Buy and Sell an Apartment Building
(An excerpt from 69
Ways To Make Money In Real Estate)
By Steve Gillman - 2005
With an apartment building investment strategy, it is possible
to make a very large profit from one deal. It does, however,
require a lot of work and possibly a few years to complete.
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 a 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 to 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.
Copyright Steve Gillman.
69 Ways To Make Money In Real Estate
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