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Analyzing Apartment Buildings as Investment Properties

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Investing in commercial apartment buildings (20+ units) can be extremely lucrative if you have access to a lot of cash flow and/or capital.  In other words, you can obviously make a boatload of passive income on the monthly rental payments, but in general, you must fork out quite a large chunk of change to acquire this type of investment property. This is definitely a classic tradeoff!

Just like at the residential rental property level, running the numbers when you’re looking to buy a large apartment building is critical to ensure you are getting a good deal.  But unlike the residential real estate market, at the commercial level the notion of the capitalization rate – or CAP rate – becomes paramount.  The CAP rate represents the price/income ratio of the property, and the higher the number, the better. But as I explain below, the final number can be open to interpretation.

The formula to calculate CAP rate is as follows.  CAP rate = Net Operating Income / Price.  NOI is calculated as gross rental income plus other income (such as a coin operated washer and dryer), less the vacancy loss (assume 5-10% of annual rental income in the absence of actual data) and property expenses (utilities, insurance, property tax, repairs, management fees, etc.).  One thing to keep in mind is that it is not unusual for sellers to wipe much of their repair expenses off the books in order to make the numbers look better.  So, in many cases it is better to assume 15-20% of the annual rental income will be spent on repairs and property maintenance, depending on the age of the building.  Some other assumptions that you could make in the absence of actual data include 10% for a property manager, 1.25% for property taxes, 0.5% for landlord insurance, and 2-3% for miscellaneous / unexpected repair bills.  A rough rule of thumb is that a building in a nice area will pay about 30% of annual gross income for expenses, whereas a building in “the hood” might pay about 50% for expenses.

Now, the analysis of CAP rates can become tricky because there are external variables in play that extend beyond the numbers themselves.  For example, properties located in nice areas will tend to have lower CAP rates because the prices of those properties will tend to be higher.  Conversely, properties located in an area filled with urban blight would have higher CAP rates because the property prices would be lower in these areas.

I hope you found this primer on apartment building analysis to be helpful and informative.  Just remember that the calculations and rules of thumb above are designed to allow you to come up with a preliminary property valuation.  In other words, this analysis will tell you if the property is a bust or if it warrants further investigation.  If the preliminary numbers look good, the next step is to launch a full blown due diligence campaign to verify all the information.

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