In This Guide
- Where to start
- Are you cut out to be an apartment building owner?
- The most attractive thing about buying an apartment building
- Identify multifamily ownership goals
- Decide on your purchasing entity
- Decide on management type
- How much money is this going to cost anyway?
- Qualifying for the loan
- Finding a Loan Broker
- Multifamily loan programs
- What kind of property to start with
- Geographic location
- Finding Your First Deal
- Vetting the Multifamily Property
- Finding a Commercial Broker to Represent You
- Making an offer
- Due Diligence
- Lender Underwriting and Closing
So You Want To Buy an Apartment Building: Where to Start
Good for you. Owning a multifamily property can generate enormous net worth as well as semi-passive income.
But where do you start?
The short answer: in your mind. You have to make a decision that you’re going to do this. You will overcome all obstacles and put in the work.
If buying an apartment building were like buying stocks, everyone you know would have one. But you can’t simply go online and buy an apartment building online. It’s more complicated than that. It’s a physical asset that comes in many forms, and it’s not exactly clear how to acquire one. There’s no standard formula.
That being said, we’re going to give you as close to a formula as we can in this post. When you finish reading this, you’ll have a good idea how to buy your first apartment building from start to finish. Ready? Then let’s go.
Are You Cut Out To Own an Apartment Building?
We just said you have to make a decision and commit. But honestly, not everyone should make that decision. First, decide if it’s right for you.
If you’re reading this, you probably have already heard of pro investors making millions and retiring early from multifamily real estate. But you probably haven’t heard of things going wrong.
Real World Issues
Since this is the real world, things go wrong even with the safest investments. Owning property is no different. What if there’s a drug dealer in the property? What if a $100,000 problem appears after you close? What if a major employer closes up shop in your town?
There are ways around these issues, but before you commit, make sure you’re ready to deal with anything that happens. A multifamily property owner needs nerves of steel and a strong gut.
Comfortable with Tough Decisions, Confrontation
Another thing to expect are tough decisions. Do you evict a single mother for non-payment? Do you allow a small cat that a mom gave her daughter for Chrismas, even though there’s a no-pet policy?
You’ll struggle with these decisions because you’re dealing with people and lives. You have to be comfortable with confrontation and disappointing people.
If that’s not you, no problem! Invest in CDs, bonds, and the like.
But keep in mind that with lower risk comes lower rewards, and vice versa.
High potential returns, both in passive income and net worth are why people get into apartment investing in the first place. Have you decided to proceed? Great!
The Most Attractive Thing About Apartment Investing
Most people assume the coolest thing about owning a multifamily property is all those rents coming in. If you have a 20-unit building, and each renter pays $800 per month, that’s $16,000 per month flowing into your business.
There are mortgage payments and expenses of course, but that’s still a lot of money. Likely more than you make at your day job.
While that’s nice, it’s not actually the best thing about commercial property. It’s actually your ability to increase the value substantially by increasing property income.
New apartment investors might not realize that the property’s value is determined not by “comps” or comparable properties like residential homes. Value is determined by Net Operating Income, or NOI.
NOI is the property’s income after expenses.
For example, if you have our property above that generates $16,000 per month or around $190,000 per year. Operating expenses like management, legal fees, utilities, etc. are $120,000 per year. Your NOI is $70,000.
Here’s the formula: Value = NOI / Cap Rate
At a 5% cap rate, the property is worth $1.4 million. (Don’t worry about what cap rate is yet.)
Now imagine you raise rents from $800 to $900 for each of the 20 units. Now your NOI is $96,000 as long as your expenses remain the same.
Your value just skyrocketed to $1.92 million at the same 5% cap rate. You just gained over half a million dollars in net worth.
This scenario is not uncommon in multifamily real estate. And yes, this is the coolest thing about owning an apartment building.
Identify Multifamily Ownership Goals
Why do you want to own multifamily real estate?
For some, it’s to fix and flip and make a profit, then do it again. For others, it’s to buy and hold, maximizing operating income so they can eventually leave their day job.
Others will buy a smaller apartment complex for an additional income stream but keep their job. This is a great idea as well.
Almost any goal is okay, but decide early in the process. It will affect the types of property you look for.
If your goal is to diversify your investments away from stocks, maybe a 5-10 unit building works for you. But if you want to eventually quit your job and do real estate full time, you might want to look for bigger properties.
However, there’s nothing wrong with starting small. You can always sell your first property and use the profits to go bigger. You may have to do this anyway if you don’t have a lot of capital upfront.
In any case, write down your goals and your 5-year plan. Don’t just have an idea in your mind. Write it down and keep it accessible. Look at it every day. Weigh every decision on your journey against this plan.
Decide On Purchasing Entity / Structure
Many new investors assume they must “go it alone” and purchase the apartment building as an individual. But this is just one way to buy the property. Following are ways to buy a property.
Individual: You can purchase a property on your own or create your own LLC that you solely own to buy the property. (It’s recommended to form an LLC instead of putting the property into your own name.) This gives you full control but also requires more capital upfront and you’re taking on all the risk, too.
Partnership: You can buy a bigger property by pooling assets with another like-minded investor. For instance, say you need 10% down to buy a property and you have $50,000. You could buy a $500,000 property on your own, but a $1 million property by partnering up with someone with the same amount to invest. While this can be a good strategy, make sure your partner is reputable and has the same goals and philosophy. You don’t want a partner who wants to flip the property if you plan for long-term income.
Syndication: This is when you simply give a chunk of money to a buyer who then goes out and selects a property and tries to maximize return for his or her investors. This is a passive way of investing in apartment buildings, and easier than doing the legwork yourself. However, your upside is limited, and you don’t get the same pride of ownership or long-term income with this method. Plus you miss out on the knowledge you would have attained by purchasing as an individual or partnership.
Decide on Management Type
No matter what size an apartment building you buy, someone is going to have to manage it.
The two main ways of managing an apartment building are self-management and 3rd party management. There are pros and cons to each
- It’s cheaper. By doing the work yourself you lower expenses and increase NOI, thereby increasing the value of the property.
- No one will do a better job than you. Since you own the building, you have the biggest interest in its success.
- You gain experience. You gain valuable knowledge on tenant issues, managing leases, marketing, and so much more.
- It takes time. You likely can’t manage a larger property while working full time. You’re all-in at that point.
- You might make mistakes, and even break tenant laws you didn’t know about.
3rd Party Management
- Frees up time. You can keep a full-time job more easily
- Easier to qualify for loans. Lenders often require outside management, especially for first-time apartment owners
- Passive income. Makes apartment investing more of a passive income stream
- You still have to manage. Even if you outsource management, you still have to keep eyes on the management company and make sure they are doing things as promised
- Cost-prohibitive. Especially for smaller properties, there may not be enough income to support 3rd party management
In short, the more management you can pull off yourself, the more profitable your property will be. But it can backfire if you take on more than your time and skills can deliver.
So How Much Is This Going to Cost, Anyway?
The amount you need to close varies greatly depending on many factors including purchase price, down payment, loan type, and lender.
Buying an apartment building will take some solid capital. It’s difficult to buy a commercial property like someone might buy a home with no money out of pocket.
Just as a ballpark example, let’s say you were buying a $750,000 25-unit property with a 10% down bank loan.
- $75,000 down payment
- $22,500 closing costs (about 3-5% of purchase price)
- $50,000 tax and insurance reserves
- $6,250 replacement reserves ($250 per unit)
- $30,000 escrowed improvement funds for things needing repaired right away
- $183,750 cash upfront to close the deal. Keep in mind this is a very generalized example and your costs could be much higher.
Beyond this total, you’ll likely need 12 months of principal and interest payments in reserve. That’s a little under $40,000 in this case (~$3,200/mo at 4% interest rate). So in total you’d need around $220,000 in liquid funds to close this deal.
Finding and Qualifying For a Multifamily / Apartment Loan
This step could come much later, but this step could determine how you go about the rest of the process.
Your biggest challenge in qualifying is that you’re a first-time investor.
As of this writing, Fannie Mae and Freddie Mac (government agencies) require at least 2 years of experience in multifamily ownership to qualify. As recently as early 2020, a new investor could buy with a Freddie Mac Small Balance Loan. This is no longer the case.
So what are alternatives?
Find a partner with experience. Loans that require experience only need it from one partner. So you could go in on a property with a partner who already owns multifamily real estate. In this partnership, you gain the experience that will be required the next time you buy.
Research bank loans. Not all lenders are created equal. Each bank or commercial lender can make its own rules. Some may require experience, some might not for highly qualified buyers. Try your local bank first, since it is more likely to approve a loan for a local buyer and local property.
Make it a very safe deal. One of the best strategies is to make the deal a no-brainer for the lender if you can. That means putting more down, demonstrating net worth equal to the loan amount, and having 10-15% of the loan amount in liquid reserves after closing.
Financial Standing / Net Worth / Liquid Reserves
- Good to excellent credit
- For the most part, no history of bankruptcy, foreclosure, tax liens or serious late payments or delinquent accounts
- Net worth of the borrower and all key principals must match the loan amount. Yes, if you need a $1.2 million loan, you may need to show a $1.2 million net worth
- 9-12 months of payments in liquid assets
You’ll need to supply documentation to the lender. While documentation requirements will vary greatly by lender, below is a list of common items.
- Current rent roll/Occupancy report with lease start and end dates
- Last 3 years operating statements
- Property description
- Trailing 12-month operating statements (T12 or TTM)
- Photos of the property
- Proforma – how you plan to manage the property going forward (although most weight will be given to the current operations. You can’t get a loan amount based on future NOI). This includes a 12-month future budget.
- Purchase and sale agreement
- Real estate tax bills
- Vendor contracts for 3rd parties servicing the property such as landscapers
Personal financial documents
- A personal financial statement (PFS)
- A schedule of real estate owned (SREO) — meaning a list of properties already owned by the buyers, current values and debt on each.
- A business plan for property ownership: how will you ensure successful management, upkeep, and operating income?
- Various forms such as a credit pull authorization and property questionnaire
- Liquidity verification, i.e. 2 months bank statements
- Buying entity org chart and documents
- Appraisal: Attempts to determine value based on property income and the area market
- Physical needs assessment: Determines which systems may need to be replaced and the amount of money needing to be set aside for these repairs
- Environmental assessment. Also known as a Phase I Environmental Assessment or ESA, this examines the property for potential contamination. If any is found, a Phase II or Phase III assessment may need to be completed
- Structural engineering report. Determines soundness of the building’s load-bearing components.
- Title report. Ensures there are no claims on the ownership of the building.
- Zoning report. May be required if there are questions about the building’s current zoning
- Property inspections. The lender may require an overall inspection of the property or inspection of a specific system such as the roof
- Property Survey. Might be required if there are questions about property boundaries or title
Keep in mind that not all of these reports may be required, but are based on the lender, loan type, and property.
Finding a Commercial Loan Broker
You can go straight to a lender, which may save you a bit of money, or — advisable for first-time buyers — find a commercial loan broker.
Brokers might charge around 1% of the loan amount for their services, which could be well worth it.
First of all, many bank loan officers are paid by salary, not commission. They still get paid if you don’t get the loan.
Brokers, however, don’t get paid until the loan closes. They are highly motivated to earn that 1% commission!
A broker will shop multiple lenders based on your profile and criteria to find the best deal — or to find a lender that will approve you at all. Their knowledge of a wide array of lenders is invaluable at this stage of your investing journey. It could mean the difference between getting approved or not.
So how do you find a quality broker? You can ask your commercial real estate broker for recommendations. He or she might suggest people you should trust and those you should avoid.
It’s a good idea to ask about the person’s experience and how many multifamily transactions of this size he or she has completed. References might not be a bad idea either.
Loan Programs to Investigate
With a good loan broker, much of the work to find the type of loan could be done for you. But it’s worth having a basic understanding of each major loan type you might encounter.
Local Bank Loans
Your local bank may be your best bet when buying your first multifamily property. Many of the nationwide loan types require experience. This may be true of your local bank as well, but it has a higher chance make an exception to a local buyer purchasing a local property. Often at banks, there’s an approval board that decides to do the loan. If you present a strong case (and maybe even know someone on the board), your chances greatly improve!
You might be able to arrange financing directly from the seller. This will require finding out the seller’s motivations. If they are more concerned with unloading the property than with the instant cash, they might issue you a loan for all or part of the purchase price. While this kind of financing isn’t too common, it does happen. You can sometimes get seller financing on top of a traditional first mortgage to cover more of your down payment. Your primary lender must know about and approve this secondary loan, however.
Some sellers want to hand you their loan rather than having the existing debt paid off at closing. This is called a loan assumption. The buyer “assumes” or takes on the existing loan rather than getting a new one.
Why? Often the current loan on the property comes with a stiff prepayment penalty. This is a penalty the lender requires of the loan is paid off before a certain amount of time has passed. Let’s say the seller has a 3% penalty on a $1 million loan. That’s $30,000 that is taken out of the seller’s profit.
The seller might offer to knock $30,000 off the purchase price in this case if you assume the loan. It’s the same to him or her either way.
You still have to go through an approval process to assume a loan. But if you’re approved it could be a good deal for both sides.
Fannie Mae and Freddie Mac (Agency) Multifamily Loans
We do a deep dive on each of these loan types:
- Fannie Mae
- Freddie Mac
Fannie Mae and Freddie Mac are government agencies that provide financing to investors with the goal of providing affordable housing to renters. As such you may be able to find more lenient terms than with bank loans, although that is becoming less the case these days.
Most likely, you will be looking at the “small balance” options within Fannie and Freddie (usually $750,000 to $7.5 million). These offer a streamlined application process and lower closing costs compared to other loan types. For some borrowers, the Agencies will lend up to 80% of the purchase price with loan terms up to 30 years — very similar to the typical residential loan.
HUD/FHA Apartment Loans
These loans require more documentation but offer more lenient approval criteria. For example, you may qualify for a loan up to 85% of the purchase price. Keep in mind that you may need to bring on a partner, since HUD will approve experienced borrowers more easily.
CMBS Multifamily Loans
Commercial mortgage backed securities (CMBS) loans, also called conduit loans, may be an option for first-timers, although they are better designed for experienced investors seeking loan amounts above $2 million. These loans are packaged up by a bank and sold off to investment funds for the expected interest income. Getting approved for a CMBS loan is typically easier when you have a low loan-to-value (bigger down payment) and high debt service coverage ratio (DSCR). See our discussion of DSCR later in this guide.
What Kind of Property Should I Buy My First Time?
There’s nothing wrong with starting small. Most first-time investors will have to start small because they don’t have the large amount of capital it takes to buy a 50+ unit apartment building. There are certainly people who buy this big on their first deal, but it’s certainly not required.
According to master multifamily investor Peter Harris, here are reasons to start small:
- Easier to understand. You’ve likely rented an apartment, owned a home, or rented out a single-family residence. A 5-20 unit multifamily is similar to your personal experiences so far.
- Easier to manage. Needless to say, managing 10 tenants is a whole lot easier than managing 50 or 100. Plus, you can likely do it yourself.
- Less competition. Big investment firms and established syndication groups are going after the 100+ unit properties to achieve economies of scale and give significant returns to investors. These high-powered groups aren’t going after 5-20 unit properties. So you’ll have an easier time getting your offer accepted.
- Opportunities to add value. You can add serious value to multifamily properties by increasing rents and decreasing expenses, as discussed in the section above “The Most Attractive Thing About Multifamily Investing.” Smaller apartment buildings may have deferred maintenance or simply look ugly on the outside due to neglect, perhaps because a small owner simply bought years ago. You can attract bigger rents by painting the outside, sprucing up landscaping, and improving common areas. Relatively small improvements can really add value without breaking the bank.
- Easier to finance. First-time buyers will have an easier time getting approved for a smaller loan amount. Your net worth, reserves, and closing cost requirements will be lower for a smaller building.
- Less sophisticated sellers. Many smaller apartment complexes are owned by “mom and pop” owners — individuals instead of hedge funds or huge corporate owners. You can better negotiate with these owners, request seller financing, and get more creative on the purchase structure.
Sure, buying a huge property is doable your first time, with the right partnerships, but it’s generally wiser to start small, get your feet wet, and make sure multifamily investing is what you want to do.
Why You Need To Look for 5+ Units
You might be wondering why we suggest 5-20 units. Why not a 2-4 unit?
In the real estate world, any property with 1-4 units is residential. It’s subject to different financing — similar financing that you use to buy your primary residence. These loans are based on your income, not the property’s cash flow.
A building with 5 or more units is considered commercial. You can get commercial loans, which are often easier to get because you can get creative — these loans aren’t as tied-down with regulation like residential loans.
But the biggest reason is that you can increase value on a commercial property faster than with a residential property. See the section above “The Most Attractive Thing About Apartment Investing.” If you increase your Net Operating Income (NOI), you increase the property’s value. In that section, we saw an example of raising value by $500,000 just by adding $100 per month rent to a 20-unit property.
With a residential loan, your value is based on comparable sales in the area. Even if a 4-unit makes you $100,000 per year, it’s not worth much more than the 4-unit across the street that makes $50,000 per year. There’s not much value-add opportunity with a 1-4 unit.
But with a 5+ unit commercial property, you can add value like this:
- Improve the property
- Raise rents
- Appraise the property based on higher NOI
- Refinance or sell to reap the profit
- Invest in a bigger apartment
If going bigger and bigger is not your goal, that’s okay, too. But it’s still worth finding a 5+ unit property so that you can get more out of it if you ever decide to sell.
Types of Apartment Buildings
There are three main types of apartment buildings:
- Low-rise: Typically three or four stories or fewer.
- Mid-rise: Five to nine stories
- High-rise: Ten or more stories
Newer investors will likely look for low-rise buildings for obvious reasons. Mid-rise and high-rise buildings can get quite expensive ($50 million+) and are more suited to large multifamily syndicators and hedge funds.
However, don’t rule out mixed-use buildings, which typically have retail on the ground floor and residential units above. These can provide diversified income. But due to the pandemic (and Amazon), leasing out the retail space might be a challenge in today’s market.
Choosing a Geographic Location
Warren Buffet said “Invest in what you know,” and this can be applied to multifamily investing.
New investors should try to buy in a community that they know well. You will know the area employers, demand for apartments, crime rates, housing costs and local rents. You may even already know a local commercial real estate broker or even an apartment owner that can help you find your first deal!
Plus, you’ll be able to visit the property regularly, make a connection to tenants, notice disrepair or mismanagement, and generally be a better owner.
Yes, it’s tempting to look at property in other states if you live in an expensive area. Often, values are high and rents are average. Still, you are likely to do better as a local investor before you try your hand at long-distance investing.
Oh, and other benefit: you’ll get approved for the loan much more easily, especially when using a local bank for a local property.
How to Find Your First Deal
One of the biggest obstacles is finding a decent property for sale.
There are sites like loopnet.com, but these properties are often already picked over and passed on by experienced investors.
According to multifamily guru Peter Harris, there are backdoor methods to finding a good property before anyone else does.
Commercial broker networking
You can look on loopnet.com for a property about the size that you’re looking for. But remember that this property is probably not a good one, so you’ll just call the agent and say that you’re a local investor looking for a property that has some upside in the following ways:
- Rents are lower than market
- It has been mismanaged and rents haven’t been collected
- Occupancy is a little low but not vacant
The goal is to get on that agent’s radar. You want him or her to call you the next time a property like the one you just described comes on the market.
Ideally, you get the call and secure the deal before it goes public. Agents love a ready buyer to whom they can sell the property fast.
The point of direct mail (DM) is to get an off-market deal. Once a property is officially listed, you’ll have competition from experienced investors. You can avoid that by contacting the right owner at the right time.
This is a numbers game. There’s little chance that you’ll make progress reaching out to 2 or 3 apartment owners. You’ll likely have to direct mail very good lists for months to get a response.
But the payoff can be big. You can find an owner whose main concern is getting rid of the property. Plus, they can save a 6% broker’s commission by selling direct to you. There’s upside for both parties.
Types of properties to target:
- Properties with out-of-state or absentee owners who don’t have a connection to the property. Management and repairs are probably quite the headache for them.
- Properties that appear run-down or neglected (you’ll have to drive around town and take notes on properties, then research ownership)
You may end up wanting to buy DM lists. That can be faster, but keep in mind that a lot of other investors are buying those lists too.
In any case send out a campaign every 4 weeks. Eventually, you’ll probably hit an owner at the right time.
Underwriting (Vetting) the Multifamily Property
So you’ve found a willing seller. Now what? How do you know if it’s worth buying?
By this point, you’ve done some initial weeding-out. As discussed in the above section “Why You Need To Look for 5+ Units”, you’ve likely removed 1-4 unit properties from your search, even if they will cash-flow and appear to be a good deal.
Beyond that you have to “underwrite” the deal, meaning calculating all the elements of the initial transaction and ongoing income and expense. This is different than the lender’s underwriting process. This is your personal process of vetting the property’s financials and opportunities.
In this step you will
- Find a physically/structurally sound apartment building
- Find a financially sounds apartment building
Finding a Physically/Structurally Sound Apartment Building
Look for ways you can:
- Improve management
- Upgrade appearance and amenities
- Cut costs
- Raise rents (after making improvements)
- Make it a better place to live
No matter what your goal — flip or hold — these are fundamentals that will improve your chances of success.
The idea property has basic systems that are in good condition but is cosmetically run-down. These have the greatest value-add opportunities.
Some repairs can get costly fast.
For this reason, you might pass on anything that is too old. These properties can get quite expensive to maintain. This depends on your comfort level with major repairs and might not be as much a concern if you have enough in reserve to deal with a large repair. But keep in mind that the purchase price should reflect these aging systems.
Some things to avoid are fault:
- Aging plumbing
- Electrical that is malfunctioning or not to code
- Dying HVAC systems
- Mold remediation
- Asbestos remediation
- Leaking roof
Sometimes, you can build the cost of repairs into your analysis. If it still pencils out, great. But don’t accept both a high purchase price and potentially expensive repairs.
A property inspection will reveal most (but not all) faulty systems. But before getting that far, visit the property on your own at first. Does it look kept up, somewhat neglected, or totally abandoned by the owner?
If the property makes sense after you analyze financials, you can request a tour from the agent where you can get a closer look.
Class A, B, and C properties
As a first-timer, you will likely be looking at a lot of Class C properties. There are no hard-and-fast definitions of A, B and C properties. Class C means these are older properties with few amenities and older systems, while Class A properties are newer and probably in more desirable neighborhoods. Class B is somewhere in between.
There’s nothing wrong with going for a Class C property. In fact, there are likely more value-add opportunities. But as mentioned above, don’t pay Class B money for Class C quality. Make sure the property’s price reflects its class and that the problems you inherit are manageable.
Finding a Financially Sound Apartment Building
The building has to have financial strength as well as physical strength.
Financially vetting a property is a complex process which we will break down in another post. However, you want to make sure that you have a strong debt service coverage ratio (DSCR). DSCR is a comparison of the property’s income and mortgage payments.
For instance, you may need a DSCR of at least 1.20x to qualify for a loan. This means that the property must take in 20% more than its debt payment obligations.
As an example, say your proposed payments were $5,000 per month, or $60,000 per year. The property’s annual NOI (income after all expenses) would have to be $72,000 per year to qualify.
$72,000 NOI / $60,000 debt service = 1.20x DSCR
Finding accurate NOI can be complex. Luckily, you can do some calculations and get fairly close. Often, the marketing package from the agent who is selling the property will contain the information you need:
- Current rent roll
- Trailing 12-month operating statements (T12 or TTM)
- Proforma – this is an estimate of what the income could be going forward. However, the selling broker may paint a rosy picture. It’s always best to get the actual income and expenses via the T12
According to real estate investor Michael Blank, make sure expenses are at least 55% of income. If it’s lower, there’s likely something missing. For instance, perhaps the current owner self-manages, but you plan to hire out management. This is a significant expense and one that you’ll want to factor into your numbers.
You can find your NOI by subtracting expenses from income.
Income: How much income the property actually collected in the last 12 months. This number might be different than proposed income, if higher rents or occupancy are projected. Actual numbers are always better.
Expenses: How much did it cost to operate the property over the last 12 months?
- 15-unit property. 10 units at $750 per month, 5 units at $850 per month. Total potential revenue: $11,750/mo or $141,000/yr
- Vacancy, unpaid rents, concessions: Greater of actual adjustments or 10%: $14,100/yr
- Revenue: $126,900/yr
- Greater of 55% of expenses or actual expenses
- Expenses per the financials in the marketing package: $88,000 including 3rd party management. This is about 70% of net income and includes outside management, so this seems like a legitimate amount.
- $126,900 revenue less $88,000 in expenses equals an NOI of $38,900
Finding the Right Price Based on NOI and Cap Rate
The property’s value is determined largely by its NOI. Here’s the formula:
NOI / Cap Rate = Value
The cap rate, or capitalization rate, is the expected return on investment from a property. On sites like loopnet.com, there will be an advertised cap rate. Cap rates are typically determined by the market. Hot markets may yield a 3% cap rate while less desirable locales may warrant an 8% cap rate (“8cap”).
Let’s say we’re in a medium market with a going 5% cap rate. Let’s plug in numbers from above to see if the asking price is a good one.
$38,900 NOI / 5% (0.05) cap rate = $778,000
In a perfect world, the broker/seller would be asking $778,000 for this property. Likely, they are asking more. But you can use your calculations (as long as they are sound) to bargain downward.
This is also a good way of determining if the property is something you want to make an offer on. In this scenario, a $750,000 asking price would likely be a good deal. But $850,000 is likely too much.
As you can see, there’s a lot of room for interpretation between revenue, expenses, and cap rates. But if you have a solid understanding of these elements, you can vet apartment building purchase prices and bargain quite effectively.
Keep in mind that you’ll also have to make sure you can get financing for the building.
Lenders will typically require a 1.25% debt service coverage ratio (DSCR). Here’s the formula for that:
Income – Expenses (NOI) / Debt Service (Payments) = DSCR
Let’s say the property price is $750,000 – a great deal based on our analysis. We put 20% down or $150,000. Our loan amount is $600,000 at an example 4% rate.
Our payment is $2,860/mo and $34,320/yr based on a 30-year loan.
Taking our example above, let’s plug in numbers.
$38,900 (NOI) / $34,320 debt service = 1.13x DSCR.
We’re a bit low since we want a 1.25% DSCR to qualify. In this case, we could look at taking a bigger prepayment penalty to get a lower rate, say 3.75%. Then we could put another 5% down to lower the loan amount to $562,500 and reduce the rate even further to 3.7%. Now we have a $2,590/mo payment. Let’s try again:
$38,900 (NOI) / $31,080 debt service = 1.251x DSCR.
We made it! In this case, you could also present to the lender quick opportunities to bring up revenue and cut expenses. You would increase NOI and DSCR, perhaps without having to put more down.
Finding a Commercial Real Estate (CRE) Broker to Represent You
It’s easy to find CRE broker. It’s harder to reassure them that you’re a serious, financially capable buyer.
You can do it, though, by presenting your criteria and documentation in a professional manner. Spend the time working out your ideal property criteria:
- Price range
- Class A, B, or C
- How soon you want to buy
- Extent of repairs you are willing to do
You’ll also want to send proof of funds, showing that you can actually buy a property he or she shows you.
It also pays to study up on the lingo, and know basic levels of income you are looking for so you can answer questions intelligently if they come up.
Just like a residential real estate agent wants to see a lender’s pre-approval before showing you properties, you have to prove you are a serious, qualified buyer.
Making an Offer
Now comes the fun part. You’ve done your homework, vetted the property including its condition and financials. Now you’re about to make an offer. How does that work, exactly?
The LOI enables you to make an offer without the time and expense of drawing up a full purchase and sale agreement (PSA). In competitive markets, you would spend all your time drafting PSAs with very little chance of getting them accepted. You can draw up an LOI in 5 minutes once you’ve examined the property financials, so you can cover more ground with less work.
There’s a good chance the broker will send a counter offer to your LOI, which is pretty normal. There will be some back and forth, but hopefully you and the other party can come to common ground.
If all goes well, the seller’s broker will accept your LOI, then you have the amount of time you stated in the LOI to draft the official PSA.
Purchase and Sale Agreement (PSA)
The easiest way to work up a PSA is with the help of your commercial real estate broker or attorney. There are quite a few legal pitfalls in any real estate transaction, so don’t just download a one-page PSA off the internet and call it good. Experienced investors have done it, but it’s not advised.
If you have an accepted LOI, use it to help your broker or attorney to work up the PSA. Getting the PSA signed shouldn’t take too much longer unless there was something the seller didn’t expect. Hopefully, you have a signed (a.k.a. “fully executed”) PSA back quickly.
Note that you won’t start inspections, or serious due diligence until the offer is accepted. Contingencies in the contract protect you in case something unforeseen comes up, like a huge repair expense discovered in the inspection. As these things appear, there’s always room to negotiate price or other aspects of the deal.
Shortly after your offer is accepted, you’ll put in the agreed-upon earnest money into escrow, which is a 3rd party holding company that will distribute funds to appropriate parties at the end of the transaction. Earnest money can be used for down payment and closing costs — it doesn’t just disappear.
Perform Due Diligence
At this point, the seller has sent you a lot of information about the property. Now it’s your job to verify it.
Hopefully you’ve received all financial documents by now. If not, now is the time to make 100% sure the property financials are as you thought they were.
Next, perform a physical inspection using a professional inspector. Even if you know a lot about construction, you will likely miss things that a trained and experienced inspector will catch. Inspect every unit. If you find major deficiencies, go back to the negotiating table with the seller. Try to get concessions like a lower sales price or funds for repair.
Also make sure the property has no liens on title and is zoned correctly. Do a seismic report, site survey, and get other 3rd party reports if there are any questions about the property or the lender requires them.
Lender Underwriting and Closing
When your offer is accepted, things kick into high gear at the lender. It will gather the purchase contract (purchase and sale agreement) as well as documentation about the property. You will submit any personal documentation that is still pending as well.
You will conduct your inspections, appraisal, and other property reports. Usually, the lender will order the reports they require.
In about 45-60 days, the loan will go all the way through the process. You will lock in the rate, typically upon loan approval.
The lender will contact you for any needed documentation. Be ready to gather and submit. You don’t want to hold up your loan process. Also, notify the seller that he or she needs to be on top of supplying things that the lender asks for.
When the loan is fully approved and through underwriting, the lender will draw loan documents. You will go to the escrow company to sign everything. The seller will sign documents transferring ownership to you.
If all goes as planned, the loan closes and you are officially an apartment building investor. Congratulations. It took a while to get here but you made it!
While this is just the beginning of your multifamily journey, this is an achievement worth celebrating. Time to go take a day off after an involved process. Tomorrow, you start managing this high-value asset!