[A609]Apartment Building For Sale

If you know what you are doing, buying, improving, and then selling an apartment building can be one of the surest ways to make a large profit in real estate. Why? The size of the investment helps. Making a 10% profit on a million-dollar property is more profitable than on a $100,000 house. But it isn't just the size of the deal.

Selling an apartment building isn't like selling a house. For example, if you paint a house, you'll get a little more for it because it looks nice. But you are just guessing at how much value that painting adds. What if you chose a color that isn't popular? How much does a deck raise the value of a house? This is not an easy question to answer.

There is a more predictable formula for raising the value of an apartment building or complex. This is because the buyers are investors, who look at income more than new paint. The formula is simple: raise net income, and you increase value.

For example, suppose investors in your area expect a capitalization rate of .08. That means that they expect a net return (before loan payments) of 8% on the purchase price. If your thirty-unit apartment building generates $120,000 net income annually, they'll value it around $1,500,000 ($120,000 divided by .08). If you can get it to generate $160,000, it will be worth $2,000,000.

The strategy then is simple (but perhaps not easy). You find an apartment building that is not being operated efficiently, buy it at a good price, increase its net income, and resell it for a profit. If the increase in income is predictable, the increase in value is.

An Apartment Building Investment Example

Suppose you find a 40-unit apartment building for sale. They are all 2-bedroom units renting for an average of $600, which is below the $675 average for the area. The vacancy rate has been at 10% for the last year, above the 3% rate that is more common for the area. You decide that this is because the place is a bit run-down, and the management company isn't very quick about getting new tenants in.

There is a community room that is dirty and generally unused. There are no laundry machines, so tenants have to go eight blocks to the laundromat. There are only a couple places that rent this cheap in town, and there are many that get $750 or more for two bedroom apartments. You can see that there is potential for improvement and higher rents here.

The gross income for the previous year was $259,000, and all expenses other than loan payments, came to $75,000. That makes the net income before debt service $184,000. Based on the prevailing cap rate in the area of .08, the value is around $2,300,000. ($184,000 divided by .08). You have been shopping not just for apartment buildings, though, but also for motivated sellers. This seller is only asking $2,000,000, and accepts your offer of $1,850,000.

The first thing you do - before you even close on the deal - is make a list of every possible way to reduce the expenses and increase the income. As soon as you close the deal, you go to work.

Cleaning the property up and doing some minor landscaping costs just $1,000 or so. You have $2,000 worth of painting done as well.

The community room is cleaned up, and you install video games for the kids. They are provided by a amusement company at no cost to you, and you get half of the income.

The other side of the community room becomes a laundry room. Again, you opt for an arrangement that gives you half of the income without any investment in machines on your part. It does cost you $9,000 to have the room plumbed and wired for the washers and dryers, however.
You allow a beverage company to put a pop machine in the community room for 40% of the gross income.

You spend $13,000 for ten small storage sheds and rent them out to tenants for $35 per month.

You spend $52,000 for several carports that will provide one space for each tenant.

You replace every outdoor light with low-watt fluorescent bulbs, for a few hundred dollars.

You replace the inefficient heater for the hallways with one that will cut your gas bill by 30%. It costs you $6,500.

You add fire extinguishers and make other minor changes to get a better insurance rate. This cost a few thousand dollars.

You fire the management company and hire a better one for the same rate.

Tenants are surveyed and repairs and improvement are made as needed or desired by tenants. This costs another $32,000.

The tenants, of course, were told there would be improvements. They were also notified that a rent increase was necessary to pay for these, but that rent would be close to that of similar apartment buildings. As the leases are up, you increase rents. You simultaneously start promoting the building as one of the nicest in the area, to fill those empty apartments.

By the following year most of the apartments are renting for $700. With the notice of the rent increase sent to tenants, you included an information sheet showing the rates at other apartment buildings, emphasizing the ones that were charging $750 or more. Only a few tenants leave because of the higher rent. All of the tenants have a nicer place to live. Moving is a lot of trouble and expense just to go to a place that is not as nice in order to save maybe $50 per month.

You keep the place for another year before trying to sell it. This is so that all of the changes in income and expenses will be fully reflected in the books for a full year. Your improvements cost around $120,000. Add this to the original purchase price and closing costs, and you have right around 2 million dollars into the project.

What does that net income look like now?

Your new and improved apartment building is now 98% occupied. With rent averaging $700 per month per unit, the total gross income from rent for the previous year was $329,000.

Your share of the laundry machine income was $2,400.

The storage sheds were mostly occupied, and brought in $3,800.

The income from the video games and pop machine in the community room was $1800.

Total gross income, then, is $337,000.

With the new heater and other changes, you reduced annual expenses to $65,000.
That makes the net income before debt service $272,000.

At a .08 cap rate, the value of the apartment building is now about 3.4 million dollars. Because it is in such perfect shape, however, you list it for sale at 3.7 million dollars, and by the end of the third year it sells for 3,500,000. Sale's commission and closing costs total almost $200,000. Since you had about 2,000,000 into the property, you have a profit of 1.3 million dollars.

Even if you (or your partners) invested $500,000 originally, that's a great return for three years. It is also a taxable capital gain, unless you roll it into the next bigger project. Another alternative is to keep the property, now that it is probably (depending on the terms of the financing) generating cash flow after debt service of about $172,000 per year. That's not a bad return either.

The most important point of this apartment building investment strategy is that you make changes that raise the net income. To make the most efficient changes, you have to learn how to do the math. However, that is a subject for another article.