You’ve heard the saying, “To win big you’ve got to bet big?” That pretty much incorporates the essence of Risk right there: there are two sides to it. “Risk” is not the same as “loss” because there’s also the chance of gain. A lot of folks tend to forget that last part.

Warren Buffett, who doesn’t buy apartments, once said “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” With his historical focus on preservation of capital this perspective about how much to pay for a desirable investment is important: buy quality and pay a fair price. The dividends of the wonderful company (or the rents of the wonderful apartment building) would be more secure; that’s definitional. And the wonderful company (or apartment building) would likely carry a higher multiple of earnings (lower cap rate) both when purchased and when sold. In this way the owners return on her money (dividends / rents) and return of her money (upon resale) are more secure. Buffett’s wonderful company is, in our world, a wonderful building.

Why is safety of return important? No, seriously. That’s not a frivolous question. The answer has two parts. We’ve already agreed that risk is not the same as loss. Risk involves both the winning side and the losing side. Loss is a single loaded result: he took a side in the transaction and the results were disappointing to him. He suffered a loss.

But the counter-party took the opposite side and is really pleased with the way things turned out.  She was immensely benefited by the risk she took and immediately got her hair done.

There is risk in every interaction more complicated than a puppy’s love and the results could be either adverse or beneficial depending on the position taken.

Say a real estate investor sells his 10 units for full market value, but immediately afterwards the market goes up. For the next twelve Sundays the buyer will brag to every foursome on the golf course about the deal he got. You and I know there was no “deal” because at the moment of purchase he paid full value. Actually, he paid more than any competing investor offered. That’s the only way he got the building. Market related transactions occur on the margins. What made the buyer think it was a “deal” is something that happened after the purchase, something that was unknown by the market ahead of time (and consequently not baked into the price).

But the seller, as the counter-party, lost potential gain. If he’d kept the property another year he would have really made out. The check he got from escrow would have had at least one more zero on it, maybe two.

So was this a risky transaction? We’re not asking if somebody afterwards wished he’d waited a while longer to sell, like his wife said. We’re asking if the transaction itself was risky. To really answer the question, risk must be defined in a way that is independent of the roles of the participants.

Risk, in our sense, is “unexpected deviation from the mean”. A risky transaction will generate unpredictable gain (or loss) to the parties in the transaction. That is why Warren Buffett was right: to an investor, security (predictable change: a bond-like stream of ever increasing income) is more desirable than risk (unseen change: the possibility of unexpected gain or loss).

We can put numbers to it. If an investor begins with $100 and suffers a 50% loss, he’s down to $50. His money will have to double just to get back to the $100 he had at the beginning. The percentage gain has to exceed the percentage loss just to return to breakeven. And that is why losses are more painful than gains are beneficial.

A secure investment, one that generates a bond-like return on and of the investor’s money, can still fluctuate in value but the changes are more likely casual rather than random. A major cause would be changes in interest / capitalization rates, and those can sometimes be anticipated. Right now, for example, most financial observers expect rates to go up, and we can guess what that would mean for values.

Apartment investments are by definition secure investments. Banks don’t lend $2 or $3 or sometimes more for every dollar of down payment the buyer contributes if the investment is risky (subject to random change in value) but not all apartments are equally secure. We’re using “secure” in the Buffett sense, meaning that it is reasonable to expect a steady stream of net income and the property is likely to appreciate in the future. Both net income and appreciation of an apartment investment are heavily impacted by its location.

Location

A poor location for income property is someplace nobody wants to be. This is not rocket science. That means that a better location would be where lots of people want to be. So the first thing we look for is how crowded the area is: Google for population density by zip code.

Next question: is it better to own in an area where all the people are rich or where they are universally poor? If they’re poor, how are they going to pay rent increases? Ok, so . . . rich is better. Google for census data and look up per-capita income: Google is your friend.

So at this point you have found a promising area that has a high population density and every person there is a trust fund baby who doesn’t care how much the rent might be because they don’t pay it. Are we in a good location, yet? Almost.

There is also the matter of building restrictions. If investors can build new apartments to meet increased demand, growth in rental income will disappoint. A good location for investing purposes is a place where population grows faster than the supply of apartments. That means area rents will go up faster than they would in a less desirable area. Your broker should be able to dip into the MLS for historical rents for similar units. Another possibility is to check City Hall for data regarding both local population increases and supply of rental units. Other approaches will occur to you.

Strong rent growth may indicate a good location, but increasing apartment prices may not. Remember that the value of apartment buildings rises and falls with interest / capitalization rates even if the Net Operating Income remains the same.

Naturally, most locations are somewhere in the middle: there’s potential, but you have to manage it. There are vacancies, but for years they’ve hovered in the 4% to 7% range. Population and housing have reached equilibrium. Everybody has to work: neither welfare nor trust fund babies here. Freeways offering access to area employment opportunities are nearby. Daily shopping is convenient.

Clearly, as investors we want to avoid areas of low population, little income, and minimal building restrictions. In such places it’s easy to tell what building has the lowest rents: it’s the one with the fewest vacancies. The low rent building is the only one that wins tenants. Everybody who owns apartments in that area competes on price and fights over $10 rent bumps. For the owners, it’s a race to the bottom.

But that’s not to say it can’t work out if – that’s a big “IF” – such a property was bought when cap / interest rates were high and sold when rates were low. That requires a long term investing horizon. It took three decades for the high rates / high caps of the early 1980’s to reach their eventual (temporary) bottom. Assume a 20 unit building with Net Operating Income of $60,000 annually. This property was purchased at a 10% cap rate ($600,000) with an interest only loan, held for years during which time the owner could not raise the rents, and sold with buyer paid closing costs for a 5% cap rate ($1,200,000). The seller turned the $150,000 original down payment (25% of $600,000) into $750,000 ($1,200,000 minus the existing interest only loan of $450,000). The seller made out pretty well, didn’t she?

But it all went to her head. The poor girl had no idea of cap / interest rate changes. She thought she won because (a) real estate is easy and (b) she’s real smart. So naturally she immediately reinvested the entire $750,000 in another building in that same area. She bought a building for $3,000,000 and rushed to complete the transaction while interest and cap rates were still low. Ha! Then rates did what they historically do once the bottom is struck: they turned back up. Eventually rates reached 10% and her building’s value had eroded to $1,500,000.

She had significant gain when the rates went her way and massive losses when they reversed. Risk was present both times. Risk is not the same as loss. The risk was the same, but whether she benefited or lost depended on which side of the transaction she was on. What made the difference were (a) population-income-building restrictions and (b) the interest / cap rate cycle. 

Corrigendum: Depreciation Recapture

A recent communication from a reader, a building owner and retired CPA, beautifully explains how the recapture of tax depreciation works relative to apartment buildings. I’m going to quote directly from his email (emphasis added):

“Depreciation recapture (IRS code sections 1245 and 1250) taxes previously deducted depreciation at ordinary rates up to the amount of the cumulative depreciation, not at capital gains rates as I believe you mentioned in your article. Remember, Uncle Sam always wants to be made whole when you sell your investment property. If you have a gain beyond the pre-depreciated amount, that will be taxed at capital gains rates (otherwise known as section “1231” property).

“If you sell at a loss, the amount of depreciation that was previously taken that is equal to the amount over the adjusted cost basis would be considered recapture and again taxed at ordinary rates.

“Thus, in this last example, if you bought a building for $1,000,000 and depreciated it $400,000, your adjusted cost basis would be $600,000. If you subsequently sold the building for $700,000, you would recognize ordinary income of $100,000 even though you sold at a loss. That $100,000 is equal to the amount of depreciation recaptured.

“In the first example, if you sold the building you bought for $1,000,000 for $1,200,000 and had depreciated the building the same $400,000, the tax ramifications would be ordinary income of $400,000 (the amount of depreciation recaptured) and a capital gain of $200,000 (long-term if you held for more than one year).”

Disclaimer:  This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Klarise.Yahya@Charter.net.

If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com.

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