I’m often asked what makes a commercial apartment purchase a good deal. There usually aren’t many similar apartment building sales nearby so there’s not much to compare it to, but there are many other factors to take into account. A professional appraiser will likely use up to three approaches, typically a Cost approach where you want to know what it would cost to replace it and you don’t want to pay more than that, an Income Capitalization approach where cash flow and risk drive the value, and a Sales Comparison approach which is only practical when the area has a high enough number of similar sales.
But because you’re an independent private investor, you’re not planning to pay for an appraisal. You want to do you own analysis. You’re pretty good with math, can operate a spreadsheet, and know how to ask good questions. Just not sure what you need to find out.
The financial analysis is critical but is a topic for another day. I’m going to share with you the uber factors that should go into any analysis to be sure your assessment is thorough. Three factors cover the level of property review you need to perform before making a purchase decision.
External Macro Factor
These are factors that include the Capitalization Rate for the market (income minus expenses as a percent of the purchase price), how old are properties in this market, is it growing, what is the level of crime, access to bus lines and main roads, proximity to emergency services, etc. There are a lot of them and this is clearly not an exhaustive list.
First identify your market. Is it a neighborhood, a distinct region, the whole city?
Then find out what Cap rates apartment properties in this market are selling for. Be careful not to generalize. If you can get your target property at an 8% cap rate but in general the region is selling at a 6% cap rate, are you sure you’re defining the market correctly? In other words, is your property in a blighted area of town which in general has properties selling at 6%, 5%, even 4% cap rates, but properties in the blighted area sell at 8% or above cap rates? If so, your 8% cap rate deal may not be so great.
If properties like yours sell at 8% cap rates, unless you completely reposition it (which means you upgrade and improve so the property is transformed into a higher class), then years down the line when you are ready to sell it, you will most likely not be able to sell it at a 5% cap rate, even 6%. Possibly 7% but most likely right around 8%. That’s okay, though, because if you have made the kinds of improvements that lead to higher rents and you kept expenses in line, your property will have appreciated.
Unless you’re purchasing your property as a turn-key operation where it is already in great condition and there’s nothing you need to do it, you should be looking for opportunities to improve it. Improvements make tenants more comfortable paying higher rent and make it easier to get a prospective tenant interested. Higher rent is also not only better cash flow each month but greater property value. (Remember that for commercial apartments, the property value is based on how much income it produces.)
You should be able to walk around the property, through units, and see opportunities to improve. Would tenants benefit from covered parking? A laundry facility? Air conditioning? Or just painting, new carpets, new appliances? Not every improvement leads to better value so be judicious, but include improvement opportunities in your property assessment.
You’re looking for the street-view appearance, which appeals to tenants or turns them away, features of the property such as paved lots, pitched roof, laundry, recreational amenities, as well as inside features like granite countertops and AC, and maintenance. Has the owner repaired, repainted, cleaned, etc. or is there a lot deferred maintenance? Are all the units rentable?
You may be targeting properties with issues around condition, because you know the seller will have to discount the property with those issues (and you know how to fix them!). These are great opportunities. You can see the external issues but typically need to agree to a price on the property before the seller will let you see any units.
You can also learn from the actual income and expenses, which the seller will provide you. Was there a big expense for water damage? Income that was lower than expected based on rents?
The advantage of using this process for evaluating investment property is that you don’t have to be chasing properties in areas with strong rates of appreciation. High appreciation rates lead to over-priced properties and little or no cash flow, and that hot market could cool down. When that happens, not only are you not going to sell it for what you expected, you’re not making anything from it while you own it.
As a real estate investor, you have better control over how well your investment performs than you do with stocks and other traditional investments. You don’t have to buy the property and just sit back and hope the market keeps appreciating. You have analyzed these factors and are executing on a plan.