Housing Slump Offers Opportunity In Apartment-Building Market

The property in Fort Lauderdale, Fla. was originally valued at $285,000. Clint Gordon, a private investor in multifamily properties, offered the bank $50,000 cash—and within 10 days had closed the deal. A few days after that, he began renting it for $15,000 a year.

Barb Getty at one of her investment properties.
Barb Getty at one of her investment properties.

"Anybody that’s getting into this business now, you get a whole lot of return if you’re paying cash for properties," he says. "You're just buying them so cheap."

Prices are “incredible” in Indianapolis as well, says Barb Getty, who owns 27 apartment properties in the downtown area. "You can start small like I did—20 percent of 40 thousand bucks isn’t a lot of money.”

Just as there have been massive price drops forsingle-family homesover the past three years, there have been big declines for apartment buildings. That suggests that it’s a good time for investors who want to be landlords to start buying.

But as with all investments, the story isn’t quite so simple.

Where’s the Flood?

Investors who thought that a tsunami of dirt-cheap multifamily properties would wash over the U.S. market in the past two years have been largely disappointed.

The distress was limited to certain places and property types, says Hessam Nadji, managing director at real estate investment services firm Marcus & Millichap.

"The pain was concentrated where we had gross overbuilding in overall housing: Florida, Phoenix, Las Vegas, Southern California, and to some degree smaller markets like Tucson, Charlotte and Atlanta," says Badji.

Marc Solomon, whose Solomon Organization owns 10,000 garden apartments in New York, New Jersey, Connecticut and Pennsylvania, says that it is difficult to find opportunities that make good business sense in his markets, which still offer slow, steady returns. "There’s a lot of dollars out there chasing these deals," he says.

While there were big price cuts in North Carolina's research triangle, competition is driving down yields, says Jim Scofield, senior investment advisor at multifamily real estate broker Apartment REP.

Last October, an investment firm “got a steal” on a community in Raleigh called Autumn River, with a capitalization rate of about 7.75 percent. The most recent transaction in the area involved a community called Southern Oaks, which had a 5-percent cap rate. (The cap rate is the full-year income from a property divided by the sale price).

"This is not just a phenomenon in the triangle, but in all the major markets—and especially all the apartment markets," Scofield says. "Manhattan, Washington D.C., Los Angeles, Denver, Chicago, Boston."

Risk and Return

There is less competition in markets where the supply is more fluid, but the risks are also higher.

"We landlords are happy," says Getty, adding the only thing preventing her from buying more properties is the ability to manage them on her own. Still, she hasn't been able to increase rents as much as she normally would.

Gordon says that his vacancies used to average three to five days. “Now I can have a vacancy of up to 60 days,” he says.

Despite all of the qualifiers, there is opportunity to be had in rental apartments because the timing is good, Nadji says. Average cap rates are still around 6.5 percent.

“I don’t think you’re going to get fire-sale prices,” he says. “But you can get that kind of return ahead of the job growth and ahead of the economic recovery.”

Rental occupancy rates contracted dramatically during the recession, as people doubled up to save money and young adults boomeranged back home. Vacancies nationwide hit a high of 8 percent in the last quarter of 2009, according to real estate research company Reis.

But industry insiders argue that rentals will bounce back quickly and dramatically as well. Indeed, in the third quarter of this year, vacancies dropped to 7.2 percent, according to Reis.

"Apartment rents are short term they adjust to market conditions very quickly," Hessam says. "We’ve seen a record demand for rental apartments so far this year—the strongest in over 10 years.”

Owning vs. Owning

Apartment buildings can also be attractive because investing in residential real estate seems similar to owning a home. But rental properties are different—starting from the purchase decision.

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Homebuyers tend to look for a place they love that fits their needs and budget. But you have to see investment properties through the eyes of your tenant, Getty emphasizes. If your tenants won’t have cars, is it near public transportation?

Randall Gorman, president of La Jolla Capital Group in California, says prospective investors need to take the emotion out of their purchases.

"I don’t care if you’re buying a condo, a duplex or a ten-unit building," Gorman says. "Just because you’ve always loved that cottage-style apartment building that you drove by taking your kids to school, doesn’t mean the cash flow fundamentals work at a given price."

If considering a property, Gorman advises making sure you can run a cash flow model. Go beyond the cap rates the owner discloses, and figure out property rents by doing research online and in the neighborhood.

Calculate your annual revenue, and thoroughly survey costs like maintenance, taxes, utilities and incentives. (Property managers typically charge about 10 percent of a month’s rent.)

Add in a couple of months of vacancies—and don’t disregard the higher interest ratesfor commercial properties. According to PricewaterhouseCoopers, the national average interest rate for apartments in the third quarter was 5.68 percent. For the first week of October, Fannie Mae reported that the average 30-year fixed rate for a primary home was 4.27 percent.

If your final net income is $16,000 annually, aiming for a 10-percent cap rate puts the purchase price at $160,000.

"Don’t buy on what might happen, but on what is happening,"Scofield says. "Only buy a property if it is cash flowing to meet your investment return requirement on day one."

Even once you buy, it’s not a smart idea to treat your investment like a home.

"Investors make a huge mistake when they spend a lot of money on bells and whistles in their rental property," Getty says. "For instance, crown molding. A rental needs to compare well to others in the neighborhood, but don’t make it a palace—you won’t get that money back."