Buy or Build?
Rehabbing an older building in a good location can look good on paper, but rehab dollars are notoriously uncertain, making it difficult to develop an accurate pro forma. For example, it would be wise to include a large construction fudge-factor cost (20 percent would not be excessive) on any pro forma for a rehab project. Likewise, yearly maintenance costs on an older structure can be very unpredictable. Even the amount that you’ll be able to charge for rent might turn out to be lower than you expected because of the perceived desirability of new vs. older property.
Offsetting some of these risks, many municipalities offer deferred (no interest and no payment until you sell the property) or very-low-interest loans to entice landlords to update and upgrade rental property in blighted areas (often called redevelopment zones).
New construction. If you’ve been building single-family homes, transitioning to two-to-four unit construction should be easy (see Accepted Fire Barriers for Multifamily Housing). You can use the same set of subs and — if you keep the building height at two stories or less — the same design team you used to draft single-family plans.
Building five units or more pushes you into another category that typically involves more stringent requirements and — in some jurisdictions — the commercial code instead of the more familiar residential code. In most areas, your plans for five units or more will also require the stamp of a licensed architect, and you may need a commercial contractor’s license to build them.
Financing becomes more complex and expensive, too. While a building with up to four dwelling units would typically qualify for a residential mortgage, most lenders consider a building with five units or more to be commercial property, financed by mortgages with stricter underwriting requirements, significantly higher down payments, higher interest rates, and more expensive origination fees and appraisals.
Insights From Experience
There are some upgrades I think are worth including in my projects, despite the slight increase in construction cost. For example, even when two-hour fire barrier walls aren’t required by code, I usually build them anyway. This not only makes my apartments quieter and safer — it also makes it much easier to turn my rental units into condominiums if the opportunity presents itself.
Glossary of Terms
Net operating income (NOI): A property’s yearly gross income minus operating expenses is its NOI. An apartment building’s fixed costs include taxes, insurance, utilities, and maintenance; what’s left over is the net operating income, an important measure that tells the bank how much money is available to pay the mortgage.
Coverage ratio: The debt service coverage ratio shows the relationship between the rental income and property expenses, including mortgage principal and interest payments (P&I). Here’s a simple example: You receive $1,000 in monthly rent, your P&I payment totals $500, and your expenses (utilities, taxes, and maintenance) amount to $300. This means you have an NOI of $700. With a mortgage payment of $500, your coverage ratio is 1.2 percent, or 120 percent of the money needed to pay the bills. Most lenders require a minimum coverage ratio of 1.1 percent to 1.3 percent for a commercial loan (the bigger the ratio, the better). Of course, in the real world the equation is more complex and includes other factors, such as the vacancy rate in your area (a knowledgeable commercial real estate agent or an appraiser can help you pin down this information). In older buildings, you may need a replacement escrow for major components, which is an amount set aside every month to pay for major capital expenses. For example, if yourbuilding has a 10-year-old roof with a life expectancy of 15 years, you will want to reserve enough money during the next five years to pay for this anticipated replacement. If the new roof will cost $20,000, you’ll need to set aside $20,000 ÷ 60, or roughly $333 per month, in an escrow account to cover the anticipated expense — your bank may require this and hold the money from your deposits. Loan-to-value ratio (LTV): The LTV is the total amount that you are borrowing relative to the appraised value of the asset, which in this case is the building. If your building has an appraised value of $100,000 and you are asking the bank for $75,000, your loan has a 75 percent LTV. The lower the LTV, the safer the investment for both the bank and you. During the recent real-estate downturn, a very conservative LTV of 75 percent would still have left you upside down if the property dropped in value by 40 percent (the national average). In other words, if your property was worth $100,000 and you borrowed $75,000 (75 percent LTV), you would still owe the bank $75,000 even if the market value dropped to $60,000. Your LTV has shot up to 125 percent. The good thing about income property is that the value is generally based on the income and capitalization (cap) rate. If your rents go up, the cap rate rises and your property’s value increases. Capitalization (cap) rate: Based on the net operating income, the cap rate measures the rate of return on the cash investment in the property, and is used by lenders to determine a property’s value and risk. In the first example, with a capitalization rate of 10 percent on a property with a $700-a-month net income, or annual NOI of $8,400 (12 x $700), you would have an estimated property value of $84,000. Investors generally look for a cap rate between 8 percent and 10 percent. Had you paid $100,000 for the same property, your cap rate would be 8.4 percent ($8,400 ÷ $100,000). The cap rate estimates the relationship between the total property value (or cost) and income.
Cash-on-cash return: Since I can’t (or won’t) buy rental property without a loan, I prefer to look at the cash-on-cash return rather than the cap rate. This is the return on investment based on the amount of cash I have to put up to buy the property. I typically look for a cash-on-cash return of 6 percent to 8 percent. In other words, the actual cash invested in the deal, after collecting rents and paying expenses, yields a return of 6 percent to 8 percent on an annualized basis. For example, if the bank requires a $50,000 down payment to buy the building, and I net $3,000 a year after paying mortgage and expenses, the cash-on-cash return is 6 percent — much better than a savings account, and better than my 401K retirement account.
I also believe in good-looking buildings that enhance rather than detract from the neighborhood. Typically, small multiple-unit projects are built within older subdivisions, because that’s where you’re most likely to find affordable lots with zoning that allows apartments. Unfortunately, many apartment-building developers have earned a reputation for “slipping in” misfit structures that suck the charm out of these heritage neighborhoods. In reaction, neighborhood groups may draft strict neighborhood standards that are challenging to comply with architecturally if you want to remain economically viable.
Even when I’m not compelled to, I always try to build structures that look like they belong. In addition to making it easier to attract better tenants, paying attention to curb appeal goes a long way toward stretching the strict financial parameters set by an investor when it comes time to sell the building. You can get a better price for a better-looking building.
Turnovers cost money, so you want good tenants to stick around. To give them a feeling of privacy and ownership, I try to give every unit a separate exterior entry. I make sure interiors get plenty of daylight and are well-ventilated with quality bath and kitchen fans. I tie the bath fans to the bath light — to make sure they’re used — and, in the kitchen, supplement the range hood with a ceiling exhaust fan that vents to the exterior. I tie this fan to the light as well. These touches make living more pleasant and reduce damage due to indoor humidity.
I include garages in my projects whenever possible. They really only need to accommodate one car, and can be either detached or attached; both configurations work well. I also include a laundry room in every unit, rather than try to maintain a common laundry facility with coin-operated machines.
Finishes. In an apartment, finishes need to be durable. Carpet may be initially less expensive than wood or laminate flooring, but it’s harder to keep clean and doesn’t last nearly as long. Even sheet vinyl and vinyl composition tiles last five times as long as carpet.
If you’re angling for high-rent clients, a few tasteful details will go a long way. For example, granite kitchen countertops are a reasonably priced upgrade — and so is a wide bathroom vanity with designer faucets, a large mirror, and nice light fixtures.
To save on maintenance costs, I install painted wood window sills (drywall sills always get damaged). I avoid casement windows, because I don’t like replacing cranks, and I avoid bifold and bypass closet doors so I’m not changing tracks at every turnover. I also furnish entry doors with a deadbolt and no locking knob, so tenants are forced to have a key in hand when they lock the door behind them. That way, I don’t have to respond to 2 a.m. lockouts.
Fernando Pagés Ruiz is a developer and former home builder who lives in Boulder, Colo.