Apartments can be good investments because they can provide strong cash flow, appreciation that you can control, diverse income sources, scalability, centralized maintenance, and significant tax benefits.
Apartments are coveted by many real estate investors for their powerful cash flow and other benefits, but there are also risks to investing in apartments that need to be examined and addressed.
This table shows the benefits and drawbacks of apartment investing that we will be covering in this article. Let's get started!
Benefits of Apartment Investing
Drawbacks of Apartment Investing
Strong Cash Flow
|Apartments Are Expensive|
Qualifying For Financing is Difficult
Diversification of Income
Financing and Leveraged Returns
Harder to Sell
Can Support Property Manager
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Table of Contents
Benefits of Apartment Investing
Apartments Can Have Strong Cash Flow
Cash flow is the biggest benefit of apartment investing. If purchased correctly, each apartment unit can generate between $100 to $150 in cash flow per month. Given the high number of units in a typical apartment complex, you could receive a considerable amount of money every month from your apartment investment. Even one apartment may cover your day-to-day living expenses, which is a tremendous benefit.
There’s not much more to say on this point – the strong cash flow is a massive benefit of apartment investing.
Another nice feature of apartments is that you can generate extra income from the apartment through amenities. You often see apartments with laundry rooms, vending machines, paid parking spaces, etc. that can all add to the apartment owner's income each month.
Apartments Can Have Forced Appreciation
One of my favorite features of apartment investing is your ability to “force” your apartment to appreciate in value.
What is forced appreciation?
Forced appreciation is a strategy used by real estate investors to increase the value of a multi-family property by increasing its net operating income (NOI). This can be done by increasing income or reducing operating expenses.
For context, NOI is basically income minus operating expenses (mortgage payments are excluded).
Increasing NOI works because the price of an apartment does not depend on how much other apartments in the area are going for. That’s how single-family homes and other residential properties are valued.
Instead, an apartment’s value is based solely on how much NOI it produces.
So if you raise your NOI, you can raise the value of your apartment. And not just dollar for dollar. In fact, for every dollar that you increase NOI, you can usually increase the value of your apartment by more than 10 times that amount.
The amount by which it increases is based on the Net Income Multiplier (or NIM).
According to biggerpockets.com, the NIM can be calculated when you know the capitalization rate (or cap rate). It is simply a reverse of the cap rate. So the formula is:
NIM = 1/cap rate
According to apartmentpropertyvaluation, the average cap rate in the U.S. is around 7%.
And at a 7% cap rate, the NIM is a little more than 14.
So at a 14 times multiple, let's see what happens in a hypothetical example.
Assume that you raise the rents on each of the 25 units from our original example by just $50 and everything else stays the same. You have increased your NOI by $15,000 a year.
If you have a 14 multiple, that means your apartment’s value jumped up by $210,000! All on a $50 rent increase.
An added bonus is that there are so many ways to increase your NOI.
You can increase income, like we just did in our example. If you can find an apartment where the owner hasn't raised rents in a while, you can raise rents to market levels and very quickly boost your apartment's value.
You also can add income streams through amenities or you can renovate the property so that you can charge higher rent. There are a lot of possibilities.
You can also get to the same place by cutting expenses. This can be as simple as shopping around and finding a better deal on your insurance, or using contractors who will do your repairs or landscaping for a better price.
You may even be able to separately meter the building so that your tenants pay for utilities.
All of this has a name. It's called repositioning.
Real estate repositioning is the strategy of buying a commercial property and improving it, with the ultimate goal of increasing its net operating income. This improvement in NOI raises its value in the marketplace. It is a common strategy used by multi-family investors: They buy an underperforming asset, improve its net operating income (through rent increases, cost savings, or other methods), and sell it for a profit.
They then take the profits and buy a bigger apartment and do the same thing. It's a way for them to snowball their profits. You can make some really big money if you do this right.
Apartments Have Diversification of Income
As we talked about before, apartment owners get many rent checks coming in each month. This diversification is a good thing because they are spreading out the risk of nonpayment among many different renters.
As a bonus, apartment investors can also diversify their income sources through the use of income-producing amenities as we discussed earlier.
Apartments Enjoy Debt Paydown
As with other forms of rental property investing, the tenants are paying down the loan on the apartment and the owner is adding to their equity in the property each month.
The benefit compounds over time because each loan payment applies a bigger portion of that payment towards paying down your principal than the previous loan payment did.
Toward the end of your loan, you will find that almost your entire payment is going toward reducing your loan amount vs. being applied toward interest (whereas the reverse was the case at the beginning of the loan).
Anyone with a new mortgage on their house knows the sad reality of this.
The point is that time is your friend when it comes to apartment investing. With the passage of enough time, your tenants will completely pay off your loan. On an apartment loan, that could equal millions of dollars.
Apartments Can Be Financed
Apartments can be financed, which means that you gain the benefits of leverage. Essentially you are able to multiply your returns because you are only putting down a portion of the purchase price as your invested cash.
Let's use a simple example to illustrate the point:
Purchase Price of 25 Unit Apartment
Increase in Value
Return on Investment
In this table, we are comparing someone who purchased our 25 unit apartment with a 20% down payment against someone who paid all cash.
We are assuming that both owners raised rents by $50 (like in our earlier example) and increased the value of the apartment by $210,000.
Check out the dramatic difference in their return on investment. That’s the power of leverage
One final benefit around financing is that banks perform a thorough examination of the apartment to evaluate whether it is a good investment. In order to get approved for financing, the apartment must meet the bank's requirements around cash flow, occupancy, physical condition, etc.
This means you have a very experienced set of eyes looking over your apartment to make sure it is a sound investment.
That should provide some comfort if you are new to apartment investing.
Apartments Give You Scale
This is simple. When you buy an apartment, you are purchasing a bunch of rental units at one time. That means that your portfolio is able to grow by leaps and bounds.
If you tried to get the same number of “doors” through single family purchases as you would in our 25 unit apartment, you would be spending a lot more time and energy to do so.
Apartments Have Centralized Maintenance
If you own an apartment, you have to maintain one roof, one set of mechanicals, one exterior, one lawn…you get the picture.
If you own 25 separate rental properties, you have to tackle each of those tasks separately. That means much more effort to maintain all of them, especially if you they are located relatively far apart from each other.
Apartments Can Support a Property Manager
Because of the scale and the greater cash flow that apartments bring to the table, you should be able to hire a property manager to handle all of the maintenance and other issues relating to the operation of the apartment.
This allows the investment to be fairly passive – your job is limited to making sure that the property manager is doing a good job.
Apartments Provide Tax Benefits
As with other rental properties, apartments enjoy the many tax benefits that real estate provides, such as deductions for mortgage interest, depreciation, and other costs of maintaining the property.
In addition, if you want to trade one or more of your existing properties for an apartment, you can defer the payment of any capital gains in those properties by doing a 1031 exchange.
You may also be able to take advantage of some interesting tax benefits if you buy an apartment in an opportunity zone. If you meet certain requirements, your taxes on capital gains may be wiped out entirely.
Apartments Can Be An Inflation Hedge
A final benefit of apartment ownership is that your investment acts as a hedge against inflation. This is because rents tend to rise as inflation rises, so your cash flow is protected against inflation.
And the value of your apartment is similarly protected against inflation because your rent is tied to your NOI. If rents increase, your NOI increases, which in turn increases the value of your apartment.
Drawbacks of Apartment Investing
We have covered in a lot of detail the benefits of apartment investing. But apartments also carry their own unique set of risks. It is important (maybe even more important) to know the drawbacks of a particular investment.
The biggest drawbacks of apartment investing include a high purchase price, strict financing requirements, lower tenant quality, high concentration risk, and a limited resale market.
Apartments Are Expensive
The most obvious drawback of apartment investing is the price. Apartments are, in general, much more expensive than single-family homes or other types of single-unit residences and often run into the millions.
That’s why many investors partner up with others to buy an apartment or they try to run syndication deals.
If you are not prepared to invest that kind of money or don't have the desire to organize a syndication, you may want to look into real estate crowdfunding, which is an option that you can pursue with a lot less work and money.
Crowdfunding platforms can be a maintenance-free option and some consider them to be a safer investment than investing in an individual rental property.
DiversyFund is one example. They offer a hassle-free way to invest in a diversified basket of real estate investments with an initial investment of as low as $500.
Qualifying For Financing Is Difficult
As we talked about before, you can get financing for apartments, and the leverage available because of financing is one of the most attractive features of investing in apartments.
But qualifying for financing is a real bear. It is way more difficult than qualifying for a regular residential property.
They are going to probe into your personal financial condition, including your net worth, liquid assets, investing experience, and more. And even if you qualify, the property has to qualify too (remember our discussion on the extensive due diligence that the bank performs on the property).
On top of all this, the terms for apartment loans are less attractive than the terms for conventional residential mortgages.
Apartment loans usually come with pre-payment penalties and other sorts of requirements, including setting aside money for capital expenditures (like a new roof, etc.).
Apartments May Have Lower Tenant Quality
A primary concern for apartment investors is the quality of the tenants that will be living in the apartment. The location of the apartment might be in a less desirable neighborhood, which means you might end up with higher risk tenants.
This can lead to high turn-overs and vacancies, non-payment of rent, and other headaches that could seriously impact your bottom line. As with most real estate investments location is everything.
Apartments Have Concentration Risk
Obviously, apartments have a large number of units in a single location. This means that if the immediate area around the apartment starts to decline, all of the units in the apartment are going to be affected.
Contrast that with having multiple single-family properties scattered throughout a larger area – your risk of that happening is far less.
Apartments May Be Harder to Sell
Apartments are much more difficult to sell than single family residences. That is because they are much more expensive so you have a smaller pool of buyers.
The pool gets even smaller because the only buyers for apartments are other investors.
It could take many months to sell an apartment. And you might not be able to get the price you want because you are going to be negotiating against a seasoned investor on the other side who is keen on getting the best possible deal he can.
Buying an apartment can be a lucrative and even life-changing investment, but it is important to fully understand and mitigate the risks that come with it.
Let me know your thoughts around apartment investing in the comments below. Do you think it is a good investment or too risky? Do any of you have experience owning them?