Investing in your first apartment building can be a nerve-racking experience. Many people who set out to invest in an apartment building end up never making the purchase. It could be because of fear of the unknown, or it could be from not taking action. Either way, many people drop out in the process between having the idea of buying an apartment building and actually making the purchase.
Pros of Apartment Buildings
It really depends on what type of asset you compare an apartment building to truly identify the pros or cons. Therefore, I will mostly cover the pros and cons compared to other real estate assets.
Multifamily properties benefit from economies of scale. Once a community reaches a certain size, somewhere between 60-100 units in most cases, it makes economic sense to have on-site management. There is also the efficiency of maintenance overhead because it is only one sewer line, one or a few roofs, possibly a centralized HVAC system, etc.
Multifamily investments can provide passive income to their investors. In addition, they lend themselves to professional property management much better than single-family residences because of their scale.
Cons of Apartment Buildings
Compared to investing in a single-family home, apartment buildings have a much higher cost of entry. This can be a barrier for many investors who are just starting.
Compared to office or retail, apartment buildings have a lot more day-to-day management and issues. Compared to other categories of commercial properties have the potential to have a triple net lease. The customer pays for all upgrades and maintenance of the property to pay for all the maintenance with apartments.
The Steps of Buying an Apartment Building
There are 7 steps to buying an apartment building. Each step has its own process and challenges.
This is a bit of a faux step in the process'97kind of chicken or the egg sort of thing. So naturally, lenders will want to know about the specifics of the project before offering you terms. First, however, you need to know some loan terms and the various loan options available to you before you can really hone in on what you can buy.
In the commercial space, an amortization of 25 years is pretty standard. These will almost always be adjustable-rate mortgages. The 30 year fixed interest rate loans are not common in the 5+ family market.
Shopping the Properties
You might start simply by looking on Loopnet or the MLS and running your own pro forma numbers when shopping properties. Then once you get confident in running the numbers and get an idea for at least what works on paper, it is time to start reaching out to commercial real estate agents.
Make an Offer
When you find a property that looks like it meets your requirements for investment, now is the time to make an offer. Depending on what size of the apartment building you are looking at, this could be in the form of a Letter of Intent (LOI), or it could be a board realtor contract.
Get it Under Contract
Once you agree with the seller on terms, it is time to sign the contract. You will want to have an attorney review the contract to make sure the terms are set up how you believe them to be and to understand all the clauses and how they all work together.
In the due diligence phase, you will be verifying that the property matches the stated condition and that it has been operating as represented by the seller. To do this, you will have inspections, verify leases, and verify financial information.
Once you get the property under contract, it is time to take that contract and your financials to the bank. During the pre-qualifying stage, you should have a good idea of which bank to apply to and their requirements.
You will then apply for a loan. This process will require a good amount of documentation and prep work.
Close on Property
Once you have all your ducks in a row, it is time to close. Hopefully, they are all in a row, at least. Getting everything in order by the contractual closing date can be quite stressful for your first deal. But, once it is done, congratulations, you now own an apartment building. Now the real work of management begins.
Types of Buildings
There are many different types of apartment buildings you can invest in. One easy way to categorize them is by size.
- Quad (Four family)
- Single apartment building
- Apartment community
You can also differentiate them by product type or design'97for instance, the difference between a garden community and a high rise or townhome-style vs. condo style.
You may hear other investors and brokers refer to buildings by their “class.” This is an informal rating or grade between A and D. Since everyone holds slightly different definitions of these classes, it is imprecise. But it will help you carry on with the conversation.
A Class apartments are those that are built within the last 15 years and offer the best amenities. As a result, these units can demand the most rent and have fewer vacancies than other apartment classes.
B class apartments are the ones slightly older. Generally older than 15 years, but could represent properties that are not as well maintained or built with as many amenities. They cannot command as high of rents as A class, and the demand comes from a different tenant base. The cap rate on a B class building will be higher than an A class as it represents a higher risk factor.
C class apartments are typically older than 30 years and require repairs and maintenance. Because of this, they receive lower rent than A and B. C class multifamilies are also in less desirable neighborhoods than A and B.
D class apartments are considered extremely risky. They are typically fully vacant or effectively vacant because they are in such disrepair. Most of the investors in these properties are either developers or speculators.
What Business Strategy Should you Target?
There are many different styles you can take when investing in real estate. However, here are a few of the main strategies:
- Buy and Hold
You may have heard of value-add properties. These are properties that have an opportunity to improve their operations or condition. The most glaring opportunity is when a building is not renting at market rates. An example of a less obvious area to improve the operation is buildings with leaky fixtures that you could fix to save on the water bill.
Does the Income Count Towards Being Approved for a Loan?
When buying an apartment building, most lenders will count the income from the building when calculating the DTI (debt to income ratio) of you as a borrower.
The question becomes, what income do they count. If the records are good and verifiable, they will usually count the trailing 24 months. In some instances, where the records are not good, they will do their own rent market study.
What Should I check for When Buying an Apartment Building?
There are many due diligence items to check for when buying an apartment. An inspector or contractor can assist you with checking the physical state of the building.
You should definitely walk every single unit and document the status of the repair of the units. Just because you saw a unit in each building or floor does not mean the rest of the units are in that condition.
An essential thing to check is that the financials provided by the seller are accurate. When they provide a profit and loss, it should correlate with the rent roll. The rent roll should correlate with the lease. There should be actual bank deposits that correlate to the lease. There are situations where the seller may have a lease for $800 a month with a tenant but may actually be collecting less per month. In this case, the building would be worth less than what you originally calculated.
What information should I get from the seller when buying an apartment building?
It is important to get the rent roll, current expenses, T-12 or trailing 12-month P&L, past tax returns, and leases from the current owner when buying property.
How much money will I make from buying an apartment building?
At its simplest form, rental income minus expenses are your profit. How much rental income you will receive depends on location and the unit types in the apartment.
Sellers will usually disclose profit and loss statements. But often only after you have submitted a letter of intent, or at least are represented by a broker that convinces the seller that you are a serious buyer. They will often publish a CAP rate publically. If you have the CAP rate and asking price, you can determine their net income without debt service by multiplying the two values.
5% cap * 2,000,000 = 100,000 NOI
To determine how much you would make, you then subtract your loan cost from the NOI to get your Cash on Cash ratio.