To many, residential real estate investing follows a natural progression. First, you start out purchasing condominiums and townhouses, then move on to detached homes and small multi-unit properties, such as duplexes, triplexes or fourplexes, until finally you make it to apartment buildings.
But this tale is fiction, according to Don Campbell, president of the Real Estate Investment Network. "Investors should do whatever their funds allow them to do," he says. "There is no arbitrary rule. If their funds only allow them to get into single-family, then that would be the strategy to take. But if their funds allow them to get into multi-family, then that's a great place to start out, too."
As long as you assemble the right team of professionals, including an accountant, appraiser, building inspector, lawyer, mortgage broker, Realtor and property manager, multi-family investing is no more difficult than single-family investing, Campbell says.
What does need to be kept in mind, however, is that multi-family investing is "a completely different game," Campbell says. GET YOUR FUNDS TOGETHER
Buying an apartment building takes much more money upfront. So to be taken seriously by lenders, you must have enough to make a 20% down payment - which, for instance, would be $200,000 for a $1 million property - before you even approach the bank.
Without the cash already in hand, you'll need to use one of two options to get it. First is a line of credit. With interest rates still at historic lows, Campbell says a line of credit can be a great way to get into multi-family investing, as long as the cost of the interest payment is properly factored into your expenses.
"Remember by using your line of credit, you don't have to give 50% of the deal away to a joint-venture partner and as long as that building is paying the line of credit's interest payment, then it is of little risk," Campbell says.
If you're uncomfortable with this idea, however, you'll have to go the joint-venture route. JOINT-VENTURE INVESTMENT
Investors are more inclined to put their money into multi-unit properties because the risks are much lower. For one, there are less overhead costs since everything is under one roof. That means working with one property manager, one landscaper and one snow removal company, as opposed to working with several businesses for a portfolio of single-unit income properties spread out over a large area.
For this same simplicity, Campbell suggests working with a maximum of two other joint-venture partners on any multi-family project. Having too many owners can create confusion when the most important decisions need to be made. Not to mention, different levels of technical knowledge can lead to frustration for everyone when handing the building's operations. And just think if one of your partners gets divorced, goes bankrupt or needs to pull his or her money out of the building for any other reason.
Given these potential risks, lenders cringe when they see too many partners on one project. They're not about to finance as much as 80% of an apartment building if there's the possibility they won't get their money back.THE BANKS' CHOICE
Unlike single-family investing in which the banks consider your ability to pay them back, in multi-residential investing, the bank's only concern is if the building can produce enough operating income to pay down the mortgage. Since there's so much money involved, the banks pore over every detail about a building to ensure it's going to be a solid investment. They want to know the condition of the roof, the boiler, the windows, the doors, the balconies - whatever could affect the value of the building.
The banks' emphasis on the condition of the property derives from the different way in which apartment buildings are valued.
Single-family properties are valued through appraisals. Typically, an independent professional appraiser will assess the property's worth by comparing it to similar properties in the same area.
The valuation of multi-family buildings and commercial properties, on the other hand, is done using capitalization rates, or what is more commonly referred to as cap rates.MARKET CAP RATES
When looking for a multi-unit property, you need to be aware of market cap rates, which are set by financial and governmental institutions and vary by region. In Ontario, for example, the Municipal Property Assessment Corporation (MPAC) determines its regional market cap rates by first dividing each multi-residential property's net-operating income by its selling price. It then selects the median for each area, which it uses as a regional market cap rate. During an assessment period (the current one being 2008 to 2012), MPAC divides each property's net-operating income in an area by its regional market cap rate to arrive at the building's value.
Since the building's profitability determines its value, Campbell says all investors should focus on finding properties which have the potential for higher rents. That way the building will not only produce more monthly income, but it will also appreciate more quickly.
For example, an owner with an annual net-operating income of $100,000 for a $1-million apartment complex in an area with a market cap rate of 10% could raise the value of the property to $1.5 million by increasing the annual net-operating income by $50,000 (150,000/0.1 = 1,500,000).To find out how cap rate affect banks' lending policies, how to find the right apartment building, with the perfect location and the best price, pick up a copy of our October issue, on newsstands until Oct. 12.
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