This article explores five ways investors can make money with multifamily apartment buildings. The focus here is commercial apartment buildings.
I will dig into each factor driving wealth creation for investors in this asset class
1. Cash Flow
Simply put, cash flow is the amount of money left over from all of the gross income collected on a monthly basis and after all operating and financing expenses have been paid for.
Cash flow = Gross revenue – (Operating Expenses + Financing Expenses)
Properties with positive cash flow provide opportunities for investors to generate regular income from the asset in the form of distributions. These distributions can be paid out monthly, quarterly, semi-annually or annually depending on how the project has been structured.
Cash flow also helps build up financial reserves for the property for use at a later date. Building a buffer of cash that may be required in cases of unexpected capital expenses and repairs.
Investors looking for ways to support or enhance their regular income, can look to cash flowing properties as that option.
Keep in mind that firms operating a ‘value-added’ investment strategy, often acquire properties that do not cash flow very much at the beginning, but do so once a number of value-added activities (actions to force appreciation such as rental increases) have been implemented. The trade-off is typically lower cash flow in the first few years for a higher payout at the end of the project period.
2. Principal Pay Down
The majority of multifamily apartment buildings are financed using some form of mortgage from a variety of Canadian lenders. In most cases, the mortgage payments are structured as principal and interest payments – a portion of the regular mortgage payment pays the interest and a portion is used to pay down the mortgage (principal).
The exact amount of the payment that is divided between paying the interest and principal depends on the rate, the length of the loan term, and how far into the mortgage you are (as the interest/principal ratio favours interest early on and shifts in favour of paying more of the principal as time goes on).
Any amount that goes towards the principal is future money in your pocket and can be accounted towards the profit made on an investment.
For example, over a 5 year period, the amount of principal pay down achieved for a building that was purchased for $1,700,000, with 30% down payment (mortgage amount of $1,190,000), at a rate of 4% amortized over a 25 year period is $153,445. Below is an example of how this is calculated.
Year
2019
2020
2021
2022
2023
Interest Paid
$47,085
$45,933
$44,733
$43,485
$42,185
Principal Paid
$28,290
$29,433
$30,642
$31,891
$33,190
Balance
$1,161,710
$1,132,267
$1,101,625
$1,069,735
$1,036,545
5-Year Total $223,421 $153,446
You can calculate the principal pay down for any mortgage using a standard amortization table available on most banks’ websites.
3. Depreciation
Also known as Capital Cost Allowance in accounting terms. This beneficial factor enables rental property owners to reduce income from rental units by a predetermined amount according to the CRA.
While technically it’s not a typical revenue stream, it sure does help the income statement come tax time!
Talk to your accountant about how to apply the Capital Cost Allowance to your properties.
4. Natural Appreciation
Also known as market appreciation, natural appreciation occurs when forces outside of the property owner’s control increase the value of the asset.
Such factors include:
* Economic (primarily local)
* Population growth
* Job growth
* Rental demand growth
* Allowable rental increase legislation
Growth or decline in any of these will have an impact on the value of your building or the building that you are invested in.
My investment firm focuses on areas that have strong market fundamentals in the first place. Markets that have strong projected population growth (you need people to rent your units, the more the better!), strong job growth and business investment in the local area, strong rental demand (where the need for rental units is greater than the pace at which rental units are being built).
Think of these factors as adding a protective layer to your investment. The more of these positive influencers in your market the better.
Ever heard of the saying “rising tides, raise all boats”? Well, buying in markets with positive projected influencers will benefit all properties within it.
5. Forced Appreciation
Last but not least, the fifth most common way to make money investing in apartment buildings.
This factor is what really got me excited about multifamily apartment building investing when I first started!
This is one of my favourite wealth building aspects of multifamily apartment building investing. It is probably the main reason why I started investing in this asset class and why I am so passionate about educating others about it!
In my opinion, aside from the ability to scale faster, this is one of the biggest differences between investing in non-commercial multifamily properties (5 units or less) and commercial multifamily (5+ units).
Your ability to force appreciation – actions that are designed to purposely improve (force) the value of the building (appreciation). These actions can be targeted at increasing revenue or decreasing expenses.
Now, this can be done with non-commercial properties as well, but the incremental increase in the resulting valuation favours commercial real estate.
To better understand how this works, you need to understand how commercial multifamily apartment buildings are valued in the first place.
Value = Net Operating Income / Cap Rate
As a reminder, Net Operating Income = Gross Revenue – Operating Expenses.
For every dollar increase in NOI, the value of your investment increases by $1 / Cap Rate. If the cap rate is 5%, then every dollar increase in NOI increases the value of your property by 20X. WOW! 20 TIMES!
For the mathematically inclined:
$1 / 5% = $20
That’s a 20X multiple.
Eat your heart out Grant Cardone 10X! I’m actually a big fan of his 10X ideas.
Let me take this example one step further with actual numbers from an apartment building I am currently transforming into a cash flow producing, high value asset.
Current rent for the average one bedroom unit is $700 per month. For this particular market, this is well under-market value by about $700.
Through renovations costing between $25,000 and $30,000, I will be able to confidently rent this unit for $1400 per month.
Assuming the cap rate for this market 5%, improving this unit and attracting new tenants will add and increment $168,000 of value to the building.
Here is the math:
An incremental $700 per month = $8400 per year in additional rental income.
Using the formula Net Annual NOI increase / Cap Rate
$8400 / 5%
= $168,000
Technically, you should subtract the renovation cost to arrive at a net value increase of: $143,000 ($168,000 – $25,000 reno costs).