Buy an apartment building, improve it financially and sell it for aprofit. That is the basic idea, as shown in this example. With anapartment building investment strategy, it is possible to make a verylarge profit from one deal. It does, however, require a lot of work andpossibly a few years to complete.
If you know what you are doing, buying, improving, and then selling anapartment building can be one of the surest ways to make a large profitin 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 looksnice. 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 deckraise the value of a house? This is not an easy question to answer.
There is a more predictable formula for raising the value of anapartment building or complex. This is because the buyers areinvestors, who look at income more than new paint. The formula issimple: raise net income, and you increase value.
For example, suppose investors in your area expect a capitalizationrate of .08. That means that they expect a net return (before loanpayments) of 8% on the purchase price. If your thirty-unit apartmentbuilding generates $120,000 net income annually, they'll value itaround $1,500,000 ($120,000 divided by .08). If you can get it togenerate $160,000, it will be worth $2,000,000.
The strategy then is simple (but perhaps not easy). You find anapartment building that is not being operated efficiently, buy it at agood price, increase its net income, and resell it for a profit. If theincrease 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 all2-bedroom units renting for an average of $600, which is below the $675average for the area. The vacancy rate has been at 10% for the lastyear, above the 3% rate that is more common for the area. You decidethat this is because the place is a bit run-down, and the managementcompany isn't very quick about getting new tenants in.
There is a community room that is dirty and generally unused. There areno laundry machines, so tenants have to go eight blocks to thelaundromat. There are only a couple places that rent this cheap intown, and there are many that get $750 or more for two bedroomapartments. You can see that there is potential for improvement andhigher rents here.
The gross income for the previous year was $259,000, and all expensesother than loan payments, came to $75,000. That makes the net incomebefore debt service $184,000. Based on the prevailing cap rate in thearea of .08, the value is around $2,300,000. ($184,000 divided by .08).You have been shopping not just for apartment buildings, though, butalso for motivated sellers. This seller is only asking $2,000,000, andaccepts your offer of $1,850,000.
The first thing you do - before you even close on the deal - is make alist of every possible way to reduce the expenses and increase theincome. 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 thekids. They are provided by a amusement company at no cost to you, andyou get half of the income.
The other side of the community room becomes a laundry room. Again, youopt for an arrangement that gives you half of the income without anyinvestment in machines on your part. It does cost you $9,000 to havethe 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. Theywere also notified that a rent increase was necessary to pay for these,but that rent would be close to that of similar apartment buildings. Asthe leases are up, you increase rents. You simultaneously startpromoting the building as one of the nicest in the area, to fill thoseempty apartments.
By the following year most of the apartments are renting for $700. Withthe notice of the rent increase sent to tenants, you included aninformation sheet showing the rates at other apartment buildings,emphasizing the ones that were charging $750 or more. Only a fewtenants leave because of the higher rent. All of the tenants have anicer place to live. Moving is a lot of trouble and expense just to goto 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 isso that all of the changes in income and expenses will be fullyreflected 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 rentaveraging $700 per month per unit, the total gross income from rent forthe 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 3.4million dollars. Because it is in such perfect shape, however, you listit for sale at 3.7 million dollars, and by the end of the third year itsells 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 aprofit of 1.3 million dollars.
Even if you (or your partners) invested $500,000 originally, that's agreat return for three years. It is also a taxable capital gain, unlessyou roll it into the next bigger project. Another alternative is tokeep the property, now that it is probably (depending on the terms ofthe 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 strategyis that you make changes that raise the net income. To make the mostefficient changes, you have to learn how to do the math. However, thatis a subject for another article.
Copyright Steve Gillman. This article was an excerpt from 69 Ways ToMake Money In Real Estate. Want to know the other 68 ways? Visithttp://www.99reports.com/make-money-in-real-estate.html
By Steven Gillman
Published: 5/6/2007 |
