The Pros and Cons of Owning an Apartment Building
It appears that lately everyone wants to own an apartment building. Experienced investors, novice investors, “mom and pop” operators, foreign investors — they’re all bidding on apartment buildings. Not only are they bidding, they are overbidding as well, driving up prices well beyond the asking price. It’s no surprise, as apartment buildings are considered an excellent investment
There are many pros to owning an apartment building, as well as some cons that you should consider before putting down any money. I’m a huge believer in multifamily as an asset class, but it’s important that you are aware of the pros and cons of owning one.
Pro #1: Passive Income — Earning Money While You Sleep
Passive investors are those who put up funds in an apartment building but have no role whatsoever in managing the property. They are usually part of a syndication, and are investing because they want to earn passive income from their investment.
There are actually multiple income streams involved for investors. They earn their passive income from monthly rents, based on the property’s net operating income (NOI). This is income after expenses. If improvements are made to the property, and the reputation of the apartment building also improves, there is potential for higher rents over time, which can boost your passive income.
In addition, investors can earn money from appreciation when the property sells, usually after a pre-defined holding period of 5, 7 or 10 years. If the property is well managed and vacancy rates remain low, the property’s value will increase over time.
Passive income offers other benefits to investors. Your money is always working for you, with no effort on your end. You are able to continue working in your current profession, or focus on whatever passions you enjoy. That’s the meaning of “passive” — you don’t have to do any work at all on the apartment building. Others do it for you.
Pro #2: Economies of Scale
Whether you have a 2-unit apartment building or 200-unit property, you will enjoy economies of scale. If you have a property manager handling the day-to-day operations of your apartment building, it’s just as easy to manage multiple units, as it is to manage two. The property manger find new tenants, collects rents, manage repairs, etc.
Let’s look at how economies of scale affect expenses. Suppose you owned a 200-unit apartment building and were able to save $25 a month on each unit on water bills by installing some water-saving devices, like low water pressure shower heads and low-flow toilets. Your $25 savings in water utilities will generate an additional $5,000 per month, or $60,000 a year in positive cash flow. Plus, that cash flow will also raise the property’s value.
The biggest impact of economies of scale is on the value of the property, and the best way to demonstrate this is by example. If you have a 2-unit apartment building, or duplex, and you raise rents by $30 a month, you’ll end up with a $60 a month increase, or $720 per year. On the other hand, if you raise rents by $30 a month on a 200-unit apartment building, your increase would be $6,000 per month, or $72,000 per year. That’s a huge difference in income, but it gets better.
Let’s look at what that $30 rent increase does to the value of your apartment building, in market with a 5% cap rate. (Cap rate is the percent-expected return on a property that was purchased for cash).
The value is defined by: Net Operating Income (NOI)/Cap Rate
In our example, the NOI divided by the cap rate is: $72,000/5%=%1,440,000
That’s right, the property value increased by almost $1.5 million from a $30 rent increase when you have a 200-unit apartment complex. That’s the beauty of economies of scale at work.
Pro #3: Tax Benefits
Possibly the best pro for owning an apartment building are the tax benefits associated with ownership, particularly the ability to deduct expenses and the depreciation on the property. Let’s look at each one.
Owners and investors are able to deduct operating expenses from their income. Operating expenses are any expenses associated with the building, like payroll, painting, costs associated with a property manager and most other recurring expenses. There are also capital expenditures, or CapEx, which are major improvements made to the property like a new roof, new HVAC systems and other large expenses.
Because of the tax laws, deductions cannot only be applied to income received from the property, but also any other income that the investor or owner receives. So if you made a lot of money in the stock market or from another commercial property, you’re in luck: you can apply your apartment building’s expenses to all the money you earned.
Depreciation is another benefit. The IRS says the life of an apartment building is 27.5 years. Of course, there’s an exception: through a process called Cost Segregation, or CostSeg, you can accelerate that depreciation for tax purposes. You’ll need a Cost Segregation study done, which breaks out different components of the apartment building and assigns accelerated time frames, like 5, 7 or 10 years on many different items, from flooring to doors to appliances and more. While a CostSeg study can be costly, it can save you lots of money in the long-term.
There are other pros to owning an apartment building, but there are also some cons. Let’s take a look at those, and how to handle them if they occur.
Like anything in life, there’s no good without bad. Owning an apartment building comes with a cost (but thankfully there are ways to minimize or eliminate the cons).
Con #1: Managing an Apartment Building Takes Time
Running an apartment building, especially one with many units, takes a lot of time. In addition to marketing the property, there’s time spent on showing prospective tenants the units, running applications through credit checks, and arranging move-in dates, along with many other tasks.
There are also maintenance issues to deal with, tenant problems to resolve, rent collection issues, competitive analysis — the list goes on and on. Here’s the good news: there are many quality property management companies available to handle the entire process, from setting the right rental rates to processing tenants to handling all the maintenance problems that might crop up. While you’ll pay for their service, it’s well worth the money, because it frees up your time.
Here’s something else you should consider: by investing in a syndication, managing the building and devoting your time to all of the tasks involved, including working with a property manager on a regular basis, will no longer be an issue. The syndicator will handle or manage all of the property management issues.
Con #2: Market Conditions May Change
You never know what the rental market might do. One day it can be robust, and the next it can go sideways. That type of market volatility can impact your tenant base and your cash flow, so you’ll need to be prepared for it, in order to protect yourself from rent volatility.
To begin with, you’ll need to leave yourself enough room for rental price changes, and lower the rents if needed. If you’ve left yourself enough room to handle rents that are lower than expected, you’ll have no problem meeting the debt service on your apartment building.
Adjusting rents in reaction to market changes is many time inevitable, but you can reduce the impact of the lost income by increasing your income to compensate for it. There are many creative ways to increase your apartment building’s income independent of the regular rents. You can do this by collecting additional fees for reserved parking, for example, or charging extra fees for in-unit laundry facilities and other amenities.
Another option is to start using RUBS — which is an acronym for ratio utility billing system. This calculates utilities based on occupancy, square footage, number of bedrooms or a combination of those factors. Utilities are passed on to tenants, and the financial burden is removed from the property owner.
Con #3: Competition is Heating Up
The apartment rental market is liquid, in that it is constantly changing. New players come in, many existing apartment buildings are renovated and go through extensive upgrades which may entice your tenants to move just as soon as their lease is up.
You don’t want to get into a rate war with competitors, so instead you can provide unique amenities that will set your apartment building apart without making your rents the highest in the market.
One option is to add smart technology. It makes your apartments safe, secure and more economical to the tenant. These include things like smart thermostats (think “Nest”), keyless digital locks for the door, smart lighting and Bluetooth home security. For a minimal investment, you’ll provide tenants with amenities they won’t find elsewhere.
Some apartment buildings are adding co-working space to their list of amenities. These are simply areas where tenants can work, which include desks, couches, tables and a fax and espresso machines. It gives tenants a place where they can come together to work — even though they’re not professionally connected to one another.
There is also car-sharing services you can offer, where tenants can reserve the use of a car by the minute, hour or day. The beauty of this amenity is that you provide several parking spaces, and a third-party runs the operation. In all of these instances, you can either use the amenities to help retain tenants, or create new revenue streams for your building.
There are both pros and cons to owning an apartment building. Earning passive income and income through appreciation top the list, but the tax benefits and depreciation are the icing on the cake for owners. There are also many economies of scale when you own a multi-unit building, which can help to increase the apartment building’s value significantly. While there are cons in apartment building ownership, they can often be easily mitigated by being proactive in the marketplace and being prepared for whatever the competition may bring your way.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specializes is multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don’t have access to.
Ellie is the host of REady2Scale, a podcast that shares true stories from within the industry, and the critical lessons learned, from the most successful real estate investors, innovators, developers, and more from around the globe!
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital at www.bluelake-capital.com and learn more about Ellie at www.ellieperlman.com.