Many real estate investors today are looking for ongoing income, especially as they grow closer to retirement age. One of the best types of income-producing investments is the smaller apartment building.
Let’s consider the nuances of this type of purchase…
We usually define a smaller apartment building as one that contains 5-10 units. Anything below five units is either a multi-family or single-family property.
Anything above that number is considered a larger apartment building.
Advantages of a Small Apartment Building
The smaller apartment building has many advantages over its larger counterpart. First, and most importantly, it is cheaper to own because the down payment is lower and ongoing maintenance costs are less.
Smaller apartments are easier to manage than the larger ones, and there is usually a better rate of return, as each unit derives more in rent.
Financing a property that is greater than four units requires a commercial, rather than a residential loan. Banks often require a 25% down payment, but there are also deals where a motivated owner is selling privately and is willing to hold the mortgage and take a smaller down payment.
However, even with owner financing, there is usually a balloon payment due within 10 years or less, so eventually you still have to refinance with 25% down.
Distressed Properties – Yes or No?
In my area of Northeast Florida, there were some spectacular deals on smaller apartment buildings from 2009-2011 when the recession was in full force. But with so many people unemployed, the units were often 80% or 100% vacant, and that’s why these distressed properties were being sold so cheaply.
“While the cost-savings of buying a distressed property are attractive, it’s important to remember that these types of properties sometimes come with risks,” said Rick Sharga, Executive Vice President of Ten-X, an online real estate marketplace.
“Successful investors don’t exclusively focus on the acquisition cost; they also look at estimated profits from cash flow and the the long-term potential of a property.”
So when you’re buying a distressed apartment, you may have to ride out the bad times while simultaneously improving the building in an effort to attract good tenants down the road.
I know one South Carolina investor who recently sold an apartment complex he bought a few years ago at a tremendous profit because he had the courage to buy when many of the units were empty.
He made the necessary repairs and improvements and eventually turned that empty building into one with 100% occupancy at higher rents.
How to Evaluate the Return on an Apartment
There are several key terms to know when considering the purchase of a smaller apartment. First, you must perform a Rent analysis.
A rent analysis is basically an assessment of the cash flow that will be generated from each of the apartment rents. You want to determine the monthly, as well as the annual totals. Ask to see the “Rent Roll,” which is a list of current tenants and the main terms of their lease.
You can also perform the Gross Rent Multiplier (GRM), which is a way to determine and compare the value of different properties by the gross rent received. The formula to use is:
Price Paid/ Annual Gross Rent
If your purchase price is $200,000, and the annual gross rent is $30,000, your GRM would be 6.6. Any number below 10 is usually good. Basically that means if we bought the property with cash, it would take us 6.6 years to get our money back.
Second, you need to know the Net Operating Income (NOI). The NOI is the gross income you get from rents, minus your annual expenses (maintenance, utilities, management, taxes, and insurance). The higher the NOI, the greater the value of your apartment will be.
Third, you should know the Capitalization (CAP) rate– the ratio of an apartment’s annual Net Operating Income, compared to the property purchase price or cost to acquire the building.
Using the above GRM example of $30,000 annual, if the NOI was $25,000, the CAP rate would be $25,000/$200,000, or 12.5%. CAP rate is really another way of saying your Return on Investment (ROI) would be 12.5% annually.
If you finance the apartment, your lender will require you to have an appraisal done to consider both the value of the property, as well as an estimate of the potential profit generated by the rents each year.
The appraiser will conduct a thorough rent analysis and will likely look at NOI and CAP rate as well.
Maintenance & Repairs
Another thing to consider is the amount of maintenance you’ll need and what it will cost. A smaller apartment may not require having a full-time handyman on site, whereas a larger apartment usually does.
Even if the seller is willing to make repairs prior to closing, get a thorough property inspection performed on all units to determine the maintenance costs you’re likely to have in the future.
The final two things you should consider are 1.) whether you will have Section 8 tenants or non-Section 8 tenants in the apartment, and 2.) the area of town where the building is located.
Section 8 Tenants
Section 8 is a program run by the Department of Housing and Urban Development (HUD) that provides rental housing assistance to landlords for tenants who qualify on the basis of lower income.
Whether or not to accept Section 8 tenants is a personal decision. Many landlords feel the guaranteed rent from the Government is a blessing. Other landlords say the quality of tenants on Section 8 is far worse than non-section 8 tenants.
You should look for a small apartment building in an area of town where the occupancy rate is stable, where there is a decent employment rate, and the crime rate is low or moderate.
An unstable occupancy rate could be a signal that there are potential problems in the location or the type of tenants that have been living there.
Nobody wants to live in a dangerous area where crime is rampant, so check with the local police station to assess recent crime statistics. A drive through the neighborhood on a weekend night is not a bad idea either.
Investing in smaller apartments is a wonderful way to derive a solid income stream. Follow these guidelines, and you’ll be more likely to invest in one that is lucrative and brings fewer headaches.
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