Investing in apartments/condos in bigger city

[Jegan Basha]

Generally investing in apartment in bigger city has a low cap rates and higher asking price.
Despite the low cap rate <4.5% ,is it advisable to invest in such apartments for long term investment?
Some investors still insist on investing in these apartment on the principle that the price will appreciate and the demand is higher.What is the most recommended way of investing in apartment ?

[Giovanni Isaksen]

@Jegan Basha let me speak to your points in order:

The apartment investment cycle arises out of the fact that there is a lag between growth in demand for apartments and when developers can provide new supply to meet the demand. This lag is caused by the time it takes to acquire land, entitle it, design and draft the construction documents, apply for and receive permits, begin and complete construction and finally to lease up the property. This doesn't count any extra delays from financing issues, labor and/or materials shortages, extreme weather, etc. Depending on the type of construction, project size and the location this time lag could be one to two years or even longer, particularly in difficult terrain and/or jurisdictions that aren't friendly to new development.

As developers see rising demand for apartments they begin this multi-year process hoping that when they get to lease-up the demand will still exist and the early cycle projects do tend to work well. This early success fuels another type of demand though, think of it as deal demand that lays on top of the true demand of renters needing more units. Deal demand comes from lenders, investors and developers wanting to make more money by doing what they do. This works ok for a while but eventually there is more new supply built then there are renters to occupy and now things get really competitive.

With market vacancies rising operators are forced to cut rents or increase incentives to lease out units and at the lower revenue levels some of the new properties fall behind on payments and the trouble starts. A couple projects go back to the bank, lenders stop lending, investors stop investing and with no money, developers stop developing. Meanwhile operators are fighting to keep renters and rents so they can hang on through the down part of the cycle and still be in business when demand catches up to the existing supply. Eventually growing demand will start to generate interest in new development again; Rinse and Repeat... and that's my short version, I'm working on an in depth white paper that should be up on our website in the next few weeks.

On to point two, Break Even Ratio or BER and I promise to be brief so I'll start with this example from my book:

BER is a measure used by lenders to insure that there is a cushion of revenue above the minimum required expenses so that they can still be repaid if everything doesn't go according to plan. The formula is operating expenses plus capital expenses plus debt service divided by gross operating income. This yields a percent and the typical max BER is 85%, in other words required expenses can be no more than 85% of total actual revenue.

In the example above the BER is 84% or pretty close to the max. It also shows a Margin of Safety of 16% which is the inverse of the BER. In this case revenue could fall 16% and the property would not be in negative cash flow. Typically we like to see this margin of safety at 20% or higher (or 80% BER) just in case. There are several margins of safety we build into our deals but they're for another discussion.

Finally when to sell. There could be a whole book on that subject but the short answer is when the property achieves its investment objective. We're value investors who believe that apartments are great vehicles for long term dependable and growing income, with the potential for appreciation. Appreciation plays are speculations and a speculation is just a hop and a skip from a gamble. Our aim is to be long term holders but we do have private equity and syndicator clients who have a target IRR to hit and once they get there they exit and pay off their investors (hoping they'll reinvest in the next deal of course). Hanging around in a deal after their target IRR is achieved only risks missing it and disappointing their investors who wouldn't be inclined to reinvest. So Jegan, what is your investment objective?