have properly reserved for any needed repairs and maintenance work.
With older properties, there is never a downside in having an excess maintenance reserve. You might lose out on some deals, but you will have an extra level of financial security.
Giovanni Isaksen, CEO of Ashworth Partners Ltd. had this to say about reserves:
The best tip for apartment investors is know where you are in your local apartment investment cycle, especially in relation to ‘The Line of Doom’ which is when existing properties start selling for more than replacement cost. Once across that line you can still do OK if you can hold through multiple cycles, if you’re not over leveraged, if the numbers work with realistic CapEx reserves, if the long term employment trend is good, if the building will not become functionally or stylistically obsolete… but that’s a lot of ifs that need to go your way.
Internal Rate of Return (IRR)
Of-course you want to measure your actual return for an investment. My favorite method is the IRR method. This extremely easy to do in excel:
Input initial investment
Forecast annual cash-flows
Forecast exit investment
Input total number of years
Seth Williams from RETipster had this to say about forecasting:
“The most important advice I can give anyone evaluating an apartment investment is to verify the accuracy of your assumptions. When you’re projecting the profitability of any investment property, it is CRUCIAL to have a realistic idea of what the income and expenses will be. Don’t trust any numbers you hear from the seller, the broker or anyone else who stands to profit from your transaction. Insist on seeing hard evidence from reliable sources to find out of what those numbers have been in the past and/or what similar properties are currently generating in the same market. With an investment decision of such great magnitude, the accuracy of your information is everything. Always make sure you’re working with reliable data.”
This metric is pretty simple, you simply take your loan balance divided by the value of the property. The vast majority of lenders have a loan to value maximum of 80%. One thing to note, is that if there is a second mortgage that mortgage is sometimes lenders add that mortgage to their mortgage to get the total loan to value. The point of this ratio is to show that the investors have equity in the property.
Debt Service Coverage (DSC)
The formula for DSC is Net Operating Income divided by the total debt service.
Typically, lenders want to see at least a 1.10 DSC. This means that for every $1.00 of debt service, the property is producing $1.10 of cash-flow to service that debt.
Capitalization Rates (Cap Rate)
When you hear of investors talking about a property for sale they normally talk about the cap rate the property is selling for. The formula for cap rate is: Net Operating Income / Current Market Value
Even though this metric is simple, most real estate brokers manipulate this number (usually by using forecasted income numbers rather than the actual numbers). Always take a stated cap-rate with a grain of salt and do your own math.
Financing Apartment Complexes
Hopefully by now you have some idea of what type of apartment complex you want to buy. Now you need to learn how to finance it.
For most first-time apartment investors they are overwhelmed by the capital needed. However, never forget my favorite quote from Tony Robbins:
There are entire books written about financing apartment complexes. What you need to know though is that the vast majority of apartment investors utilize multiple sources of funding.
This is completely different than small residential investors who typically just use their own cash and bank financing.
Apartment investors will use: Hard-Money maybe to buy a property, then private funds to refinance the hard money, then after the property is improved and stabilized, refinance with long-term bank financing.
Let’s look at the main sources of capital for financing apartments:
Obviously unless you are a very well-to-do investor, buying an apartment complex in cash is completely not reasonable. However, if you do have excess cash I do consider this a great funding source.
You are going to make more investing in apartments than you will in a savings account. The only thing is you don’t want to use all your cash and then be liquidity constrained.
Most investors use bank financing for apartments simply because it’s the most traditional model. Community banks are more flexible and can provide a lot more options for new apartment investors than larger regional and national banks.
Banks will require some type of cash-down payment or some type of hard equity you can pledge so the bank’s loan-to-value (LTV) at 80%.
FHA has several government-guaranteed loan programs that offer extraordinary terms for investors such as:
You might be wondering why most investors don’t utilize this strategy. Well, just like your personal mortgage these loans are extremely hard to get from an underwriting perspective and because it’s a government program. From my experience, it takes anywhere from 9 to 12 months to get this type of loan.
A lot of investors consider private funding the holy grail. This is why: you get to set the terms.
There are a lot of laws regarding raising private money – I HIGHLY encourage you to talk to an attorney if you are thinking about raising private funds for the purchase of an apartment.
A lot of investors give private lenders a preferred rate of return. That means the private lenders are guaranteed a certain return, before the lead investor can take any money out.
If an apartment investment is particularly risky, you could offer investors a combination of interest and equity. This sounds expensive, however if it allows you to take control of an apartment complex with little to no money of your own – it’s worth it.
Joe Fairless had this to say about raising private money:
When buying apt communities you either need to use your money or other people’s money. Or, you combine the two. My #1 tip is for anyone who is raising money to buy an apt community (i.e. multifamily syndication). When you are raising money you’ll get people who verbally say “yes” but eventually don’t end up investing. On my last deal, a 320 unit in Dallas, one of my biz partners had an investor who told him he’d invest 500k. Well, he didn’t end up investing anything because a house he was counting on selling didn’t sell. So, here’s the tip:Raise at least 30% more than what you need to raise. Simply tell the extra 30% people that they are back-up commitments if a life circumstance happens and your current investors can’t invest.That will allow you cushion for any de-commitments due to circumstances that are outside of your control.
Hard money lenders typically charge double-digit interest rates and 2 to 5 points to originate the loan. I am extremely negative about hard money lenders because of the high interest rates and fees.
It’s very hard to make a decent investment return when you are paying a high double digit interest rate. The benefit of-course is hard money lenders typically loan on the property, not on the actual cash-flow of the property or your personal tax returns.
I hope you have found a lot of value in this guide on how to buy and finance apartments. Buying an apartment complex is a large and complicated transaction. My goal in this article was to break the process down into short and simple actionable steps.
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