Investing in apartments can be overwhelming.
Developing a financing proposal for a potential capital source, you’ll need to focus on the following.
Business Performance Metrics:
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 real estate agents 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.
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. In the example above if there were 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 absorption 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.
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”
Reserves for Apartments
Reserves are a very big deal when investing in apartments. 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 unforeseen 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.
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
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.
Apartment building financing is a Winston Rowe & Associates specialty.