Investing in Apartments – Complete Success GuideMarch 3, 2019
Investing in apartments is a time-tested method to build net worth and to collect stable rental income. When done properly, apartment investing can generate lucrative returns, making it a wise investment for many commercial investors. Whether you are just starting or desire to continue investing in apartments, you should understand the fundamentals and current trends. We’ll discuss these and provide some case studies of how excellent investors make money by apartments investing.
2019 Trends Are Good for Investing in Apartments
Apartments investments benefit from the right economic conditions and a benign demand/supply balance.
Economic Conditions Support Apartment Investing
It appears that 2019 will continue the 2018 Goldilocks economic conditions that were so positive for apartment investing. These include:
- Interest Rates: The pace of economic growth slowed in the fourth quarter of 2018, and pundits expect further slowing this year. This means that the Federal Reserve has room to postpone or abandon future interest rate hikes in 2019. Higher interest rates are not necessarily bad, because they can price some potential homebuyers out of the mortgage market. This creates rental demand, which helps support returns on apartment investing. However, when interest rates rise too much, acquisition and construction loans for apartments investments become more expensive as well. Current interest rates are still reasonable and shouldn’t discourage you from investing in apartments (multifamily).
- Unemployment: We are currently in a full employment economy following a decade of improvement. Yet many households today do not earn enough money to afford the down payment or monthly payments on a mortgage. It appears that these folks belong to the workforce housing segment of renters. To clarify, this is a group of workers who cannot afford home ownership and instead live in apartments and multifamily housing. They live within commuting distance of employment centers. The upshot is that as long as U.S. wage growth remains stagnant, the need for workforce housing will provide support for investing in apartments.
As you can see, the economic framework looks solid for continued rental growth in 2019.
Supply and Demand Factors in 2019
A recent Forbes article points to some rental softness in select U.S. markets after years of apartment appreciation and new construction. This is by no means monolithic, and each market requires individual research. The result is often flatness in net operating income (NOI). As you recall, we’ve already discussed the role of interest rates. As we said, we believe rates will not have a significant impact this year as GDP growth retreats. Interestingly, rent softness from new construction and higher property taxes will impact some markets but spare others.
How to Invest in Apartment Buildings
Apartments Investing Fundamentals
The upshot is that, as always, it pays to focus on fundamentals when investing in apartments. The long-term income potential from apartment investing remains compelling. What are the fundamentals? Here are three:
- Value-Add Apartment Investing: Value-add investing means increasing the value of a property through renovation and better management. Renovation will help boost rental income and cut the vacancy rate. Better management will cut expenses and increase margins by improving efficiency. Opportunity Zones are a new wrinkle in the tax law that incentivizes value-add improvements to buildings and businesses. Value-add is a fundamental strategy for increasing NOI.
- Conservative Underwriting: This is real estate lingo for making realistic assumptions about the income and expenses from apartment investing. To be realistic means accounting for the cost of the changes you’ll make. This includes the financing options you can access. Further, it includes a rate of return (or cap rate) that is in line with comparable properties. The best practice is to set a minimum cap rate and not invest below it. Remember, the higher the cap rate, the better the deal for the Buyer. The lower the cap rate, the better the deal for the Seller.
- Location, Location, Location: Yes, it’s trite, but it’s also true. People need a place to live. All things being equal, most will prefer to live in a location that suits them. That might mean a high-falutin, gated condominium community. Or perhaps it’s a downtown apartment that is close to work and entertainment attractions and activities. Don’t forget, we discussed workforce rental housing, which must be affordable yet convenient. In sum, you should know your market and then concentrate on locations that make sense for that market.
What Is the Profit Potential from Apartment Investing?
No one will invest in apartments to take a loss, or even a paltry profit. Why bother, when you can do better hoarding Treasury bonds? Instead, apartment investing should be lucrative, and very happily, it can be. The question then becomes, how do your forecast and measure your profit potential? Here are some key factors:
Cash on Cash Return
This specific metric starts by considering all the cash you’ve put into your apartment investment. Then you take your net cash left over at year’s end and divide by your total investment. This is of course after collecting your rent and paying your expenses (including debt service). The amount of cash-on-cash return you demand should relate to the risk level you are willing to undertake.
We consider three categories of risk:
Low-Risk Apartment Investing
You buy an apartment building that has stable rents and low vacancy in a high-demand area. Rents will likely stay about the same, going up only slowly but seldom retreating. The acquisition cost of this kind of property is higher due to the minimal risk. You can expect a cash-on-cash return in the range of 4% to 8% on a low-risk property. It makes a perfect passive investment, because there is little need to add value to the property.
Medium Risk Apartment Investing
You can get a higher cash-on-cash return by investing in an apartment with working-class tenants, a slightly higher vacancy rate and mid-level rents. Typically, the building might reside in a neighborhood that is starting to gentrify. Moreover, if you still want a hands-off approach, expect a cash-on-cash return in the 8% to 12% range. However, if you can provide more hands-on involvement, you can boost your cash-on-cash return to the 12% to 16% range. This means taking on chores such as shoveling the walks, making minor repairs and renting out the vacant units. In other words, you invest more of your money and effort to earn a higher return.
High Risk Apartment Investing
If you seek the best possible returns and aren’t afraid of the risk, a high-risk apartments investment might be perfect for you. It means buying a building in the low-rent district with higher vacancy rates. Naturally it will also have higher eviction rates, more difficulties collecting rent, and a poorer demographic profile. Not surprisingly, your tenants might receive governmental rent subsidies. Of course, these are headaches for sure, but they also mean you’re more likely to get a bargain purchase price. Obviously, this type of property is ripe for value-add.
Although, you’ll probably have to manage the building yourself to get the necessary efficiencies. Therefore, if you’re willing to make the commitment, you can expect higher cash-on-cash returns. These returns can start at 20% and run as high as 50%. This is true in these types of very challenging neighborhoods. Yes, under the right circumstances, you can receive full payback in as little as two years. Or the whole enterprise might go down in flames – that’s what makes it high-risk. These types of investment are extremely management intense.
Some Apartment Investing Success Stories
These are well-documented examples:
Grand Cordone, host of The Cardone Zone radio show, bought his first apartment building in the early 1990s. The 38-unit building cost $1.9 million and he put $350,000 down. He picked a building in an area where the city doesn’t allow new buildings. He has since parlayed his initial investment into ownership of more than 5,000 units. This was based on a favorable supply/demand balance and the extensive use of leverage.
Michael Blank purchased a small, 12-unit apartment building on which he clears $40,000 annually. Blank needed $227,000 to close, which he raised from five investors who collectively took a 50% split. In other words, he wasn’t working with his own money. Using investor money, he bought the property for $530,000 and spent $54,000 on renovations. He charged an acquisition fee of $15,900 and earns 30% returns, of which 15% goes to the investors. He sold the building after five years for $850,000, a profit of about $40,000 a year. This arose from cash flow, asset management fee, disposition fee, capital appreciation and reduced loan principal.
Jered Sturm bought a multi-million dollar apartment complex at age 26. Four years ago, Jered and his brother purchase their first rundown old house. He has since participated in seventeen (17) fix-and-flip projects. He also bought a bunch of rental rehabs that he then refinanced. They relied on sweat equity to grow their company. They started with bank financing before graduating to private money. Then, he doggedly searched for their first modern building while guarding against overpaying.
Gratefully, they were able to find a 1989 building in undamaged shape with 95% occupancy. The purchase price was 89% of appraised value. They added value by installing individual water meters for each unit. They also remodeled some spaces to become paid storage units. Furthermore, they replaced the coin laundry with rented washers and dryers for each unit. The loan was an 80% LTV 5-year ARM charging 4.25% interest. The term was 20 years with a 25-year amortization period (called a 25 due in 20). The investment proved wildly successful.
The rewards of apartment investing can be substantial. For more information about financing apartment investments, call us as Assets America® today 206-622-3000.
Multifamily Market Trends from Yardi-Matrix