How to Buy an Apartment Building – Total Guide

Introduction

Are you a Reactive or Proactive Multifamily Investor?

Having worked with hundreds of multifamily property investors over the last 30 years, it amazes me how many of them were reactive investors and did not know what they wanted to invest in from the beginning. Often this group found themselves spinning in circles, grabbing at opportunities that met several of their objectives but certainly not all the essential ones. Some bought properties that were fully occupied, only to find out months after closing the property was in a bad neighborhood and this explained why many of their tenants were paying late or not at all. Others in this group decided after closing to do expensive value-adds and then could not raise the rent enough to justify this additional cost. And let’s not forget those who decided to self-manage a property out of state, only to have it ruin their lifestyle with far too many road and plane trips taken to take care of their investment properly. ln the end, the reactive group far too often chose a property that took up too much of their time and did not give them the return on investment they expected.                                                                        

And then of course, there were my proactive clients who knew exactly what they were looking for at the beginning. Many of these were experienced. They not only knew where they wanted to buy and the quality of the neighborhood, but also the condition of the property they desired, and the value adds they were going to make if any. They knew if they were looking for a solid already performing asset for retirement, or a fix and flip to sell for a quick profit. Most of all they knew their plan for management and their minimum acceptable Return on Investment (ROI). Did they need to raise investors? Well, they knew this too. Here are the ten steps my proactive investors decided on at the beginning, before their property searches:

10 Tested Steps to Buying a Multifamily Apartment Building

1. Determine Your Investment Goals 

What is the Minimum acceptable Return on Your Investment (ROI)? – We have to start here because this is why you are purchasing an apartment building in the first place. We are talking about the cash-on-cash return on the money you put down, and also the Internal Rate of Return (IRR) which is the return over time (usually 4 – 7 years) from acquisition for refinance or disposition. This includes annual net income, annual rental increases, annual appreciation, and annual depreciation over this time frame.   If you plan to have investors, you will be selling them the numbers on these.

Where do You Want to Buy? – Does it need to be in your own backyard so you can keep an eye on it, or just about anywhere in the country?  What quality neighborhood do you want? How close to freeways and major shopping do you require?

Is this a Long-Term Hold, or Fix and Flip? – Is your goal to keep this property for retirement long term, or do you want to do some improvements and sell it at a profit in the near future?

What Price Range Are You Looking At? Of course, how much you can put down is the largest determinant here – See the section on Financing below to get an idea of how much down payment multifamily lenders require.

What Property Class are you Looking For? – A Class property that is 10 years old or less and has low repair and replacement expenses? B Class – 20 years old or less needing moderate repairs. C Class – over twenty years old with ongoing repairs and replacements. Value-add property – needs remodeling /repositioning.

Are you Raising Money from Investors? – If so, how much are you personally contributing towards the down payment and closing costs? And how much do you need to raise from investors? If you are a bit tight, I recommend you put in 20%, and certainly no less than 15%. A sponsor putting in 25% is the gold standard that gives your investors the cozy feeling that you have substantial skin in the game and are not going to bail if things get tough. If you need to have a co-sponsor share the downpayment with you, fine. Where will you find partners? Are they going to own a share of the investment based on the percentage of the downpayment they put in? Are they going to make decisions on how to run the investment with you? If you want total control as the sponsor without having to do a consensus, you will want to raise capital from passive investors through a real estate syndication. These investors are truly passive and not allowed to make decisions. They just simply get an agreed amount of return on their investment over time.

2. Find  Properties that Fit Your Investment Goals

Find a Commercial Real Estate Agent – to find properties for sale that meet most of your goals. Apartment Buildings are commercial properties (if they have 5 units or more) and are valued based on their net operating income and market Capitalization Rates (Cap Rate). This is why you will need a commercial broker rather than a residential one. If you are looking nationally, you should use, Loopnet.com, as it has the largest number of commercial listings in all 50 states.

3. Research Financing Options

Find a Good Commercial Loan Broker – Searching for the right commercial loan is time consuming – especially if you are sifting through 4 lenders or more to find the best terms and rates. An experienced commercial loan broker will be able to prequalify you for many different loan programs and will know the underwriting guidelines for each. This can save you time and money. If you need to borrower $1 million or more, one of our loan officers at Apartment Loan Store will be pleased to size your deal for value and financing – and also, prequalify you for your ideal financing. Give us a call.

Contact Lender’s Yourself – Call or visit at least 5 lenders in these categories.  Community Banks, Regional Banks, Large Banks, and Credit Unions. Private lenders and hard money lenders could be an option too. My book, The Encyclopedia of Commercial Real Estate Advice has two detailed chapters on financing and can point you in the right direction on the right loan program and how to get lenders to compete to boot.

Make Sure You are Qualified for the Loan you Want – Far too often borrowers seeking a commercial loan waste time and money applying for a loan that they do not qualify for. All lenders have different requirements for borrower net worth, liquidity, credit and experience. Make sure the individual who will be approving your loan looks over the submission package at the beginning. 

Make Sure the Property is Qualified – Lenders also have different requirements for property location, loan size, condition, net operating income, and Debt Service Coverage Ratio (DSCR). Historical financials showing the property has performed well over time are also important to lenders.

4. Search Properties and Estimate the Value of your Top Picks 

Get Basic Financial Data from the Listing Agent on the properties you are interested in. Ask the listing agent for a current rent roll and annual income and expenses. A trailing 12-month report (T-12) is best. You will be verifying this data after your offer is accepted during the due diligence step. What you need to know at this stage is if the property’s net operating income will meet your minimum return on your investment after estimated loan payments. This is the time you also need to get a rough idea of the property’s value. To do this, you will need to get some sales comparables that are a year old or less from your real estate broker of like size and scope apartment buildings. First determine market cap rates. Then determine the subject properties cap rate by taking the net operating income and dividing it by the sales price. Then come up with a value for it based on market sales and cap rates. You need to determine if the property’s sales price is spot on or overpriced or underpriced. Read my article on “How to Value an Apartment Building in 15 minutes” for further assistance.  

5. Determine Value Adds 

Make a list with estimated cost of any value ads you plan on making to the properties you are interested in. Ask a commercial real estate broker to come up with comparables of properties for sale or ones that have sold in the past year that are in the category of what you are planning on bringing this property up to. You need to determine here if these improvements will upgrade the property to where you can increase the rents enough to make the value adds worth it. When you apply for financing, be sure to add the value adds onto the use of proceeds for your loan as they can usually be financed.

6. Make Offers

Submit letters of interest on the properties you are interest in. Of course, try getting a better price right out of the gate, but if it’s a competitive market, offering full price at the beginning may be the only way to tie up the property. Once you have done all your due diligence, this is the time to present the facts to the seller on why you need the price lowered due to lower than pitched net operating income or property condition. Getting a better price will be easier for the seller to swallow if you can show them a commitment letter for financing at the same time. A bird in the hand . . .

7. Raise Investors

Once you have control of the property, and know how it’s going to be financed, it’s time to raise investors. This step is taken before applying for financing in case you need a partner with deeper pockets or experience to qualify for the loan you want. Remember, your lender will need proof of the down payment and the financial strength of all key principals. 

Create a Business Plan - This should be 12 pages or less. At the beginning, write up a short synopsis on the quality of the property, its location, and attributes, like below market rents, great neighborhood, good occupancy, etc.   Then go into how you plan to improve the property and back that up with sales comparables that support the new rent structure. Conclude this section by showing how the net operating income will increase over time with the improvements and increase the income and value of the property. Estimate what the property will be worth in so many years after improvements are made and rents are increased.
Practice Your Pitch to Investors – Rehearse, rehearse, rehearse, to your spouse, your kids or even your dog, before you take this to the street. You want the investment to sell itself.

Make a List of Potential Investors – You can start with your relatives and friends. Find someone who invests in apartment buildings. People who invest in real estate know others who do the same. Slowly build your list.

Put Investor Funds into an Escrow Account – the last thing you want is for an investor contributing substantial funds to back out at the last minute. You will have all investors sign an agreement to put their funds in an escrow account at a title company that can only be used to close this transaction once your loan is approved in writing. If you do not obtain financing or cannot close on the property for some other reason within a specified amount of time, your investors will get all their money back.

8. Apply for Financing

Write up an Executive Loan Summary – Use your business plan to write a shorter version for an executive summary of your loan request. This should be 6 pages or less and include bios on all key principals, and a 2-year pro forma showing projected income and expenses.                                                                 

Interview 4 Lenders or More – Interview at least 4 lenders and get their rates, terms and guidelines. Get them to compete for your business. Be sure to get a term sheet or a letter of interest from all lenders you are interested in. You will need this to compete. See my book, The Encyclopedia of Commercial Real Estate Advice for more advice on how to get lenders to compete for your business. 

9. Conduct Due Diligence 

The reason this step comes after applying for financing is because your lender will request more items during the loan approval process. There are two types of due diligence: Financial and Property Condition.

Financial Due Diligence – You need to not only know how the property is currently performing financially, but historically too. Start out by having the listing agent obtain a 12-month trailing income and expense statement and the last 2 calendar years of income and expense statements on the property. If there are discrepancies in these, your loan underwriter may request a rent collection report to determine if there have been rental concessions and to make sure everyone on the rent roll is paying the rent.

Property Condition Due Diligence – Your lender will require a property inspection report. This should not only identify major repairs and replacements needed, but also the cost to cure them. For any repairs that are substantial, you can try to use them to lower the purchase price prior to closing.

10. Closing

There is more to this step than you might think.\

Have the Escrow Officer put Title Company Expenses in Writing – you need to know far ahead what these expenses are going to be, so you can get them financed and include them in your estimate of the down payment. Ask for these early on.

Read Draft Loan Documents – Once your loan is approved documents will be prepared by your lender or their attorney. For larger loans, you will need to have your own real estate attorney look these over for you. Most banks and credit unions use boiler plate docs which they dislike changing. But this does not mean they cannot be negotiated.

Study Carefully the Estimated Closing Statement – it is best to have your loan professional check this over with you. Make sure all items are accurately represented on the closing statement including loan amount, title expenses, loan expenses, loan broker expenses, real estate broker expenses, proration of rents and deposits, prepayment of escrows for taxes, insurance, property taxes, and escrows for repairs. Do not forget to check the initial interest on your new loan for accuracy, which will be from the date you own the property until your first loan payment. Once you sign off on the estimated closing statement, the final closing statement will be produced. It can be difficult to get changes made or refunds for inaccuracies after the loan closes. Often to do so you will need the agreement of your lender or seller.

How Profitable is Owing an Apartment Building Today?

When I first started lending in the late nineties, apartment buildings were affordable and profitable. Better yet, you could buy one with as little as 20% down and earn more than 10% cash on cash return on your down payment. Today, it takes burning the midnight oil to find a property you can get into with 30% down and a 5% return on your cash invested. Ideally, you will need to find properties that you can improve with value adds. We are talking about ones that have under market rents, and need inexpensive improvements like paint, new floor coverings, fixtures, and appliances.

Purchasing a First Apartment Building Success Story

Twenty-four years ago, I got a call from Kelly Fabros, a young woman who wanted to purchase a $6.8 million dollar 164-unit multifamily property in Wichita, KS. I asked her some screening questions, and then, to get her off the phone I told her, “You do not have the downpayment, or experience to buy this property. You only own a single unit rental. Moving up to a duplex or four-plex is what you should be thinking about, not 164 units.” 

“You don’t have to insult me,” she replied. I can raise the down payment from investors, and I will partner with someone who has the experience (she had taken a course on this), and I will learn what I need to know along the way.” 

Kelly did raise the down payment from four investors and brought in one heavy hitter who had the net worth and experience she lacked. She did all her due diligence in record time, and I closed her loan in 58 days. Four years later she was a multimillionaire. Since then, I have closed loans for many beginning multifamily investors that have what I call “The Kelly Factor.” They are high energy, focused individuals that get the seemingly impossible done simply because they don’t know they cannot do it, and they are willing to do the work. If you think you too have the “Kelly Factor” and are willing to do the 10 steps in this article, then don’t let anything get in the way of your dream. For more in-depth guidance on everything you need to get started here is a link to my book, “The Encyclopedia of Commercial Real Estate Advice”.