How an Apartment Makes Money
This pro forma is based on the four-plex shown above, which the author built on the site of an old house he held for five years while paying down the lot. The building sold in 2008 during the height of the real-estate crisis for the full asking price.
The financing procedures for apartments and other commercial buildings are not that different from those for building a spec house, but you’ll want to be well-armed with financial details before seeking out a lender (for more on the subject, see “Getting Started in Commercial Real Estate,” Business,
One key piece of information is the pro forma, the financial projection you’ll prepare to accompany your loan application (see sample, facing page). In a few lines, this summary tells the story of how you expect the building you’re buying or developing to pay expenses, repay the loan, and make a profit. The pro forma will include at a minimum the yearly gross rents, a vacancy factor, building operating expenses, and the yearly mortgage payments.
Hold or sell? Most people build or rehab apartment buildings in order to hold them for many years and realize the combined benefits of cash flow, building depreciation (a paper tax loss), and land appreciation. More than once I have spoken to a landlord who pointed proudly toward his or her property and declared, “That’s my retirement.” But that’s not the only strategy.
I built several of my apartment buildings on speculation and later sold them. Unlike homes, which have an intrinsic value that can go up or down, income property derives its value primarily from rents. My strategy was to build, lease, and then immediately put the building on the market. Since the mortgage and expenses were being covered by the rental income, I had plenty of time to wait for the right buyer and had a fairly narrow negotiating range on price, since the basic value was set by the income.
Bear in mind that while the market is favorable in multifamily right now, with low interest rates and easy leasing, multifamily mortgages typically come with a five-year interest-rate reset. That means that the 4 percent mortgage you banked on to make the numbers work today could go up 2 percentage points or more in five years — in fact, you should plan on it. Plan too for lower rents, higher costs, and a mortgage that rests at the upper limits. If you prepare for the worst and don’t bank on optimism, your apartment buildings may indeed provide a handsome retirement. (If you’re interested in learning more about real estate as a wealth-building strategy, I recommend What Every Real Estate Investor Needs to Know About Cash Flow, by Frank Gallinelli.)