The Benefits and Drawbacks of Apartment Complex Ownership, Explained
Apartment buildings are a fantastic investment option for many people, but they aren’t for everyone. One major advantage of owning an apartment complex is that buyers can finance a large portion of their investment using commercial real estate loans. Apartment buildings also allow an investor to raise money from others in order to purchase large investments and increase their potential profits. In addition, apartment buildings offer a wide array of tax benefits for investors.
If you’ve already decided to invest in real estate, but aren’t sure what type to invest in, you should know that apartments do offer some benefits over other types of commercial real estate. For example, multifamily investors can take advantage of high-leverage, non-recourse financing options through HUD, Fannie Mae, and Freddie Mac, and can often get additional tax benefits, particularly when it comes to affordable housing. Plus, apartments generally have a lower risk profile than other types of commercial real estate. For example, while retail stores may go in and out of business, people will always need a place to live.
Despite this, owning an apartment building isn’t for the faint of heart. Apartment properties are active businesses, and things can go wrong, including maintenance issues, legal issues, and problems with investors, lenders, or zoning officials. In addition, if your apartment investment fails, you could be held liable.
In this article, we’ll review some of the most common pros and cons of apartment investing. That way, you can get a better idea of whether investing in multifamily real estate is a good option for you, based on your specific needs, desires, and personality profile.
The pros of owning an apartment complex include:
Debt financing via multifamily loans
Syndication opportunities
Equity growth/property appreciation
Depreciation deductions and cost segregation
Other tax benefits
Forced appreciation/value-add opportunities
Affordable housing opportunities
Supplemental income sourcesMonthly cash flow
The cons of owning an apartment complex include:
Personal legal and financial risks
Underwriting and property selection
Capital raising issues and closing costs
Negotiating with stakeholders
Market factors and issues
Maintenance costs
Difficulty and expense of exit
Pros of Owning an Apartment Complex
Debt Financing
Real estate investors can typically take out multifamily loans with LTVs of up to 75% to finance their investment properties. This greatly increases a project’s overall return on investment, as measured by metrics such as cash-on-cash return and IRR (internal rate of return).
In some cases, such as when using agency loans from Fannie Mae or Freddie Mac, or HUD multifamily loans, that leverage can be increased to 80-90%, with amortizations of between 30-40 years. Long amortizations mean lower monthly payments and higher DSCRs (debt service coverage ratios), which means that more money ends up in investor’s pockets every month
In addition to initially financing your apartment property with a loan, you can also refinance your property later on to get a better rate or a lower monthly payment. You may also be able to take cash out with a refinance and use those funds to improve your property or to function as the downpayment for another multifamily or commercial property.
Syndication Opportunities
Raising money for a business can always be a challenge, particularly if the business model is unproven. However, apartments are one of the best-proven business models out there, which means that it’s significantly easier to raise money for multifamily real estate investments than, say, tech startups. In fact, there are thousands of real estate investing clubs across the country with the sole purpose of sourcing real estate deals to invest in.
Syndication refers to the process of raising money from a group of limited partners (LPs) who will passively invest in the property, which will ultimately be controlled by one or more general partners (GPs), which will retain additional fees but will take on legal liability for the property and any loans they have taken out. Syndications are typically restricted to accredited investors, i.e. those who earn an annual income of $200,000 or more or have a net worth (excluding their primary residence), of $1 million+.
However, in 2017, the Jumpstart Our Business Startups (JOBS) Act changed all that by allowing equity crowdfunding for small businesses, startups, and real estate deals. Under Regulation A of the JOBS Act, retail investors can invest in real estate projects, just like accredited investors, provided the correct legal guidelines are followed.
Most real estate crowdfunding is conducted via online platforms, including CrowdStreet, EquityMultiple, Fundrise, and RealtyMogul, to name a few. In 2020, it was estimated that over there are 330,000 active crowdfunding investors in the United States, meaning that this is an exciting new way for investors to raise capital for their projects.
Equity Growth
Assuming the property has been financed with a loan, the longer an investor holds an apartment building, the more equity they will build in the asset as the loan is paid off. This, of course, also applies to single-family homes and other types of commercial real estate but is still an important factor to appreciate when it comes to apartment investing.
Depreciation Deductions and Multifamily Cost Segregation
Because real estate wears out over time, apartment owners are allowed to take annual depreciation deductions off of their yearly income taxes. Depreciation is typically spread out over 27.5 years for multifamily properties and 39 years for commercial properties.
This is great in itself, but it’s even better when combined with a process called cost segregation. Cost segregation allows owners to accelerate their depreciation deductions by ordering a special type of engineering inspection on their property, which identifies parts of the property that may depreciate faster, such as carpets, roofing, or electrical components, allowing investors to take those deductions significantly faster.
For larger properties, this can lead to millions of dollars of tax savings. Even though investors will typically have to pay a depreciation recapture tax later on, due to the time value of money (TVM), money in an investor’s pocket today is far more valuable than money acquired (or saved) in the future.
Other Tax Benefits for Multifamily
In addition to cost segregation, there are countless other tax benefits of owning apartment properties. For one, you can deduct interest expenses off of your income taxes. You may also be able to deduct property maintenance costs, travel to and from your property, real estate educational costs (such as seminars), and other operating expenses.
If you take a loss on a commercial or multifamily investment, you may also be able to deduct this from your income taxes, particularly if you make less than $100,000 per year or are designated as a full-time commercial real estate professional.
For now, investors can also take advantage of 1031 exchanges, which allow investors who sell a commercial property and purchase a new commercial property of equal or more value to defer their payment of capital gains taxes until they sell the new property. 1031 exchanges can be executed multiple times, meaning that an investor can buy and sell many properties without paying capital gains until they finally cash out.
Forced Appreciation/Value-Add Opportunities
One of the most tangible benefits of multifamily investing is the fact that property owners can often make low-cost upgrades that can significantly increase rents, and therefore the overall value of the property itself. This is sometimes referred to as “forced appreciation,” meaning that, in many cases, an owner can increase the value of the property regardless of market conditions.
This generally occurs when an apartment investor utilizes a distressed or value-add business strategy when purchasing a property. Distressed investing involves purchasing a property with lots of deferred maintenance and possibly a high vacancy rate in order to make substantial improvements. Distressed investing is relatively high risk and often requires high-interest (think 10-20% APR) hard money loans due to the fact that banks and agencies aren’t willing to take on the additional risk of financing a low-quality property.
In contrast, turnkey investing occurs when an investor purchases a new (typically 5-10 years old) property in excellent condition. These properties are typically Class A assets located in good markets, and often have top-of-class amenities like swimming pools and brand-new appliances. Turnkey properties are relatively low risk, but they also offer a lower level of potential upside.
This is why many investors prefer a value-add model, in which an investor purchases a B or C class property with relatively high occupancy, typically between 15-20 years old, and makes superficial improvements, such as repainting, re-landscaping, and adding new appliances or other amenities. This strikes a balance between higher-risk, higher-reward distressed property investing and lower-risk, lower-reward turnkey deals.
Affordable Housing Opportunites
In some cases, apartment complex ownership offers the opportunity to invest in affordable properties via the HUD Section 8 program. Section 8 properties have a long list of their own pros and cons, which would be enough to cover several articles in their own right. However, affordable housing investing can be highly beneficial for some investors, as most or all of the property’s rents are paid directly by a local or state housing authority that advertises the property on official waitlists, meaning that owners have little to worry about when it comes to occupancy.
Despite the benefits of Section 8 properties, affordable housing operators often have to deal with higher rates of crime and vandalism, which leads to higher maintenance costs and potential legal risks.
When compared to market-rate properties, affordable properties are also provided a wider range of financing options, often with higher leverage and lower debt service coverage requirements. For example, the HUD 221(d)(4) loan program for multifamily construction or substantial rehabilitation offers LTVs up to 90% for affordable properties, an amount of leverage that’s unheard of in other types of commercial mortgages. In some cases, investors can also take advantage of LIHTC (low-income housing tax credits) to finance their property.
Supplemental Income Sources
Many investors find that rents aren’t the only way to gain income from an apartment complex. Investors can also gain income from charging for or offering other services, such as parking spots, laundry machines, and vending machines. While they may seem minor, monthly income from these sources can add up substantially over the life of an investment, significantly increasing profitability.
Monthly Cash Flow
In addition to gaining value over time through equity buildup, market appreciation, and forced appreciation, multifamily properties can provide significantly monthly cash income to owners. This can help investors increase their income, and can also be a great selling point to attract outside investors into a real estate project. While it’s true that some other investments, like annuities and dividend stocks also provide monthly or annual payments, these are generally not nearly as significant as those generated by apartment complexes.
The Cons of Owning an Apartment Complex
Personal Legal and Financial Risk
As we mentioned earlier, apartment investing isn’t for the faint of heart. Good multifamily investors are resilient, persistent, and willing to face a certain amount of risk in order to obtain the potential financial rewards that multifamily investing has to offer.
As the general partner (GP) of an apartment syndication, you are ultimately legally responsible for what happens to your property. If you have taken out a loan on the property, unless the loan is non-recourse, you will be personally liable for making the lender whole should you default on your property.
This means that the lender could go after your personal assets, such as homes, cars, or bank accounts. Even if a loan is non-recourse, if you violate one of the “bad boy” carve-out agreements, the loan could become a full-recourse financial instrument. While these carve-outs are often restricted to committing fraud or intentionally declaring bankruptcy, they can sometimes include things as minor as failing to submit a quarterly P&L (profit and loss) statement to your lender or loan servicer on time.
In addition to facing legal problems from a lender, you could also face lawsuits from residents or guests who have become injured on your property. Even with a good property liability insurance policy, this could lead to large out-of-pocket costs. Finally, you could also face lawsuits from your investors, particularly if they feel you mislead them as to the potential profitability of the investment or failed to pay them agreed-upon coupons at a specific time.
Underwriting and Property Selection
One of the biggest drawbacks of apartment investing is the time and effort it takes to successfully complete a deal. Identifying a property can be the first challenge for a prospective investor, and unless you have a large team, this can often take many months. To intelligently choose an apartment investment, you will need to first create a series of “must-haves” for prospective properties. These may include:
Property price/price per unit
Property condition/class
Amount of units
Market area/location
Estimated IRR
Estimated free cash flow (FCF)
Property management costs
Prospective maintenance costs
Maximum state and local property tax burdens
In many cases, you will need to underwrite, or analyze hundreds of properties before finding several that match your qualifications. This can be very time-consuming and means that you will need to become highly skilled at the process of underwriting. As a part of this process, you will need to be able to create accurate simulations that represent the potential profitability of your investment under various circumstances.
This takes a small degree of math, but mainly is a skill that can be developed by spending a fair amount of hours on excel using pre-programming models that will help you estimate the expenses, income, and potential IRR of an investment property.
These will be essential for both your own knowledge and as part of the pro-forma OM (offering memorandum) that you will show to potential investors, lenders, and other stakeholders in your deal.
Capital Raise Issues and Closing Costs
Raising money for apartment complexes isn’t for the faint of heart. While there is a variety of new ways to attract investors, including developing a strong presence on social networks like LinkedIn or Instagram, selling a deal still requires significant effort and willingness to face rejection. Unless you already have many connections in the industry, it can be very difficult for first-time investors to prove their reputation and gain the trust of investors.
Even if you have “firm commitments” from many investors as your deal comes closer to closing, there’s always the chance that some of them will pull out at the last minute. This can lead you scrambling to find enough cash to close. This is especially problematic if you have already invested a significant amount of time and money into the deal, such as paying lender underwriting fees (which can often be $25,000 or more) or for third-party reports, such as appraisals, property condition assessments, and environmental assessments.
Negotiating With Stakeholders
In addition to working with investors, you will also have to work and negotiate with a wide variety of other stakeholders, including your commercial real estate broker, your commercial loan broker, the seller, their broker, your lender, and various third-party contractors that are needed to provide due diligence on the property and the overall deal. This can be time-consuming and frustrating, even for the most patient and experienced investors.
Occupancy and Tenant Issues
It’s important to realize that owning an apartment complex is owning an active business, and one of the most important business challenges is keeping up high occupancy. Otherwise, you may have challenges paying your monthly mortgage payments and keeping up with other expenses. Even if you use an outside property management company (as most owners should), ultimately, you are responsible for keeping your property’s occupancy high.
In addition to general occupancy issues, problems with individual tenants may arise, such as arguments between residents, noise complaints, or even domestic violence problems, which could further increase property vacancy rates. These issues can be greatly exacerbated when investing in affordable properties or those in low-income or high-crime areas.
Market Factors and Issues
While an investor is fully in control of the market or markets they choose to invest in, they have no control over how these markets will change over time. For instance, what you thought was a good neighborhood may actually decline, instead of improving, over the life of your investment. In addition to neighborhood decline, which can lead to increases in crime and reduction in property values, “Acts of God” such as fires, earthquakes, and hurricanes can damage or completely destroy an apartment property, leaving the investor with serious financial problems.
Maintenance Costs
Unlike many other kinds of commercial properties, apartments generally need constant maintenance. In the short term, this can include landscaping costs, replacing appliances, and fixing A/C or heating systems, while in the longer term, it can include replacing roofs, electrical systems, or other major building components.
As local and state regulations change, apartment owners may also be forced to make additional changes to their property, such as accommodations for disabled individuals, which can also greatly increase maintenance costs.
Difficulty and Expense to Exit
Real estate is one of the most illiquid investments out there, which means that it can be very difficult to quickly take money out of your property. The sales process for a multifamily property can take between 3-6 months at the low-end, and can often take longer for larger properties or during tough market conditions.
It can sometimes take quite a while to find the right buyer. And, when you find a prospective buyer, it can take them weeks, if not months, to complete the due diligence process and become approved for a loan. In addition, selling a multifamily property can be expensive. Unless you’ve sold the property “off-market,” you will generally need to pay your broker a fee of between 3-6% of the property sales price, just as you did when purchasing the property.
In addition, you will generally need to pay a prepayment penalty to your lender for exiting your loan early. Depending on the type of loan, this can be quite expensive. In many cases, you will not be able to prepay the loan for at least one year after you’ve taken out financing.
For Fannie, Freddie, and bank debt, lenders typically employ step-down percentage-based payments, such as 5% of the remaining loan balance in the second year, 4% in the third year, and so on. For CMBS, defeasance is often required. Defeasance involves replacing the remaining loan amount with a similar amount of income-generating securities, generally U.S. Treasury bonds. Defeasance generally requires the use of an outside consultant, which can also increase your exit costs.
Alternatives to Investing in Apartment Complexes
Different Asset Classes May Be Better for Some Investors
If multifamily investing isn’t right for you, you may find that other asset classes better fit your needs. For instance, retail, industrial, and self-storage properties generally require significantly less hands-on work once a property has been acquired. In many cases, these properties operate on triple net (NNN) leases, meaning that the tenant is required to pay for almost all maintenance and property management costs.
While these property types can be somewhat higher risk than multifamily, they can still be extremely profitable if underwritten and selected correctly.
Passive vs. Active Apartment Investing
Just because the cons of apartment ownership listed above seem to outweigh the pros doesn’t mean that you can’t benefit from investing in apartment complexes. For investors who want to take a more hands-off approach, passive real estate investing may be an ideal alternative.
As we mentioned earlier private placements, passive real estate investors are generally limited partners (LPs) in a project, meaning that they have little or no say in how the project will be operated. In addition to private placements, investors may also choose to invest in the aforementioned public crowdfunding platforms, such as Fundrise, EquityMultiple, CrowdStreet, or others.
In addition to private placements and crowdfunding platforms, investors can get exposure to the multifamily real estate market through other avenues, such as purchasing shares in a public or private REIT, or investing in the stock of a publicly-traded real estate investing or development company.
Regardless of how you invest in it, multifamily real estate can be an excellent asset class to invest in, providing potentially high returns for relatively low risks. Everyone needs a place to live, and with populations growing, the demand for apartment units is likely to only increase in the near future. By doing your research and selecting the best method to invest in multifamily, you can diversify your portfolio while generating income that can help support you and your family both today and tomorrow.