Over the last century, countless real estate investors have grown their wealth exponentially by buying apartment buildings. But, before they became successful investors, they all started as beginners, eager to purchase their first multifamily property. If you want to follow their footsteps and purchase an apartment complex of your own, this article is a great place to start. We’ll walk you through all the basics of apartment investing and provide you with everything you need to know to begin your journey. Of course, when it comes to investing in multifamily real estate, knowledge is power– so don’t rely on this article alone; rather, use it as a jumping off point to begin your research and start your journey off on the right foot.
In this guide, we’ll discuss:
The Pros and Cons of Apartment Investing
Apartment Investing Strategy and Holding Periods
Value Add Investing Strategies
Choosing a Location
Finding a Commercial Real Estate Broker
Finding a Multifamily Loan Broker
Qualifying for a Multifamily Loan
Loan Types: HUD, Agency Loans, Banks and CMBS
Other Building Considerations
Syndication: Bringing New Investors into the Deal
Sale, Prepayment and Tax Considerations
When deciding whether to purchase an apartment building (and what kind to purchase), it’s important to review the benefits and disadvantages of investing in multifamily properties. While we’ll address this in a traditional pros and cons fashion, it may be equally effective to look at apartment investing through a different lens; by analyzing its risks, benefits, and the required time commitment involved. To put apartment investing into a reasonable context, it needs to be compared to the alternate investments one could purchase– say, stock in a well-known company.
For instance, if we compare purchasing a 10-unit apartment complex for $2 million to purchasing $2 million of stock in a blue chip company, we can certainly say that there will be more time commitment, and potentially more risks, when purchasing the building. However, there’s also the potential to make significantly more profit; especially due to the fact that most apartment buildings are purchased with loans. Instead of using $2 million to purchase an apartment building of the same value, an investor could use it as a 25% down payment on a loan for an $8 million apartment building. Of course, stock in a company is only one alternate option; investors can buy bonds, invest in a hedge fund, or even purchase single-family homes or industrial properties– however, all those comparisons are beyond the scope of this article. With that being said, we’ll get straight to the pros and cons:
Pros of Apartment Investing
More diversification and less vacancy risk than investing in single family homes; for instance, one vacancy may not be a huge deal for an apartment investor
In general, apartment investing often results in a greater chance for higher returns than investing in “safe” stocks, though in practice, this completely depends on market conditions and investor choices
Investors can use a loan to purchase an apartment property, often with as little as 25-30% down (and sometimes less)
Tax deductions and incentives, including:
Mortgage interest tax deduction
Accelerated depreciation via cost segregation studies often allows investors to take a large portion of their property’s value as depreciation within the first 5-10 years of ownership
1031 exchanges allow investors to defer paying capital gains taxes by ‘exchanging’ one piece of multifamily or commercial real estate for another, as long as the new property is of equal or greater value to the previous one
Apartment owners can generate supplementary income from laundry machines, vending machines, additional parking spaces, pet fees, or renting space to commercial tenants
Cons of Apartment Investing
Apartments can be notoriously difficult to manage, especially for first time owners. Many owners choose to outsource this to a property management company, which will likely charge between 10-20% of rents (though flat fee arrangements are also often available)
Apartment owners can face additional liability risks, especially for larger multistory complexes, as well as complexes with pools, gyms, and other areas where accidents may be more likely to occur
Safety inspections and legal compliance issues can be both expensive and time consuming (something single family home investors rarely have to deal with)
Unlike stock in Google or Coca-Cola, apartment buildings are not particularly liquid, and can be difficult to sell. Even in a seller’s market, it can often take a few months to find a suitable buyer and close the deal. In a market where prices have fallen significantly, it may often be more desirable to hold on the property for a few years until prices rise again.
Apartment Investing Strategies and Holding Periods
Before purchasing a multifamily property, it’s essential to determine how long you plan to hold onto it. Commercial and multifamily investors generally choose one of two strategies: a shorter-term value-add/fix and flip strategy, or a longer-term buy and hold strategy. Shorter-term investors typically hope to buy a property, make improvements and adjustments that can increase the property’s net operating income (NOI), and re-sell the property for a profit within 1-5 years. In contrast, buy and hold investors typically plan to keep the property for the long haul, say, 20-30 years, while enjoying the annual income that it provides. After that, they may sell the property, or, in some cases, pass it on to their heirs.
While a planned holding period can change based on investor preferences or market conditions, it’s still important to create a solid strategy going in. For investors who know they’ll only be sitting on a property for the short-term, things such as prepayment penalties (fees for paying off your loan early), and whether to take out a fixed-rate, adjustable-rate, or hybrid adjustable-rate loan must be taken into consideration. In contrast, long-term buy and hold investors could generally care less about prepayment penalties, and, when possible, will seek longer-term fixed-rate loans. Though both short-term and long-term holding periods can be profitable, if you’re investing with one or more partners, you’ll want to make sure that everyone’s on the same page about when the property should be sold. For instance, an investor who wants to flip a property in 18 months probably shouldn’t be investing with a partner who wants their grandchildren to inherit their interest in the property.
Value-Add Strategies for Apartment Investing
In many cases, first time apartment investors will want to seek out a property that needs significant improvement, whether in the form of physical upgrades or superior management. These properties are generally referred to as “value-add.” For instance, an investor may want to acquire an apartment property, replace the management company, upgrade the units, increase rents, and utilize other methods to cut costs and increase profitability.
In addition, owners may wish to have tenants pay for their own cable (if it’s already being paid for by the building), as well as paying for a larger share of their utilities. Other value-add opportunities include finding new supplemental sources of income for your property, such as vending machines, storage sheds, or new parking spaces. For less intensive value-add deals that only require minor amounts of capital, investors may choose to self-fund repairs. However, for larger value-add deals that require significant property repairs or rehabilitation, an investor may want to get additional financing.
Choosing a Location
The old proverb “location, location, location” is equally true for multifamily real estate as it is for a single-family home. No matter where you choose to invest in an apartment, it’s extremely important to be confident about the location you choose. Before deciding on a location, an investor should be familiar with area information, including:
Employment and economic data
Economic health of local employers (especially for smaller markets)
Population and population growth trends
Crime and safety data
Since appreciation over time is essential for an apartment to become a profitable investment, investors should look towards markets where values are likely to grow significantly over the property’s expected holding period. For instance, an investor with a 3-4 year horizon may be willing to pay more for an apartment building in an area where costs are currently rising. In contrast, an investor with a 20-year horizon may seek a lower-priced property in an area that seems positioned for growth to begin over the next 5-15 years. While it’s impossible to predict the future, creating a series of educated market assumptions can help narrow down likely possibilities. Over time, that means lower risks– and higher potential profits.
Investing Near Your Home
While it’s not necessarily ideal to purchase a multifamily property near your current home, doing so can have certain benefits. For one, you’re already likely to be familiar with the local market, so you may know things that other investors don’t, giving you a certain advantage. Plus, it’s easier to monitor your property in-person if you live nearby, making things more convenient, especially if you do your own property management.
Finding a Commercial Real Estate Broker
Most people purchasing a single-family home will do so through a real estate agent; and, similarly, most investors buying an apartment building will want to work with a commercial real estate broker. A good commercial broker can help you identify quality apartment properties in your area, will have a good understanding of real estate investment fundamentals, and may even be able to help you negotiate on the sale price. While going through a broker will generally facilitate the process of finding a building, it’s not the only way. You may also want to directly contact the owners of apartment buildings in your area to determine if the owner is interested in selling. This can be a hit or miss process, but you may be able to find a hidden gem this way, especially if the seller wants to get rid of the property quickly due to outside circumstances.
If you’ll be using a loan to purchase your apartment building, you may want to work with a multifamily loan brokerage and/or advisory firm. While it’s up to any individual investor whether they want to use a broker or go to a lender directly, using an experienced intermediary can have a variety of benefits, especially for first-time borrowers. A good advisor can leverage their experience and relationships to help you select the best financing option for your individual situation and goals. They can also help with the more onerous and confusing aspects of the commercial loan application process, such as documentation and third-party reports, as well as shopping around a deal to multiple lenders in order to achieve the best terms for a borrower.
This is especially the case for Freddie Mac®, Fannie Mae®, and HUD multifamily loans, as these loans generally involve a more complex documentation and application process. Debt advisory firms generally charge between 0.75% and 2% of the total loan amount, which may seem like a lot, but, in our experience, is generally a great investment. Of course, that’s what we do, so we may have a bit of bias, but, in truth, getting the right loan can save you a lot in interest payments, prepayment penalties, refinancing costs, and other fees over the life of your investment.
As we’ve mentioned before, the vast majority of apartment buildings are purchased with loans. Debt increases leverage, which means that the less money you need to put down, the more relative profit you’ll make out of the investment. Think of it this way: would you rather put in $4 and get $8 out later, or would you rather put in $1 and get out the same $8 later? Most smart investors would choose the second option, as this means they could reinvest the other $3 into similarly profitable investments. While interest and fees can make apartment loans expensive (meaning that your $8 could be more like $6.50), with the right loan, investors can make exponentially more profit off of a property.
However, to get a multifamily loan, you first need to get approved. Approval criteria varies with different lenders and loan types, but in general, borrowers will need to have good credit (660+ is usually ideal) and between 25-30% of the total loan amount as a down payment. In addition, the property itself will need to have a debt service coverage ratio or DSCR, of 1.25-1.30x. This means that the building’s income will need to exceed its annual debt service by at least 25-30%.
During the application process, borrowers will also need a significant amount of documentation, including an appraisal and other required third-party reports. Borrowers will typically need to pay for all of this themselves. Required documentation and reports generally include:
Appraisal: An appraisal attempts to gauge the current market value of a property. It typically must be conducted by a professional appraiser currently licensed in the area in which the property is located. Appraisers will generally use a combination of the methods, including:
The income approach, which estimates the value of a property based on its income.
The sales comparison approach, which estimates the value of a property based on recent sales of similar properties nearby.
The cost approach, which estimates the value of a property based on the estimated cost to rebuild it, plus the value of the land, and minus any depreciation.
Physical Needs Assessment/Property Condition Report/Engineering Report: This report looks at the current condition of an apartment property to determine when specific components will need to be repaired or replaced. This is used to calculate required replacement reserves, which are funds set aside each year for expected future repair costs. These reports may be requested by a variety of apartment lenders, but are most commonly required for HUD multifamily and Fannie Mae/Freddie Mac multifamily loans.
Phase I Environmental Assessment: A Phase I Environmental Assessment (ESA) examines a property for environmental issues, such as contamination, that could pose a threat to current/future residents or the surrounding community. Phase II and Phase III ESAs may be required when issues or evidence of contamination has been found in the initial Phase I assessment. Phase I ESAs may not always be required by lenders, but often are.
Title Report: A title report will make sure that there are no legal claims to a property’s title that could supersede your own.
Property Survey: A survey records the boundaries of a property, as well as determining any easements and or other title issues that could impact the property’s use. This is not always required by lenders, especially if a report is available from the past several years, however, it is more commonly required when potential title issues are known to be present.
Seismic Report: Typically only required in areas where earthquakes are common, such as Southern California.
Zoning Report: May sometimes be required when there are potential issues or confusion around the zoning status of a property.
Recourse vs. Non-Recourse Apartment Loans
Before considering individual loan types, it’s very important to determine a loan is recourse or non-recourse. If a loan is recourse, a lender can repossess your personal assets in order to seek repayment for an unpaid debt. For example, in most states, home mortgages are fully recourse. In contrast, many commercial real estate loans are non-recourse, which means that the lender can only repossess the specific collateral for the loan (i.e. an apartment building) and cannot pursue a borrower’s personal assets, such as their home or car, in order to pay off the borrower’s debt. However, nearly all non-recourse loans come with standard “bad boy” carve outs, which stipulate that if a borrower commits certain ‘bad boy’ acts, such as intentionally misleading the lender, the loan will become a full-recourse financial instrument.
Loan Types: HUD, Agency Loans, Banks and CMBS
Bank Loans Aren’t Always Your Best Option
When it comes to choosing a loan to finance your apartment complex, you’ll have quite a few options, each with their own unique advantages and disadvantages. Banks may be the first option that comes to mind, but they aren’t always the best choice. These days, your average bank may be willing to do a 70-75% LTV, full recourse loan with a 5-year adjustable-rate term and a 25-year amortization. While that might do the job for some apartment investors, it simply isn’t the best option out there. That’s why we always recommend that investors think beyond their local bank in order to learn their other financing options.
Fannie Mae and Freddie Mac Multifamily Financing
For borrowers with good credit and a sufficient net worth (i.e. a net worth as large as the loan, with around 10-15% liquid assets), agency loans from Freddie Mac or Fannie Mae are often the best option. These non-recourse loans offer incredibly low interest rates, as well as LTVs up to 80% and amortizations up to 30 years. Loan amounts can be flexible, too; for instance, Freddie Mac’s Small Balance Loan program offers loans in amounts as low as $750,000 with fixed and adjustable-rate terms up to 10 years and 30-year amortizations.
HUD/FHA Multifamily Loans
While it can be even harder to qualify for than an agency loan, the HUD 223(f) loan is the creme-de-la-creme of apartment purchase loans. While HUD does prefer more experienced borrowers, they offer LTVs up to 85% and DSCRs as low as 1.18x for market-rate properties, with higher LTVs and lower DSCRs for affordable properties. In addition, HUD offers its 221(d)(4) program for apartment construction and substantial rehabilitation, but these types of projects may not be ideal for a first-time apartment investor, and can be significantly more risky. All HUD multifamily loans are non-recourse, fixed-rate, and fully amortizing over 35+ years, making them a fantastic option for buy and hold investors.
CMBS Loans for Apartment Properties
CMBS, or commercial mortgage backed securities can also be a great source of debt for apartment investors. CMBS loans, or conduit loans (as some call them) typically provide low interest rates and some of the most lenient borrower requirements out there. The entry point for CMBS loans is a little higher, generally $2 million+, though exceptions are sometimes made. Like many types of commercial loans, CMBS loans are pooled together and securitized, then sold to investors on the secondary market. These loans are not serviced by the borrower’s original lender, instead, they are assigned to a separate servicing company, which can sometimes create headaches for CMBS apartment loan borrowers. Like HUD multifamily and agency loans, CMBS loans are generally non-recourse.
While banks, agencies, HUD, and conduit lenders aren’t the only types of apartment lenders out there, they’re generally the only types of lenders suitable for a first time apartment buyer. Options for more experienced multifamily borrowers include life companies, which offer long, fixed-rate terms at very low rates (but generally want highly experienced investors), and hard money loans, which typically have very high interest rates, but can be the only form of financing accessible to borrowers with credit or legal issues. For additional leverage on larger deals, a borrower may be able to layer a CMBS or bank loan with an additional, second-position loan, known as a mezzanine loan, though this is also not generally ideal for first time investors.
Due Diligence for Apartment Purchases
While a lender will want a lot of documentation about an apartment building before providing you a loan, it’s critical that you conduct your own due diligence, too. Typically, before seriously considering purchasing a multifamily property, an investor should:
Examine a property’s rent roll and T12 (trailing 12 months) financial statements. A rent roll is a list of all current rental income received by a property owner, while a T12 financial statement represents the property’s income and expenses over the previous 12 month period. Keep in mind that both of these documents may be somewhat exaggerated to make a property look more profitable than it really is, so it’s essential that you look at these with a critical eye and verify any information that appears inaccurate or confusing.
Have the property professionally inspected. While you generally only need to have an inspection conducted if you’re very serious about purchasing a property, doing so can help you identify potential issues, saving you a lot of time and money in the long run. However, it may not be necessary to have every unit inspected. In many cases, every second or third unit will be sufficient.
Consult with mentors and/or other investors. Getting a second, third, or fourth opinion on an apartment building purchase can also make a big difference, especially if it’s coming from an investor with significantly more experience. You may want to reach out to friends or family members to see who they know, or attend events with a local real estate investing organization. If these aren’t available, you may want to seek out advice through online real estate investing forums like BiggerPockets, just be sure to take advice from strangers with a grain of salt, unless you’re sure that they have significant experience and a good reputation.
Cap Rate Considerations for Apartment Investors
Capitalization rate, or cap rate is one of the most important metrics in commercial and multifamily real estate investing. Calculating an apartment property’s cap rate is one of the best ways to determine your potential annual return. Cap rate is defined by the formula:
Net Operating Income (NOI) / Market Value (or Purchase Price)
For instance, a property with a market value of $750,000, and an NOI of $50,000 would have a cap rate of 6.6%. In general, higher cap rates are better; so, if you have to choose between two similar properties, one with a cap rate of 5%, and one with a cap rate of 7%, it would typically be best to choose the second. Despite this, cap rates are generally lower for newer apartment properties located in better areas, as these properties will have lower maintenance costs and may also have higher potential rent growth.
Other Considerations for Apartment Investors
Finally, when determining whether to purchase an apartment property, investors should be mindful of some of the following additional considerations:
Utility Billing: Many buildings, especially older ones, have shared utilities. This can be an issue, especially as tenants may overuse utilities if they are not paying the bill themselves, greatly increasing your expenses. However, this issue is commonly addressed by implementing a ratio utility billing system (RUBS), which divides all monthly utility expenses by the number of units in a building, with unit bills being prorated based on the size of a unit, the number of bedrooms/bathrooms, and other factors.
Contaminants/Health Risks: In addition to having shared utilities, older apartment complexes may contain contaminants such as asbestos or lead paint. These issues typically will need to be remediated by a new owner, which can be very expensive. Ordering an inspection early on in the decision-making process can help you determine whether a building has these issues, and, if so, how serious they are.
Plumbing Issues: Plumbing can be yet another issue faced by the owners of older apartment buildings. Repairs can be expensive, and additional contamination issues may arise if the building has lead pipes.
Roofing: While a lot apartment buildings have flat roofs, these can present certain issues, particularly with leakage. Like many of the other considerations we’ve mentioned, a flat-roof is unlikely to be a deal-killer, but it’s still something to keep in mind.
Wooden Building Elements: Apartment buildings with significant amount of wooden framing, sometimes referred to as “all frame” buildings, can be significantly more expensive to maintain than buildings with brick or concrete exteriors. Potential issues include rot (especially in warmer, more humid climates), and increased fire risk (particularly in drier areas).
Insurance Costs: Older buildings, as well as those in run-down areas will generally be more expensive when it comes to insurance costs. Potential buyers should always make sure to check current insurance costs, as well as to inquire with other insurers to determine if the current owner is under or overpaying.
Syndication: Bringing New Investors into the Deal
While you may want to invest in a property by yourself or with a partner, some people decide they want to pool money from a larger group of investors in order to purchase a larger building, increasing potential profits. This is a process referred to as apartment syndication, and, while it’s not everyone’s cup of tea, it can be an excellent way to raise capital for more expensive real estate investments. The syndicator or syndicators typically act as general partners (GPs), taking on a greater degree of risk and liability, while the other investors take a passive role as limited partners (LPs). As a function of their increased risk exposure, the GP or GPs are generally party to a higher level of returns above a certain amount (called a preferred return), and are often awarded additional sponsor fees for the time and effort taken to arrange the deal and manage the investment over time. Syndications are typically done by more advanced investors, but if you have real estate experience, and are willing to take the time to forge relationships with investors, it may be a worthwhile endeavor.
Sale, Prepayment, and Tax Considerations
Unless you plan to hold onto your apartment building until you die, and pass it on to your heirs, you will most likely want to sell it at some point. As we mentioned previously, investors should generally plan out their estimated holding period well in advance. If you fully own the building, this is your decision alone, but, if you’ve invested one or more partners, you’ll need to take their opinions into account, too.
If you’ve used a loan to finance your apartment building, and you’re still paying it off, you’ll probably need to pay a prepayment penalty in order to sell the property. This compensates your lender for the interest payments they will lose out on as a result of your paying off the loan before the end of its term. Many multifamily loans, however, are assumable, which means that the new owner of the building can actually take on, or ‘assume’ your loan, provided that they’re approved by the lender. While a small fee is usually involved, having a new borrower assume your loan is significantly less expensive than paying a prepayment penalty.
Finally, it’s important to understand the tax implications of selling multifamily real estate. If you’ve realized a profit as a result of the sale of your property, you’ll generally need to pay capital gains taxes, rather then regular income taxes. However, if you’ve taken depreciation deductions against your income taxes, you’ll often need to pay your regular (typically higher) income tax rate on those gains, in a process referred to as depreciation recapture. In order to avoid paying capital gains taxes when selling a property, some investors choose to engage in a 1031 exchange. This allows individuals to ‘exchange’ one commercial or multifamily property for another of equal or greater value, deferring the payment of their capital gains taxes until the sale of the new property.
In general, all apartment investors should hire a professional real estate accounting firm through the duration of their holding period. This will help ensure that the sale and tax payment process goes off without a hitch. Investors interested in 1031 exchanges will need to hire a 1031 exchange company, and, for certain types of exchanges, an exchange accommodation titleholder.
Wrapping Things Up
Investing in your first apartment complex can be incredibly exciting– but it can also be a lot of work. Fortunately, the more research and preparation you do upfront, the less work and unexpected hassles you’ll endure when you actually purchase your property. And, while this article may seem long, it’s really just the tip of the iceberg when it comes to the information you’ll need to know to be a successful apartment building owner. We’ve said it before and we’ll say it again– when it comes to real estate investing, knowledge is power. So keep reading, surround yourself with like-minded friends and mentors, and, when you’re really ready, take the plunge and buy your first multifamily property.