Apartment buyers look for at least two years of increasing net operating income (“NOI”) when purchasing an apartment building. Just like the U.S. economy, a certain amount of annual gross domestic product (“GDP”) growth is expected to keep up with consumer price index (“CPI”) to be competitive with other countries. When analyzing income / expense statements, buyers look for opportunities to cut expenses and increase income. Yes, the concept seems very simple, yet remains so true. Buyers also want to see consistent results year over year. Do the tax returns match the income statement or are there significant deviations?
Are the owners treating the property as an income producing asset or a tax shelter into which they can incur as many line items as possible like auto, telephone, mileage and travel expenses? Alternatively, if the last two years’ expenses are “lean and mean” at 30 percent of gross income, are they repeatable? If the property was professionally managed, the answer is likely yes. If the property was owner-managed, then the owner probably didn’t take a salary for their management activities. Therefore, if the owner didn’t record charges for management labor, the annual expenses could look unrealistically low. In this case, the buyer would probably just estimate total annual expenses at 40 to 50 percent of gross income.
Remember this very carefully: purchasing an apartment building involves purchasing the real estate and the business model. Poorly run businesses are worth less than smoothly run businesses. This is the same reason a corporate run McDonald’s can sell for a 3.5% cap rate and a mom and pop run 24-hour diner next door would sell for a 6.5% cap rate.
Let’s dive a little deeper into these numbers. If both properties are producing the same NOI of $100,000, then the McDonald’s is worth $2.85M and the 24-hour diner is worth $1.53M (NOI/ cap rate = value). This valuation principle is the same reason junk bonds offer a higher yield compared to class A rated securities. Just to recap, cap rate is an indicator of risk. If we can justify a lower cap rate with proven higher income and lower expenses – that is the golden trifecta to add value.
Has Your Apartment Complex Been Stabilized?
We are not talking about earthquake retrofit work. That’s important as well, but we are talking about getting a good portion of units updated and up to market rent for a reasonable period of time. Let’s say you have a 40 unit complex all 2bed/2bath. You remodeled one apartment before COVID and still collect $2,500 per month for that two bedroom/two bath apartment but your other 39 units all rent for between $1,600 and $1,750 per month. Can you claim that your property is stabilized with pro-forma rents at $2,500 for all 40 units? Yes, however, it’s unlikely any seasoned buyer would calculate their offer based on the higher rent. Unless the buyer is all cash, financing would also be based on actual rent roll and buyer strength. Be optimistic and realistic at the same time.
For Buyers looking to flip an apartment asset, poorly managed buildings represent an opportunity to create equity. Owners of poorly managed buildings are likely tired and fed up of the headaches created by these properties. The same tired owners are likely to give in to tough negotiations.
Overcoming Objections – Pre-Inspection
Even with the best management companies in place, owners should remain in touch with the operations and physical condition of the property. There is a healthy balance between maximum cash flow and budgeting for long term capital expenses. Absentee owners or owners mentally absent from the management are devaluing the property they own. When it comes time to sell, owners should know and anticipate any possible buyer objections in order to overcome them in advance.
The worst scenario an absent-minded/absentee owner could come across in a sale is accepting an offer in the amount of $8M. During the inspection period, the buyer discovers deferred maintenance in the amount of $500,000. If the owner was in touch with the condition of the property prior to the sale, the owner might have been able to spend $100,000 in all the right places instead. For example, when a buyer sees a crack in the concrete foundation, they will assume the worst and abundant problem possible. Maybe it’s just one minor crack that the seller could have fixed for $10K, but when the buyer inspects the area and has a foundation repair company come out, they will bid $50K for the job. When a buyer sees a cosmetic and or structural defect their mind races thinking “if this is wrong, what else could possibly be wrong?” In other words, if the seller doesn’t even bother to spend $200 to clean the mold-looking stains in the bathroom, is it possible there is $8K worth of hidden mold remediation work needed in most of the bathrooms? Another example is an expansive wooden staircase with only a couple damaged treads. Buyers will assume the whole staircase is soon to be rotten. A simple pre- inspection by the management company or owner can prevent a situation like this. Buyers love to lower their risk, so they will always project a worse-case scenario of inflated expenses on the seller. It’s ultimately up to the market and the seller to prove value otherwise.
Penny Foolish – Dollar Smart
Having property management in place frees up time for owners to make the big picture moves that add value such as increasing the rent, adding amenities, and improving the curb appeal. For example, adding solar panels to pay for common area lighting. Spend $35K on a solar panel array to save $350 per month and $4,200 in utility costs per year. At a 4% cap rate, that is $105K in increased value. The net out-of-pocket cost is $70K less any federal or state rebates available. If you’re an owner fixing leaky toilets yourself, I doubt you have the time to think about creative value-added strategies. Saving yourself the cost of $200 per plumbing service call could cost you millions of dollars in lost opportunity cost. If I had to choose, I prefer to be penny foolish and dollar smart.
Property Management companies have the industry connections to get routine maintenance work done cheaper than a one-time customer. Lower expenses equal higher net operating income and value. Inform your property management company that you want to increase value.
Your first purpose may be to cash out or refinance for a lower rate. Your second purpose may be to sell and 1031 – carefully select capital improvements to save more money for your next property. If you’re trading out of a 40-unit into a 65-unit complex, you will want a big cushion of reserves on hand.
Your third purpose may be to sell for a record high price. (Go all out with your improvements.) These all involve different capital investment strategies. For example, tell your manager that your 40-unit complex is going to be appraised in two weeks. Let’s hustle and get simple things done like power washing the building, slurry and stripe the parking lot, and touch up paint on the exterior. Offer tenants $20 gift cards for cleaning and organizing their apartments prior to appraiser entry. Make sure the gardener comes the day before inspection. Have the laundry room and leasing office professionally cleaned the day before inspection. Offer free dump week and order two extra garbage bin pickups. Uncluttered properties present infinitely better than messy ones.
Have Clear Goals
Don’t be scared to discuss your value goals with your property manager. Owners with clearly stated goals are the best clients to work with. Even if you’re using another broker to sell or refinance the property, I am sure that transparent discussions will result in good ideas on how to move forward.
Disclaimer: The information given in this article comes from a practical perspective. This article is written from the viewpoint of the landlord and should not be considered as legal advice. Each owner’s situation is individual and unique. It is recommended that you consult with your legal or tax professional for advice that fits your situation.