Are you considering adding an apartment building to your investment portfolio? Most new investors often focus their due diligence on market rents and the pro forma cap rates, items that are, no doubt, critical. In my experience it helps to first evaluate the 3 M’s:
- Maintenance
- Mechanical
- Management
The 3 M’s are the lifeblood of an apartment and are crucial to effectively evaluating a multi-family investment, no matter if it’s a value-add project or a fully stabilized property. Failure to thoroughly research the components will likely result in an extended hold period and diminished investment returns. Prior to your next multi-family investment, the following should help in evaluating these vital areas.
Maintenance
“What do the units look like? What about the roof, any leaks?” Generally, these are the first questions any investor asks when evaluating an apartment purchase. These are important items, but other areas to consider:
- Window quality and insulation. If windows are not properly sealed or older, more heat/cooling to each unit will be required, resulting in elevated utility bills.
- Water, piping, and wiring. Higher water and electric bills fall to the owner regardless of the bill back situation.
As an example, the following are two identical operating statements; the only difference, a 5.0% increase in annual operating expenses per unit.
| Operating Statement @ $4,000/Unit OpEx | Operating Statement @ $4,200/Unit OpEx | |||
| Market Rental Rate | $1,000 | Market Rental Rate | $1,000 | |
| Number of Units | 25 | Number of Units | 25 | |
| Annual Potential Gross Income | $300,000 | Annual Potential Gross Income | $300,000 | |
| Vacancy & Collection Contingency (% of EGI) | 5.00% | Vacancy & Collection Contingency (% of EGI) | 5.00% | |
| Effective Gross Income | $285,000 | Effective Gross Income | $285,000 | |
| Operating Expenses Per Unit | $4,000 | Operating Expenses Per Unit | $4,200 | |
| Annual Stabilized Operating Expenses | $100,000 | Annual Stabilized Operating Expenses | $105,000 | |
| Stabilized Net Operating Income | $185,000 | Stabilized Net Operating Income | $180,000 | |
| Potential Purchase Price | $2,500,000 | Potential Purchase Price | $2,500,000 | |
| Stabilized Cap Rate | 7.40% | Stabilized Cap Rate | 7.20% | |
| Loan-to-Value Ratio | 65% | Loan-to-Value Ratio | 65% | |
| Debt Interest Rate | 6.50% | Debt Interest Rate | 6.50% | |
| Annual Debt Payment | $123,253 | Annual Debt Payment | $123,253 | |
| Cash Flow | $61,747 | Cash Flow | $56,747 | |
| Equity Investment | $875,000 | Equity Investment | $875,000 | |
| Year 1 Equity IRR | 7.06% | Year 1 Equity IRR | 6.49% | |
| Change in Return | -8.10% | |||
Only a marginal operating expense increase results in an equity IRR reduction of about 8.0%, and this only reflects the first-year return. Any investor’s maintenance due diligence should extend from the obvious to the not so obvious.
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Mechanical
“What is the remaining life on the heating and cooling system? Where is the service log?” are among the first questions asked by any seasoned multi-family investor. Focusing on mechanical systems often provides the best initial view when evaluating a multi-family property. In order to avoid a costly update/replacement, invest in the following during due diligence:
- HVAC inspection with a licensed contractor. Avoid those $100,000+ replacements because you believe installing a few in-unit air conditioners qualifies you to evaluate a commercial boiler system.
- Bring an electrician and/or plumber to your inspection. In particular with older, value-add projects, plumbing and wiring in units can range from adequate to immediate updating.
Whether imminent or within the projected hold period, a property’s systems are its heartbeat and should be your initial focus. These items often require specialized contractors and, depending on your location, availability can delay repairs impacting net income and your ROI.
Management
Commercial real estate appraisers are fond of saying, “A good property manager is worth their weight in gold.” Appraisers understand the value creation from experienced management, but, more importantly, are acutely aware of the value destruction by poor or incompetent management. With that in mind, as part of due diligence, consider the following:
- Review the average monthly collection rates, average vacancy days, etc. This will answer the question, “Are operations running efficiently?”
- Speak with the seller about the management firm. What are the onsite manager’s strengths and areas of concern? When collections or tenant retention are an issue, the onsite manager is usually the source.
- Interview the management team. After all, they are your partner and the face ownership to the tenants: bad managers = bad tenants = bad property.
- Finally, does management know your competitors? If they are not regularly performing market rent studies and competing area market trends, you are probably leaving money on the table.
To demonstrate management’s impact, let’s use the previous operating statements, but increase collection and vacancy loss from 5.00% to 7.00%.
| Stabilized Operating Statement @ $4,000/Unit OpEx | Stabilized Operating Statement @ $4,200/Unit OpEx | |||
| Market Rental Rate | $1,000 | Market Rental Rate | $1,000 | |
| Number of Units | 25 | Number of Units | 25 | |
| Annual Potential Gross Income | $300,000 | Annual Potential Gross Income | $300,000 | |
| Vacancy & Collection Contingency (% of EGI) | 5.00% | Vacancy & Collection Contingency (% of EGI) | 7.00% | |
| Effective Gross Income | $285,000 | Effective Gross Income | $279,000 | |
| Operating Expenses Per Unit | $4,000 | Operating Expenses Per Unit | $4,000 | |
| Annual Stabilized Operating Expenses | $100,000 | Annual Stabilized Operating Expenses | $100,000 | |
| Stabilized Net Operating Income | $185,000 | Stabilized Net Operating Income | $179,000 | |
| Potential Purchase Price | $2,500,000 | Potential Purchase Price | $2,500,000 | |
| Stabilized Cap Rate | 7.40% | Stabilized Cap Rate | 7.16% | |
| Debt Leverage | 65% | Debt Leverage | 65% | |
| Debt Interest Rate | 6.50% | Debt Interest Rate | 6.50% | |
| Annual Debt Payment | $123,253 | Annual Debt Payment | $123,253 | |
| Cash Flow | $61,747 | Cash Flow | $55,747 | |
| Equity Investment | $875,000 | Equity Investment | $875,000 | |
| Year 1 Equity IRR | 7.06% | Year 1 Equity IRR | 6.37% | |
| Change in Return | -9.72% | |||
The impact on poor management is even greater than the maintenance change mention earlier; a modest increase in vacancy/collection results in a Year One equity return decline of nearly 10%.
Conclusion
Focusing on the 3 M’s will provide insight into the nuts and bolts of your potential investment. Don’t be shy about bringing in an HVAC specialist, a plumber, an electrician, or any other specialty contractors, to inspect the systems, and delve into what maintenance issues await you. Evaluate management to ensure all are aligned with your vision for the property, be it value-add or maintaining the status quo. Finally, understand that your investment return is driven by two items:
- What you pay for the property
- What you invest during the hold period
The allure of existing rents that are 25% below market, with the listing broker estimating a stabilized cap rate that is 50 basis points lower than the current rate is tempting but, in reality, achieving the desired ROI could be near nil if you fail to consider the 3 M’s when evaluating a multi-family property.
