Apartment investing 101

By ,
Ask a Lender
September 27, 2017


Key Points

What to know about investing in an apartment complex

  • Do your due diligence on the property’s net operating income, rent roll, physical condition and the local rental market.
  • Apartments with up to four units can be financed with residential loans, similar to a typical home mortgage.
  • Apartments with five units or more must use commercial loans, which have more complex requirements.
  • With commercial loans, lenders prioritize your management experience and the net operating income of the apartment.

Apartments are considered relatively stable multifamily real estate investments given the consistent demand for housing and tendency for property to appreciate in value. It does take some sophistication to successfully identify, finance and manage an apartment building, however. If you’re thinking about how to invest in an apartment complex, here are some factors to consider.

Size matters

Before you start looking at complexes on the market, decide what size apartment building you intend to purchase. Lenders evaluate apartment complexes as either residential or multifamily based on the number of units. Residential and commercial mortgages have different eligibility requirements, discussed further below.

The size of the complex will influence the impact of tenant turnover and vacancy risk. Larger apartments with several tenants may require more work to manage, but provide a financial buffer if some of your tenants move out. Vacancy risk can be higher for smaller apartments, where losing one tenant could drop your income considerably.

Consider as well what role you plan to take in the management of the property. If you want an active role in a smaller investment and intend to carry out the daily operations and maintenance work on your own — perhaps even while living in the property — an apartment with no more than four units might work well. If, however, you are investing for large returns and prefer a more hands-off approach, a multifamily apartment overseen by a professional property management company may make more sense.

Identify value

As with any major real estate investment, it is imperative to conduct due diligence on the property. The sellers and their real estate agents will do their best to make the complex look like an unbeatable deal, so verify all of the information provided. It is wise to work with an experienced multifamily real estate agent, appraiser and accountant to get an accurate assessment of the building’s physical and financial condition, and how competitive the local rental market is.

The value of an apartment complex is based on its net operating income, or the revenue generated after all expenses are deducted. There are two ways to add value: reduce operating costs or increase income. As such, consider any repairs or renovations in the context of the rent.

Your accountant can help identify the net operating income of the complex by analyzing the profit and loss statements as well as the rent roll — that is, the list of all apartment tenants and their lease terms. The capitalization rate is another method of estimating value. This is obtained by dividing net operating income by the property’s current market value. Your appraiser and real estate agent can help identify market value by comparing similar properties in the area and looking at the wider market absorption rate — or how long it takes for vacant apartments to be filled.

Examine potential regulatory requirements that could dampen a viable investment. Identify property taxes, which tend to be higher for apartment complexes. Contact the local zoning office to determine how your property is zoned. This will affect how you are able to use it, particularly if you plan to renovate for commercial activity. Zoning can also impact your property insurance premiums.

Residential financing

Lenders consider an apartment with one to four units as residential, and will assess it with the same criteria used for typical home mortgages. Your credit score and debt-to-income ratio play a large role in determining interest rates and other loan conditions.

Properties with up to four units can be financed with residential loans that conform to Fannie Mae and Freddie Mac standards. If you are living in the building, you may be eligible for a U.S. Federal Housing Administration (FHA) home loan, which offers benefits such as a down payment of as low as 3.5 percent and no loan prepayment penalties.

Commercial financing

Apartments with five or more units require multifamily commercial loans, which carry more complex underwriting requirements. Your personal credit and financials hold less weight in commercial loan eligibility. Lenders are more concerned with the net operating income of the apartment, its debt service coverage ratio — that is, the net operating income divided by total debt — the loan-to-value ratio and your demonstrated experience in property management. A down payment of at least 20 percent is typically required. Compare lenders and their requirements for financial reserves, commercial usage limits and any prepayment penalties.

Fannie Mae and Freddie Mac offer multifamily loan programs with fixed and adjustable rates. Loan terms are up to 30 years with a minimum debt service coverage ratio of 1.25 and loan-to-value ratio of up to 80 percent. These programs typically have minimum occupancy requirements.

There are limited government-backed financing options for multifamily apartments. The FHA 223(f) program can finance the purchase of eligible multifamily rental housing with a debt service coverage ratio of at least 1.15 and maximum loan-to-value ratio of 83.3 percent for market rate properties. Loan terms are up to 35 years with low interest rates. Additional government-backed programs exist to finance specialized rental housing for low-income individuals, seniors and underserved communities.

Protect yourself

Most real estate investors form a limited liability company (LLC) to separate personal financial holdings from those related to investment properties. While forming an LLC is expensive, it can protect your home and personal assets.

Determining whether an apartment building is a good investment depends on your finances, dedication and patience. Carefully review potential properties with a team of professionals and compare lenders for the best financing.

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