How To Analyze An Apartment Building For Profit
Do We Have A Deal?
When you set out to buy an apartment building you find everyone has an opinion on what is a good deal and what is not. It’s nice that others want to share, but realize right now the only opinion that counts is the opinion of you, the future owner, your lender, and your private investors who will be backing you.
It’s important that you view apartments as a cashflow stream, and understand all the elements of the apartment building as factors that influence the ‘stability’ and ‘growth’ of that cashflow stream.
Apartments are different to single family houses. They are not valued based on recent sales of similiar properties in the same neighborhood. They are valued based on the income they produce.
They are “income properties”.
So when you are analyzing an apartment building as a potential investment you are trying to figure out what price makes sense for the amount of income the property is producing now, or could produce after improvements.
Terry Vaughan, author of Paper Into Gold, co-founder of Creonline.com and master investor, has one of the most useful set of rules for analyzing any investment property.
It’s called The Winner’s Edge. Here it is:
1) Play the game when the odds are in your favor to win, or don’t play.
2) Make your profit going into the deal, or don’t play.
3) Always reduce your exposure.
If you notice anywhere big money is being made you will also see these three rules being applied.
For you to be successful apartment investors, you must learn to identify deals with true profit potential, only participate in those investments where all the “profit factors” are present, and use other peoples’ money to the greatest extent possible.
On any apartment building you decide to invest in there are 3 main objectives concerning profit.
1) Put as little of your own cash in the deal as possible. Having zero of your own cash invested is best. Use private investors for all the cash requirements of the deal.
2) Recover any cash you have invested as quickly as possible. If you do have any cash invested in the deal, make sure you get it all back within the first year of ownership.
3) Maximize property appreciation as quickly as possible. Cashflow will make you financially free but you will become wealthy from the appreciation of your buildings. Buy properties in markets that are positioned for rapid appreciation. Also, make property repairs, increase rents and fill vacancies as rapidly as possible to maximize your equity.
Finding deals that achieve these investment objectives puts the odds of a successful investment powerfully in your favor.
There is one element in objective number 3) though that you need to pay special attention to, because it is a “profit factor” but somewhat out of your control. And that is, the nature of the market you are investing in.
Is it a volatile market that gets white hot with high rates of appreciation in an up cycle (e.g. Los Angeles), or is it a very stable market that doesn’t do much in either direction (e.g. Indianapolis)?
The nature of the market will determine your investing strategy to a large degree. You must determine in advance what you want to achieve and then invest in a market where your odds of achieving that are most likely.
Is it more important for you to have consistent cashflow from a property with minimal risk of interruption or loss from a downturn? Or are you more concerned with generating huge amounts of equity in a rapidly appreciating market?
Either one is fine. The important point is to be aware these two situations exist and adopt the strategy that best serves your life.
One person may have a goal to own their own super-maxi racing yacht in 7 years time. In that case, looking for volatile markets that are about to take off and then buying large 100+ unit properties with both hands in those markets for 2-3 years would be the strategy most likely to realize that goal.
Another person may be risk averse and only concerened with meeting the financial demands of raising her handicapped son as he grows older, and then funding her foundation that helps other families with handicapped children. In this case, buying a property in a stable market where demand for housing never fluctuates wildly in either direction, but is always there, would be the strategy most likely to ensure those goals are achieved.
Growth or cashflow … which one is for you?
Class Of Property
Just as there are different markets with different characteristics, within a market there are different “classes” of property. When you start talking to commercial brokers about apartments you will hear them referring to properties in different classes. The classes of property range from class A through class D.
Class A properties are premium high end rentals in the best parts of town.
Class B properties are in good areas and are rented usually by white collar professionals and middle class occupants.
Class C properties are in working class areas and rented by wage earners and their families, and some government subsidized tenants. i.e. Section 8.
Class D properties are in war zones, bad parts of town, and rented by largely by Section 8 tenants, immigrants, itinerant workers and people working for minimum wage.
Class A properties usually have minimal management and the highest rent, but they are vulnerable to high vacancy in a downturn.
Class D properties are easy to keep full whatever stage of the real estate cycle but management is a full-time job, and crime is high.
The best properties for investment are Class B and Class C properties.
Class C properties are in the rent range where there is always demand, but are somewhat limited by how much the rent can be raised in an up cycle. This makes them ideal for investors who want steady cashflow.
Class B properties are higher quality properties and have tenants with higher incomes that can withstand higher rent raises in an up cycle. This makes them ideal for investors who want robust equity growth in a rapidly appreciating market.
Another factor related to the class of property is the unit “mix”. The unit mix simply describes how many of the different number of bedrooms and bathrooms the property has. It’s important to know the number of 1 brm, 2 brm and 3 brm units an apartment building has.
1 brm units tend to attract transient tenants who are likely to move and cause high turnover, so it’s generally better to have more 2 brm units than one bedrooms.
On the other hand, 3 brm units will attract families with kids. Although you can charge higher rent for a 3 brm, having kids around results in wear and tear on the property and also makes it harder to rent the other units.
The optimum mix is often considered to be two 2 brm units for every 1 brm unit, but in reality it comes back once again to your investment objectives and having the unit mix that supports achieving them.
Apartments are income properties, so their value is directly tied to the income they produce. Analyzing the cashflow of a property is an important skill you need to acquire so you can determine what price makes the deal profitable, that you can pay.
There are a three main methods of analyzing cashflow, each one of them will tell you something different about the deal.
These three analysis methods are, 1) CAP rate, 2) Cash-On-Cash Return, and 3) Return On Investment (ROI).
All three of these methods utilize the Net Operating Income (NOI).
The Net Operating Income is, quite simply, the Total Gross Income plus any other income (like laundry machines), minus the Total Operating Expenses. The result is the Net Operating Income. In more detail, that calculation might look as follows:
To arrive at the figure for Expenses, $310,097, you might have something like:
Now that we know how to calculate Net Operating Income (NOI), let’s look at establishing value and seeing if you have a deal.
There are several methods investors use to establish value, but the most common approach is the CAP rate.
CAP stands for Capitalization, and the easiest way to understand a Cap rate is it is the return you would receive from the property if you bought it all cash.
The Cap rate is calculated by taking the Net Operating Income of the property and dividing it by the selling price. If we write it as an equation it is expressed as:
Cap rate = NOI / Value (selling price)
When you know this formula well, you can derive the NOI when you are given just the Cap rate and the asking (or selling) price. Or any one of the variables when you only have the other two.
Cap rates are a general indicator of demand and how hot a market is. The lower the Cap rate, the more expensive the property is compared to the NOI, the lower the return it provides.
The higher the Cap rate the higher the return and the less expensive the property is compared to the NOI.
As a general rule of thumb, to receive any kind of “cash-on-cash” return you want to see at least a 10% Cap rate. The only justification for buying at Cap rates lower than 10% is if you are in a rapidly appreciating market and the property still manages to produce a positive cashflow.
The next most commonly used formula for analyzing cashflow is the Cash-On-Cash Return.
The Cash-On-Cash Return is calculated by taking the Net Income (i.e. the Net Operating Income minus the Debt Service) and dividing that by the total amount of cash that was invested to buy the property.
More simply the Cash-On-Cash Return is the cashflow left after everything else is paid, divided by the the cash you put into the deal. Annualized.
If you are buying the property as a cashflow vehicle you should have a Cash-On-Cash Return return of at least 15%.
Then again, if you are buying a property in a market poised for rapid appreciation, a Cash-On-Cash Return of 10% would be acceptable.
Thirdly, there is the overall Return On Investment of the entire project. You caluclate the property’s ROI by taking the Net Operating Income, subtracting the Debt Service, then adding the principal paydown on the mortgage, and then dividing by your total cash into the deal. As an equation it looks like this:
NOI minus Debt Service plus Principal Paydown / Total Cash Invested
Calculating the ROI is useful mainly for comparing different properties to one another, or for comparing your real estate investment to other investment vehicles like stocks or bonds.
Other things to consider when analyzing a deal are whether opportunities exist to increase the value of the property.
Because apartments are valued based on the income they produce, this means looking for opportunities to increase the income of the property.
There are three main “value plays”, so to speak, and the are:
1) raising rents
2) filling vacancies
3) lowering expenses
Do any one, combination, or all of them results in the NOI going up. And when you increase the income on an income property, you increase the value of the property.
The best deals to buy are those with the “profit factors”; below market rents, a high vacancy rate, and high expenses due to poor management.
You can buy based on the current cashflow to negotiate a low price and/or flexible terms, then bring in new management, rehab the units, fill the vacancies, cut unnecessary spending and within a 3-6 months increase the value of the building 30-50%.
Hunting down and then capitalizing on value plays to capture upside value are a big part of what makes apartment investing so exciting.
Buy or Pass
There are many deals out there to consider, not all are worth buying though.
It’s important that you know what you are looking for in a deal before you buy it. Indeed, you should have you financial plan mapped out before you buy anything, and then go and find the best apartment buildings in the right markets that will get you to your financial objectives.
Use all the analysis tools you have learned here. Get a steady stream of potential deals coming in for you to look at, and when you look at each property, carefully scrutinize the deal for whether it fits with your plan and will contribute to your success.