Multifamily properties are relatively straightforward and easy to understand. After all, many people have lived in an apartment building at some point in time. Purchase the property, rent units on an annual basis, invest in capital expenses as necessary to maintain the property. (OK, it’s not that straight forward, but you get the point.)
Despite the relative simplicity of multifamily investing, there are some important considerations for investors looking to take the leap. Here are seven things to look for when investing in apartment buildings:
- Market conditions.
Before investing in a project, you should always understand current market conditions. This is true at both a macro- and micro-level. At the macro-level, be sure you understand where we are in the current market cycle. Buyers typically have the upper-hand in a down market, whereas sellers can drive prices up in an up-market.
At a more micro-level, consider local economic conditions. Specifically, understand the local economic drivers that can provide rental demand. Is the property located near a major hospital or university? Are there major employers located nearby? What are the risks associated with the local economic drivers? For example, if the major economic driver is a naval base, is there any risk that the naval base could shut down, and if so, what impact would it have on demand for this apartment building? The stronger (and more diverse) the local economic drivers, the better positioned the investment is to weather a downturn.
- Comparable or planned developments.
No matter what asset class you’re investing in, you should always evaluate your potential competitors. When investing in an apartment building, that means doing your due diligence to understand what other multifamily properties are located nearby, their average rents, their vacancy rates, and their properties’ amenities. See how the investment you’re considering stacks up relative to these others.
Go beyond the competition that already exists. Look into what other developments may be planned or in the pipeline locally. This will help you understand what competition, if any, could affect the value of the property you’re considering investing in.
- Condition of property.
When evaluating an investment opportunity, consider the condition of the property. Are the major systems (HVAC, electrical, plumbing, roof, etc.) in good condition? How much life do these systems have left in them? If critical building systems need immediate repair or replacement, the capex costs need to be evaluated in conjunction with the purchase price to understand the total investment cost basis.
Aside from the condition of major building systems, investors should evaluate the general aesthetics and condition of the interior building and interior units. Is there room to improve the units, and correspondingly, increase rents? This may be an opportunity for value-add investors. Those looking to take a more hands-off approach are typically better off purchasing a fully stabilized apartment building in turn-key condition.
- Current cash flow.
Properties are often valued based on their income generating potential. Understanding the current cash flow can help you back into an appropriate purchase price for the property. It also helps investors identify areas for improvement. For instance, if cash flow seems to be low, understand why. Could rents be increased? Could strategic investments in amenities (e.g., storage lockers, on-site laundry) result in increased cash flow?
- Occupancy level.
Multifamily apartment buildings are generally considered fully stabilized when occupancy reaches 93-95%. When looking at an apartment building, you should consider the current occupancy level. If there is significantly more vacancy, understand why. Are the asking rents too high? Has there been an influx of new competition? Is there a problem with the current management company and/or the leasing strategy? This could represent an opportunity for an investor, assuming market fundamentals are strong and the property can be brought back to stabilized occupancy.
- Value-add opportunities.
We’ve touched on this briefly above, but to elaborate: anyone looking to invest in apartments should consider the value-add opportunities that could result in larger returns on their investment. Value-add properties are inherently riskier than investing in Class A or core properties, but they offer the possibility of greater profits. Value-add improvements include (but are not limited to), cosmetic improvements to the building or units that increase the appeal to tenants; improving management/operations; lowering expenses; and raising rent to market rates.
Here’s an example of how that might work in practice. The new owner of a 10-unit apartment building might decide to individually meter the heat, electric and water used by each unit. This allows the owner to pass on these expenses to tenants. In shifting the utility cost burden to the tenants, the owner saves on operating expenses and increases revenue.
- Appreciation potential.
Returns are generated through cash flow or appreciation. When considering an apartment investment, evaluate the property’s appreciation potential. As noted above, this will often depend on where we are in the market cycle (properties purchased at the height of the market—which is hard to predict—often experience less appreciation than those purchased during a downturn). It will also depend on local economic drivers, as discussed above. If you suspect people will continue to want to live in that area, and there’s little competition on the horizon, then the property may have real appreciation potential – especially when combined with various value-add improvements.
Multifamily has long been a darling among commercial real estate investors, but that doesn’t mean you should dive in blindly. Looking at these seven critical features will help you differentiate a good investment from one that’s great.