It’s a common situation: finding yourself looking for a new property to invest in, yet still wondering how to analyze apartment investments. Finding the right apartment investments is not always an easy task. Finding an opportunity that truly presents a good deal is complex if you’ve yet to invest in this type of property. How do you know if the asking price makes sense? How can you ensure you’re going to get a solid return on your investment? This guide can help.
Begin By Understanding Key Metrics
Learning how to analyze apartment investments begins with a close look at the key metrics involved. There are three ratios that will help you understand the value of a multifamily property like an apartment building. The first of these is the capitalization rate. Sometimes called a cap rate, it’s a multiplier you’ll use with the net operating income, or the money you can make after the expenses are paid but before you make the debt service payment. It’s essentially the ratio of the net operating income divided by the price of the property. Feel free to ask about the cap rate of the property. Most brokers will be happy to tell you that multifamily properties trade at a certain cap rate in the area, and that will help you determine the fair market value. For example, imagine your broker tells you that apartments in the area usually trade at a 5% cap rate. The net operating income of the property you’re considering is $75,000. With those two numbers, you’ll quickly realize that the building should be worth no more than $1.5 million. Nice areas tend to have low cap rates and fairly high prices. You’ll want to select a property that has a cap rate of at least 8% generally. Cap rates tend to vary from area to area, though, so use that number only as a guide. Keep in mind that you’ll need both the cap rate and the net operating income of a property to determine whether it’s a good investment. As you search for that information, though, you may come across some inconsistencies when you work to determine the operating income. In general, you may want to assume the expenses tend to run at least half of what the reported income is, as that will give you a good starting place to determine the value.
The second ratio to consider as you’re looking into how to analyze apartment investments is the cash on cash return. Cash flow is essential with this type of property, and this number is what you have after all of the expenses are divided by the total cash you invested in the property. For example, if you have expenses of $50,000, and you invested $200,000 in the property, your cash-on-cash return rate is 25%. A good return rate tends to be at least 12% after you reach an occupancy rate of at least 90%. While you might initially buy the deal with a lower cash-on-cash return, over the first year as you make the right changes and shift your marketing, you want to ensure that rate reaches at least 12%.
The third key ratio is the debt service coverage ratio, also called the DSCR. This is the ratio of net operating income to the amount of annual debt service that must be paid. Most banks want that ratio to be at least 1.25. This number comes from the net operating income divided by the debt service. So, if your net operating income is $20,000 and your annual debt service is $15,000, your DSCR is 1.3, which falls just above what the bank might want. Generally, though, you’ll want to hit at least 1.5 with the DSCR, so make certain you find a deal that will land you in that space.
Beyond those three metrics, you may want to consider a few other aspects as you learn how to analyze apartment investments. The first one is fairly simple. You’ll want to make sure this type of investment is truly right for you. Even if you already have a substantial real estate portfolio, if you’ve never invested in an apartment building, you’ll want to consider it carefully. Obviously, the cost of owning an apartment building doesn’t just include the initial capital you must invest, but also the ongoing cash required to manage multiple tenants at once. It may also require more time involvement than other property investments you’ve made in the past. You’ll need to handle tenant turnover, maintenance issues, and lease paperwork, among other things. If you’re not sure you’re interested, you can hire a property management company to take care of things, but that may mean added investment and costs on your part.
If learning how to analyze apartment investments seems like it might be too much for you, or it’s just not the right option to meet your needs, then think about the type of building in which you’d like to invest. Apartment buildings vary extensively from multi-story modern units in the city to smaller buildings in the suburbs. Find properties that meet your requirements by talking with a broker about exactly what might meet your requirements.
Finally, if you do find the right property to meet your needs, due diligence is essential on a deal like this. The metrics above are helpful, but think about where the building is located, what condition it’s in, and the overall number of units so you know how easy it will be to manage and what local socio-economic factors could affect the overall profitability of your investment. Make certain you hire an inspector with some experience in apartment buildings, and get leases and any other legal documents from the previous owners so you can spot potential hidden problems.
At Roy & Company, we have more than a decade of experience in helping investors learn how to analyze apartment investments and find the ideal properties to meet their needs. Contact us today to learn more about how we can help you add to your portfolio.
