Updated: Feb 18
There are lots of good reasons to add real estate to your investment portfolio and investing in apartments historically has produced consistent (and resilient) returns. Part of the reason this is so true is that apartments fulfill a basic human need - everyone has to live somewhere. Another key to the consistent returns is there are so many different ways to make money by investing in apartments, and in this article, I highlight five.
Before I get into the list, if you are way too busy with your job, family, school, and other obligations that you don't have the time to buy real estate, that's not a problem. We at Four Oaks Capital spend the time and money to find, analyze, purchase, and manage apartment complexes so that you don't have to. You can partner with us and earn true passive income. To learn more, schedule a call with us to discuss how it works.
Now, here's the list:
1. Cash Flow
Apartment ownership is much like any other business where the profit is equal to income minus expenses. In the specific case of apartments, the income is largely from the collected rents from the tenants, but there are other sources of revenue too. Operators can include add-ons for various items, such as parking, on-site storage, pet fees, and etc., to increase the property's income. Similarly with expenses, owners can make reasonable changes to the expense column to increase the total profit.
Let's go one step further - how do we know the property will cash flow? The answer here is very simple. Not only do WE make conservative estimates on the future income and expenses of the property, but so does the lender. Typically, on the apartments that we purchase, the lender will use its vast resources to make sure the property has sufficient verified income to pay for all of the expenses, including the loan payment, with a rather generous buffer. That buffer is your cash flow.
Cash flow in such an investment property can be paid out on a regular basis and can typically produce 5-10% annual return on investment (ROI), and since inflation typically has the same effect on both income and expenses, the returns are automatically indexed for inflation.
2. Natural Appreciation
Over time, inflation has pushed the price of goods and services (including real estate) steadily upward. Relatively low levels of inflation are actually good for the economy and can be very good for real estate, and by itself, inflation will increase the value of a real estate by roughly 2% per year throughout the U.S. (which is the Fed's target for inflation).
Of course, another way of looking at inflation is the effect it has on your wallet - it reduces the value of a dollar year over year. So how does this help you make money in real estate? By taking advantage of debt and a process called leverage.
To illustrate how leverage works, let's use a simple model and assume we purchase an apartment complex for $1 million. We finance the purchase with $800,000 loan and put $200,000 down. If, over time, through natural appreciation, the value of the apartment complex increases by 10%, what is our ROI?
A 10% increase means the apartment value increases by $100,000 to $1.1 million, but because of leverage, our return on investment is much higher.
Take the $100,000 increase and divide by the amount of money we have invested, or $200,000, and our ROI for this property is 50%. In this case, the leverage from the bank loan multiplies the 10% natural appreciation by a factor of 5.
In other investments, inflation is known as "the silent killer" due to the effect it has over time. In the case of real estate, when combined with leverage, inflation works in your favor. Even when adjusting the returns for inflation, the return on investment in this scenario is still 35%.
This natural appreciation is very much like the equity in your home - it's only realized either at sale or a refinance.
3. Forced Appreciation
Natural appreciation just happens, but there's also mechanisms in which we can FORCE the value of the apartment investment to go up. To understand this, first we must understand that commercial real estate's value is proportional to its income stream. In other words, if you force the income to increase by 10%, the value of the apartment complex also increases by 10%. As in the case above, leverage will multiply the returns from forced appreciation to the same extent as natural appreciation.
This is where an investment strategy focused on adding value provide significant returns. If we purchase a property that is a bit older and with lower rents than everything else in its neighborhood, we can renovate the property and raise rents. These higher rents would therefore push the property value up proportionally. Likewise, finding efficiencies to reduce expenses has the same proportional effect on the property's value.
Continuing with the same hypothetical scenario, we purchased a $1 million property using an $800,000 loan. Over the life of the investment, there was 10% natural appreciation due to inflationary pressures and an additional 10% increase to the income from forced appreciation. Now, the property is worth $200,000 more than when we purchased it, which is a 100% ROI. Adjust for inflation, that's still an 80% ROI.
At Four Oaks Capital, we specialize in purchasing apartments with significant value-add opportunities where we can force appreciation by targeted renovations and management efficiencies. To learn more, schedule a call with us to discuss how it works.
4. Debt Paydown
As recently covered, we obtain a loan to finance a significant portion of the property. Over the years of ownership, not only does the value of the property increase, but the amount of debt is gradually paid down over time in a similar fashion to what happens with a single-family home mortgage. Of course, unlike your home, the monthly loan payment on the apartments is paid by the income off of the property. I'll re-emphasize that point, the tenants pay down the debt, whereas in the case of a home mortgage, YOU pay down the debt. Like appreciation, the equity created by debt paydown can only be realized at sale or through a refinance.
Let's use the same example of a $1 million dollar purchase with an $800,000 loan. If over the life of the investment, the property appreciates 10% due to natural inflation, gains another 10% in value due to forced appreciation, and has another $100,000 of the loan principal paid off, at sale, the property will be worth $1.2 million with $700,000 in debt for a total payout of $500,000. Since our initial investment was only $200,000, that's a $300,000 profit and a 150% return on investment, which is 125% adjusted for inflation.
5. Tax Advantage
Following our scenario along, it's understandable for you to ask - what about all the taxes we'll have to pay on that amount? Well, turns out that real estate is a very tax-advantaged asset.
Let me introduce you to a concept called depreciation - it's easiest to see by using an example of a new car. As time passes, the value of the car will inevitably go down, regardless of how well you take care of it. That decrease in value is depreciation. With real estate, the IRS will allow apartment investors to depreciate the apartment building and everything in it and claim this depreciation amount as a LOSS on taxes. This depreciation only affects the paper value of the property - as we've seen with the cases above, the true value of the property will actually increase over time.
Now, focusing specifically on an apartment investment, the amount of depreciation is generally significantly higher than the cash flow, meaning the returns from the cash flow are literally tax free. What's more, this loss from depreciation can even offset OTHER INCOME that you received during a tax year (subject to limitations), reducing your overall taxes and putting even more money in your pocket.
What about the money you receive at sale? The depreciation will also offset the gains at sale, but there's typically a lot more income than deprecation; however, there are still a few tools to minimize the taxable income. If you weren't able to use all of your losses from depreciation in previous years, they carry FORWARD to future years, meaning you should be able to offset a substantial portion of the sale proceeds. Additionally, since the depreciation is highest in the first years of ownership, you could simply reinvest a portion of the proceeds in more real estate and have the depreciation from that asset offset your gains in the same taxable year.
Take advantage of all that real estate has to offer. Start by scheduling a call with us - we can answer all of your questions and help you see if apartment investing is right for you.