I am a commercial mortgage banker. Last week a client called me bouncing off the walls with excitement, asking me to finance a $1.7 million 18-unit apartment complex in Lincoln, Nebraska. I grilled him about the neighborhood, the occupancy, the net income and the condition of the property, knowing that just the previous week he was gung-ho to buy a smaller and much more expensive property in his hometown of Seattle. He replied that that property was overpriced while this one was beautiful, at under-market rents and 100% occupied with a waiting list.
I did some research of my own and found that the building was in a working-class neighborhood, the rents were actually high based on the area median income and the photos my client had seen were old — the property didn’t look as good as he thought. What’s more, I knew he couldn’t manage this property himself but would have to hire management that specialized in lower-income tenants.
The previous property that had turned my client’s head was diametrically different: it was in the trendy Capitol Hill neighborhood of Seattle where affluent millennials and retired people thrived. My client was correct that the property was overpriced, but I felt it was a better investment for him. He lived nearby and could keep an eye on it; he had a team of trusted professionals there and it fit his lifestyle. He loved managing his own properties, in great areas, with good tenants who gave him almost no headaches.
The number one tenet of commercial real estate investment is “Raising rents equals raising property value.” Capitol Hill has demonstrated this perfectly, having made it through the last three recessions unscathed with consistent annual rent increases. So how do you buy an overpriced apartment building safely and profitably? Here are six tested tips from my own experience:
1. Choose a property in a good neighborhood close to home. This way you can check on it regularly and be immediately available if something goes wrong. More importantly, you know the market because you live there and are likely to know professionals who will watch your back — trusted real estate brokers, bankers, property managers and contractors. Finally, buying in a good neighborhood means tenants are more likely to pay rent during a recession, because they have more income and likely have savings to boot.
2. Don’t take shortcuts with due diligence. With such low returns today, you cannot afford to make any mistakes on the property’s net operating income, occupancy, tenant quality and physical condition. Ideally, get the past three years of operating statements and the past 12 months of rent rolls. You’ll want to do a rent collection report comparing rent showing on the rent rolls to what’s actually collected showing on the operating statements. Lastly, even if you are getting an inspection done, walk every unit yourself with a contractor.
3. Don’t overleverage, and make sure you can break even at 75% occupancy. During the Great Recession of 2008, my clients who put 25% or more down and could break even at 75% occupancy after paying all the expenses and the mortgage did not lose their properties. You will need to do a two-year pro forma based on as many facts as you can muster to demonstrate this.
4. Choose inexpensive value adds. It’s almost impossible today to find rental property needing major rehab that is not overpriced. Choose properties that, based on their current condition, have under-market rents that can be raised soon and expenses that can be lowered. Then stick with inexpensive cosmetic upgrades like paint and new floor coverings.
5. Choose the lowest payment financing. This is essential to increase your return until you can raise rents and lower expenses. Buying at high prices means you will have very little profit for the first two years, so this is the one time choosing a shorter-term loan with the lowest payments makes sense. If you can get interest-only payments, all the better.
6. Have working capital and additional sources of income. This is the big one: if you are going to overpay for a property today, you will need time to make it profitable. Cash in the bank and more than one source of income will ensure you can hit a home run even if there are costly unexpected repairs or a recession.
No one knows if the price of investment property will keep going up or come down soon. What is known is that if you decide to buy at today’s high prices, you absolutely must do so intelligently. This means choosing a property that doesn’t need much work in a market you understand, knowing the property’s economic and physical condition, getting the best financing and most importantly not overleveraging and not being broke after closing.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.