The Complete Guide to Buying and Selling Apartment Buildings Chapter 5-6

A competent supervisor should beable to resolve most issues.man-Larger multifamily complexes are typically those with 150 units or more.Larger properties allow the owner to achieve a hig

Establishing Your Niche and

Locating Properties

Success is not measured by what a man accomplishes, but by the opposition

he has encountered and the courage with which he has maintained

the struggle against overwhelming odds.

—CHARLES LINDBERGH

The preceding chapter discusses themerits of the value play This chapter examines some important concepts toconsider prior to the deployment of your acquisition campaign You mustfirst determine your niche in the marketplace by analyzing key factorsregarding the type of property you are seeking Once you have definedexactly what type of property you are looking for, you will be ready toembark on locating the property best suited to your needs

Establishing Your Niche

Before you begin your search for an apartment complex, you must firstdefine your niche in the marketplace There are four crucial factors to con-sider:

1 The resources available to work with.

2 The size of the property.

3 The age of the property.

4 Your holding period.

It goes without saying that there is some crossover among these factors Forinstance, the more capital you have to work with, the larger and moreexpensive a property you can acquire One is not necessarily a function ofthe other, though Just because you have a large pool of capital to draw fromdoes not mean that you have to buy a larger property Let us examine eachfactor in more detail

Availability of Resources

Obviously, the amount of capital you have available for real estate ments is a key factor in establishing your niche The more you have to workwith, the greater your choices are In general, loan-to-value (LTV) financ-ing of 80 percent is readily obtainable If you had $100,000 to invest andprocured an 80 percent loan, you could buy a $500,000 apartment building.With that same $100,000, you could acquire a $750,000 complex with an

invest-85 percent loan or a $1 million building with a 90 percent loan In my rience, “nothing-down deals” do not exist when it comes to buying larger

expe-properties You may be able to find them for single-family homes, but formultifamily properties, be prepared to come to the closing table with your

checkbook I am not suggesting that it is impossible to find a nothing-down

deal for apartments; I am just saying that I have never seen one I supposeyou could structure a deal on an 80/10/10 basis, meaning 80 percent bankfinancing, 10 percent seller carry-back, and 10 percent from a partner,friend, or relative The bottom line is that the capital you have to work withwill be a constraint and a determining factor in establishing where you willfit into the multifamily marketplace Define your limits before conductingyour search

Property Size

While the number of units you can acquire is in part a function of the tal you have to invest, there is a wide range of prices per unit available Someolder apartment complexes may sell for as little as $5,000 per unit, whilenewer properties may sell for as much as $75,000 to $100,000 per unit ormore, depending on the region you choose to invest in I recommend thatnewer investors get their feet wet with a smaller property of 50 units or less

capi-A smaller apartment building will provide you with the opportunity to bedirectly involved in the operations of the property In short, it will give yousome hands-on experience As your expertise and knowledge grows, so willyour confidence This self-assurance will manifest itself through your ability

to graduate to larger and larger multifamily properties

Midsized apartments typically range in size from 50 to 150 units As youmove up the scale in size and magnitude of the properties in your portfolio,you will most assuredly want to employ full-time managers and mainte-nance personnel Furthermore, unless you plan to keep up with all of theaccounting functions, such as the accounts receivables, payables, and col-

lections, you should seriously consider engaging a reputable property agement firm An effective management company will handle all of the day-to-day operations such as managing the staff, collecting the rents, andpaying all of the bills It will also generate month-end financial reports fromits accounting programs, which will provide you with all of the details of rev-enue and expenses Depending on the size of the company, managementfirms generally use field supervisors, adding a level of supervision thatwould not otherwise exist These supervisors will usually oversee and beresponsible for 5 to 10 different apartment complexes If your on-site man-ager runs into a problem outside of the normal day-to-day operations, he orshe can call the field supervisor for help A competent supervisor should beable to resolve most issues.

man-Larger multifamily complexes are typically those with 150 units or more.Larger properties allow the owner to achieve a higher degree of efficiencythrough economies of scale Depending on the size, instead of having oneall-purpose maintenance person, you would be able to hire one maintenanceperson who is also qualified in air-conditioning and another who hasplumbing skills, in addition to a groundskeeper and perhaps a porter.Employing individuals with these types of skill sets can be a very effectivecost-savings measure because you do not have to call in an outside contrac-tor every time an air-conditioning unit goes out, for example With mainte-nance personnel on-site and readily available, your tenants will benefit, too.They will appreciate the better service Satisfied tenants mean lowerturnover, resulting in additional cost savings to you Larger complexes gen-erally mean larger budgets, which can give you greater flexibility in the wayyou operate your property You can afford to have a professionally trainedsales staff that will ensure that things run as smoothly as possible A skilledmanager will know how to address issues as they arise and how to deal withthem effectively This, too, will result in lower turnover Trust me: a quali-fied manager can make all the difference in the world in how profitable yourapartments are Don’t be afraid to spend a little more on the individual over-

seeing the day-to-day operations An increase in salary expense of $5,000for a competent manager will be more than offset by an increase in revenues.

Regardless of the size of apartment building you purchase, the use of a fessional property management company can be extremely important to you

pro-as an owner You and you alone must determine what the best use of yourtime is Where do you add the most value to the process? In the early stages

of building wealth through real estate, the day-to-day, hands-on ment will give you invaluable experience not available from any othersource As your level of expertise increases, however, it will be time to shiftsome of those responsibilities to others Why burden yourself with trying topersonally manage and oversee every detail of a 100-unit complex, forexample, when you can pay someone $20,000 to $30,000 a year to assumethose duties for you? This frees up your time to focus on more importantthings, such as preparing to implement your exit strategy for your existingbuilding and beginning to identify potential acquisition targets for your nextvalue-play opportunity

involve-If you allow yourself to get bogged down in the day-to-day management,you will soon discover there is little time left for anything else I am not, ofcourse, suggesting that you remove yourself completely from the process.Your role is to manage the managers by defining your objectives for theproperty You provide the leadership, and then get out of the way and let

them do their jobs Do not micromanage You will continue to maintain

close contact and make yourself available for questions In addition, you willscrutinize every detail of the financial reports every month to ensure thatyou are on track to meet your stated objectives

In summary, whether you own a small, midsized, or large apartment plex, you must decide as the owner what the best use of your time will beand how you personally can add the most value to maximize the return onyour investment

com-Property Age

Depending on their age and physical condition, apartment complexes are

commonly classified as A, B, C, or D properties As a general rule, the newer

a property is, the more expensive it will be on a per-unit basis You mightpay, for example, as much as $75,000 to $100,000 per unit for a newly con-structed building, or you might pay as little as $5,000 per unit for a mucholder building

Class A apartments will typically be newer properties, less than 10 years old

and in excellent condition They may even be newly constructed buildingsthat are still being leased up This type of apartment will command the high-est price per unit for several reasons, one of which is the cost of new con-struction, building materials, and labor Due to an inflation-driven economy(even at 3 to 4 percent per annum), it is a simple fact of life that it costsmore to build today than it did a year ago, 5 years ago, or 10 years ago.Before developers and builders begin a project, they will perform a feasibil-ity study to determine whether the project makes sense They will estimateall of the costs that go into the project, examine the potential market rents,calculate the pro forma net operating income, and extrapolate the value ofthe completed project based on a range of capitalization rates If the rate ofreturn on the developer’s invested capital meets the threshold, the project isdeemed viable and they move forward with it All of these factors drive thevalue of the property and result in a higher per-unit cost compared to olderbuildings Class A apartments are often held by a group of investors thatowns a portfolio of properties, possibly in a real estate investment trust(REIT)

Advantages of Class A buildings include higher rents, lower maintenancecosts, and numerous amenities such as swimming pools and weight rooms

to attract tenants Disadvantages include a much higher per-unit cost to you

as the investor and, usually, a lower initial rate of return Another tage you must be aware of is that in the event of a downturn in the economy,this will be the first group to get hit, especially if the downturn is followed by

disadvan-a strong upwdisadvan-ard cycle This is due to the fdisadvan-act thdisadvan-at disadvan-as interest rdisadvan-ates decline,more and more product comes on line, and as rates start to go back up,there are still a number of projects in the pipeline yet to be completed In avery strong upward cycle, the housing market may become oversaturatedwith supply If the economy softens, Class A properties may be affectedbecause of (1) the oversupply of new product and (2) tenants’ tendency tomigrate toward less expensive housing in an effort to save money and con-serve their own resources Instead of paying $1,500 a month to live in a niceClass A complex with all of the amenities, they will likely look to move down

to a Class B property for only $900 per month I remember that the Texaseconomy, and Houston in particular, got hit hard with a situation very sim-ilar to this in the mid-1980s There was an oversupply of Class A buildingsavailable; oil prices turned downward, and layoffs followed Almostovernight, vacancy rates increased significantly, and prices came down hardand fast Many, many bank loans went bad as investors walked away fromtheir properties

In summary, for the value-play investor, Class A apartments offer the leastupside potential because there is no additional value to create The proper-ties are newer, the utilities are already submetered, and they offer manyamenities to their tenants Furthermore, not only is there no additional value

to create, but investors will often pay a premium for these higher-qualityassets

Class B apartments are slightly older than Class A buildings, usually between

10 and 20 years old, and are still in relatively good condition Class B erties will generally range from $25,000 to $75,000 per unit, depending onthe market These properties are often located in solid middle-income areasand are likely to be the most stable among the various property classes This

prop-is due to the fact that the surrounding neighborhoods are well establprop-ishedand are in relatively good condition, with little or no deterioration Theapartments are still new enough to offer many attractive amenities, and oldenough to be affordable for many families As air-conditioning units andother equipment begins to fail, Class B properties will experience highermaintenance costs than the newer Class A apartments.

Opportunities to create value acquiring Class B apartments are available tothe patient investor who takes the necessary time to conduct a diligentsearch They are not as readily available as Class C apartments, however.The example cited in Chapter 4, the 22-unit building, was a solid B propertythat had not been kept up As previously mentioned, most of the deteriora-tion was aesthetic and was therefore not that costly to bring back into goodcondition

Class C apartments are those that range in age from 20 to 30 years and in

price from $10,000 to $30,000 per unit, depending on the relative marketvalues, rents, and property condition Value-play opportunities are abundant

in the Class C category for a variety of reasons Many of these older unitsare still in fairly good condition, but may not offer some of the amenities thatnewer ones do Cosmetic improvements can do wonders for Class C build-ings, as can the addition of a few of the amenities that newer apartmentsoffer Modernizing the individual units with updated appliances and cabi-nets is an affordable way to add value In addition, many of the Class Cbuildings were built before the notion of submetering became popular Asenergy costs rose, investors in newly constructed units began more andmore often to pass these costs on to the tenants Also, many investors inexisting buildings have retrofitted their apartments with individual meters toprovide the tenants with direct control of the comfort in their respectiveunits, as well as the responsibility for the bills The all-bills-paid propertiesare quickly becoming a dying breed as investors move to shift these costs totenants, especially in the face of ever-higher energy costs

Class C buildings are usually in fairly stable neighborhoods that are wellestablished and have not suffered from deteriorating conditions in thesurrounding area As an investor, however, you must be careful in yourselection of Class C apartments—some buildings may qualify as Class Cunits, but the immediately surrounding area may be suffering from declin-ing values due to high crime, an influx of low-income families who maynot have the resources to properly care for their homes, or any other num-ber of contributing factors Conversely, you might find a C property in a

B neighborhood, which would likely present an excellent opportunity toadd value by bringing that building up to the standard of the community

in which it is located

The migration in and out of neighborhoods is sometimes cyclical innature, with the cycles lasting many years, perhaps even decades Anexample of this has occurred in many larger cities over the past 100 years

or so At first, homes sprang up all around these cities As the cities began

to grow and mature, many people left the inner-city areas and moved tothe surrounding suburbs The decline in demand for inner-city areas led tolower rents and, ultimately, deteriorating conditions in many cases Thegrowth in suburban America created a whole new set of problems, most ofthem related to heavy traffic conditions In an effort to avoid lengthy dailycommutes, younger couples and singles have begun to return to inner-cityareas in recent years Neighborhoods that just a few years ago attractedonly low-income families now find themselves in vogue and have under-gone dramatic transformations In many cases, older buildings have beencompletely razed and replaced with new, upscale apartments that attractaffluent professionals who work in the downtown area Simply put, it iscrucial to note the trends that are occurring in the community where youare considering putting your investment capital to work Acquiring a Class

C apartment complex in a neighborhood that has reversed in trend and isenjoying an increase in popularity and demand may very well prove to be

a perfect value-play opportunity

Class D apartments are generally those in excess of 30 years of age; they

range in value from $5,000 to $10,000 per unit, depending on the relativemarket values, rents, and property condition Value-play opportunities doexist in this category The caveat, however, is that they tend to be more cap-ital intensive Older buildings may require repair or replacement of heatingand cooling equipment, boiler equipment for hot water, roofs, parking lotsurfaces, and the like Depending on the age of the building, it may even betime to replace the electrical wiring This can be very costly Furthermore,you will want to know whether the wiring is copper or aluminum This maysound trivial, but believe me, it is not—for the simple reason that a number

of lenders who specialize in financing multifamily properties will not even

consider loaning money on an apartment with aluminum wiring The risk of

fire is supposedly higher in a building with aluminum wiring than in onewith copper wiring, so they do not loan money on them (Copper versus alu-minum wiring may or may not be an issue in Class B and C apartments aswell, so you will want to consider this when conducting your research.) I amnot suggesting not to buy an apartment complex just because it has alu-minum wiring; I just want you to be aware of the potential issue from yourlender’s perspective

Class D buildings are likely to be found in declining neighborhoods, soimprovements to the property may not result in that much added value,because people who can afford higher rents will likely choose a similar prop-erty in a nicer community at comparable rates This is not to say that oppor-tunities do not exist in the Class D category Quite the contrary is true, but as

an investor putting your hard-earned capital to work, you must go in withyour eyes open A thorough analysis of similar apartment buildings within a 1- to 3-mile radius of the building you are considering will give you an idea ofthe potential upside in the property you have targeted I have seen an 800-unitapartment complex in a solid Class B to B+ neighborhood that was for allpractical purposes abandoned A group of investors came in and gutted the

buildings and completely renovated the apartment complex What was once a

D to D− property is now a very attractive B+ to A− complex that enjoys highoccupancy and was much welcomed by the surrounding community Thisgroup of investors was obviously well capitalized, judging from the extensiverenovations required to bring the apartment complex up to this new higherstandard I do not know personally what they paid for the property, but I amcertain it is worth considerably more today than it was before they bought it.This value-play example probably falls outside the scope of most investors, but

it does represent the breadth of opportunities available, from those thatrequire only a minor face-lift to those that require extensive surgery

Holding Period

For value-play investors, the quicker the turnover, the better Remember,you are attempting to maximize your wealth by going in, creating value, andgetting out Depending on the size of the property you are acquiring and theextent of work being done, your turnaround time may vary from threemonths to two or more years Among the most important factors to considerwhen determining your optimum holding period are the tax implicationsand how they will impact your bottom line

The holding period can be broken into two primary categories for tax

pur-poses Capital gains are treated as either short term or long term Short-term

capital gains are defined as gains on properties that are bought, held for a

duration of less than 12 months, and subsequently sold, while long-term ital gains are defined as gains on properties that are bought, held for a dura-tion of greater than 12 months, and subsequently sold Selling an apartmentbuilding in less than 12 months should be a last resort, so as to avoid short-term capital gains treatment Short-term capital gains are treated as ordinary