Why I like Investing in Large Apartments

Why I Like Investing in Large Apartments

As a private equity capital raiser for a large apartment syndicator I’m very aware of the power of apartment investing. I meet potential investors on a daily basis who are interested in apartment investing but most have never invested in apartments before. They may have heard from a friend who is involved and seeing good results or this may be the very first time they were ever exposed to this idea. The primary reason this is fairly unknown is because most syndication groups operate under SEC regulations that prohibit advertising their deals to the general public. They are only available to accredited investors, which provides a hurdle for many investors to participate.

Other more active investors get started investing in apartments by starting small with an 8 or 12 unit then gradually trade up. That requires active investing (developing knowledge, time and skill) of which most of the investors I deal with are not interested in being. They want the benefits of being a passive investor without the hassle of being active in it. Hence, syndication groups provide just what they are looking for. Syndicates pool money from passive investors to make these acquisitions, improve the asset and provide a very solid return to investors. Syndicates are the “active” partner in the deal. Most syndicate groups like to target older apartments (think 1980s) because they can add value in the form of renovating the interiors, exteriors and placing new more sophisticated property management companies on site to improve the operational efficiency of these apartment communities. It’s not uncommon for “value-add” syndicators to target a 10% cash on cash return in the form of quarterly distributions and an overall IRR of 20% over a typical five-year hold period where upon the asset is sold.

I recently completed reading a powerful book from my peer Paul Moore called The Perfect Investment. I highly recommend it if you are an investor already investing in apartments or looking to invest in this profitable real estate niche. I talk to Paul often and we share best practices. He brought up some good points in the book around demographic trends leading to more renters for some time to come (millennials and boomers for instance) and shares with us that risk-adjusted returns on apartments are 4x the stock market (wow!). During the 2008 financial crisis, Paul’s research indicates that the delinquency on residential mortgages was as high as 4-5% nationwide while multifamily loan delinquencies were 1% and almost nil if you excluded over exuberant markets (think Las Vegas, Phoenix and Miami) and had experienced operators.

I shared with him my experiences of an investment company in Houston that partnered with us on a few deals in the Texas market where they were the property manager. They had their own properties in Houston (10 or so) and they have a chart showing how well their apartments (B/C value-add class – built in the 1970s and 1980s) held up during the oil downturn while Class A (newer built) apartment occupancies dropped 15-20% during that time showing the resiliency of the B/C value-add asset class to economic downturns. Hence, I wanted to put something together for my investor base as well as prospective investors on why I think investing in large, value-add class B/C properties may be one of the best investments out there from a stand point of low risk and high return, a rare combination.

I’ll start out here with some basics on why I like this investment. This comes primarily from another syndicator peer of mine Brian Adams in which he lays out why apartment investing makes for an IDEAL investment. Where:

I = Income

D = Depreciation

E = Equity

A = Appreciation (especially forced appreciation)

L = Leverage

I’ll add a few more TIPS (benefits):

T = Tax advantaged

P = Performing Asset

S = Scale

We’ll explore this briefly here.

Income: Apartments throw off income from the rents generated less expenses. This can be paid out monthly or quarterly. We often see distribution in the 8-12 % range and many syndicators offer a preferred 8% return meaning the limited partners get paid first up to 8% before the general partner gets paid.

Depreciation: The building, not the land depreciates and hence, reduces your taxable income. Many syndicates also utilize accelerated depreciation techniques as well.

Equity – As you pay down the loan and make improvements to the property and operational efficiencies to generate higher rents (income) your equity stake in the property increases.

Appreciation – This is my favorite and what makes apartments (commercial property valuation model) stand out over non-commercial (less than 5 units) and single family rental properties so I’m going to elaborate on this one a bit more. If I can find apartments that need some work (value-add) and increase the NOI, I can greatly increase the market value of the property, even if the general market around me is stagnant. Not so in residential where homes are valued based on what other comparable properties sold for. In commercial valuation, the model is NOI/cap rate = market value. (A cap or capitalization rate is simply what an investor should expect to earn if they paid 100% cash for an apartment. Example: If an apartment costs $1M and the cap rate is 6, then the investor should expect to get 6% or a return annually of $60K from the investment). So, assume the cap rate stays the same and I’m able to increase the NOI even modestly per the equation above, the market value will almost exponentially increase. This concept called forced appreciation is what makes apartment investing and commercial real estate for that matter so powerful and is little understood by the average investor.

Example: At one of our 300+ unit apartment acquisitions this past year, we identified a desire for covered parking. A survey of residents suggested about 2/3 would pay for covered parking for a modest $25/monthly fee. If 200 units then paid $25/monthly fee, that generates about $5K/monthly revenue or $60K/yr. The cost was $90K to build it so we would break even in about 18months. But from a valuation model, we added $1M of equity. How’s that? We increased NOI $60K / 6 cap (.06) = $1,000,000. That is the true power of value-add apartment investing and the concept of forced appreciation. Keep in mind, we were not relying on comparable properties to drive appreciation so much as looking at what value-add opportunities our own residents would be willing to pay for and letting the valuation model take care of the rest. Hence, more control in driving value than reliance on outside forces.

Leverage – This goes for real estate in general and we can answer this question best with an example that is a bit easier to think about. If I bought a $5M apartment building for cash and the building generated a NOI of $300K/yr., then I’m getting a 6% return on my investment. Now let’s say I purchased this property with a 20% down payment (or $1M) and added value improving the NOI by 50%, my new NOI would be $450K/yr. less new debt payment of $225K/yr. = NOI of $225K. However, $225K / 1M down payment = 22.5% return on the investment vs 6% on the all-cash deal. This is the power of leverage. 

Tax Advantaged – Investing in real estate is a highly tax efficient investment. It’s not uncommon for annual distributions to investors of 10% or so to be offset on paper as a loss on your annual K-1 partner distribution tax statement because not only depreciation (mentioned earlier) but property taxes and loan interest are significant deductions that offset gains. This occurs generally over the life of a five year investment. Additionally, value-add syndicators frequently do a “cash out” refinance after the renovations are complete in a few years after the property is purchased and property NOI is optimized. This refinance is considered by the IRS as a return of the investors capital and is not a taxable event. At time of sale, say in year 5, there is some depreciation recapture, but the expected gain at sale is considered a long term capital gain and is treated at a lower tax rate, currently 15%.

Performing Asset – In my experience, most of the value-add older apartments in the strong markets we acquire them are making money even before we make improvements. Hence, its considered a performing asset and this reduces investor risks. There are investors who like turnaround plays and will invest in apartments where the occupancy is less than 70% and not making money but that is a lot riskier. We like to purchase apartments that have an occupancy of greater than 90% and want to build on that by improving the look and operations of the buildings. This lowers investor risk. We don’t buy on hope, we buy on proven and improve from there.

Scale – The more units typically in an apartment the more opportunity to gain economies of scale and lower your cost per unit expense of maintaining them. There are certain thresholds in number of units where onsite property management and maintenance make sense. The cost of an onsite manager to manage 100 units versus 200 units are about the same cost but the cost per unit goes down as you move up the scale as an example.

So, in sum, there are many benefits to being an investor in large, multifamily apartments. Focusing on value-add Class B/C is where we find the most opportunities for attractive returns for investors. Get a hold of Paul Moore’s book to supplement what I’ve covered here and help you more fully understand the strong renter demand trends and understand more the relatively high returns versus lower risk of this powerful asset class. Accredited status is required for many of these deals, but if you meet that criteria, you have an opportunity to put some of your money into what I believe is a very attractive investment niche.