You just got your first investment offering memorandum for an apartment complex investment opportunity. The photos are nice and glossy; everything looks good, but what about the numbers? What about the substance under the hood that is going to provide you a return on your investment? How exactly does this apartment community make money?
Many new investors often get mystified when they look at the numbers of an investment opportunity, especially if they do not have a career in a finance related field. You may even think – “why are there so many different items listed as income, I thought they just rented apartments?”
It can seem overwhelming and anxiety inducing to see all the different calculations that go into identifying a profitable apartment investment opportunity.
Over time once you get more familiar with offering memorandums and apartment investing these different numbers will start to become more familiar to you. If you are investing as an active investor, then it is important for you to get a strong foundation in the math behind a good investment opportunity. Having a good base understanding of the numbers allows you to apply this powerful income property investment strategy.
If you are a passive investor there’s hope for you. While I always suggest having a good base understanding yourself before making an investment decision, passive investors have the benefit of the expertise of the deal sponsor. The deal sponsor has put in the hard work of sifting through the numbers, identifying various scenarios and concluded on the merits of the deal. Further, any good deal sponsor worth their management fee would gladly provide explanations on the numbers you will see in an offering memorandum. That’s great news, you don’t have to be the expert, because you have an expert already working for you!
What are these numbers that we are even talking about? To break things down into a simpler manner – there are the financials and there are the returns on investment. In the financials you get a view of the income statement that shows the expected revenues and expenses that the property will generate. When revenues exceed expenses, you will have a net profit, however when expenses exceed revenues there is a net loss. After consideration of the revenue and expenses there non expense related distributions for capital activity such as repayment of loan principal and then payment of remaining profits to investors (i.e. your return on profit).
There is a lot to break down in the numbers of an apartment investment opportunity; in this article we will focus on diving deep into the different sources of revenues that a property will generate. This should not be confused with the many ways that an investment property will pay you.
Apartment complexes earn revenue from 2 main categories: Operating Income and Other Income. This would be the Operating income for core business activities of renting out apartment space to tenants and then Other income for additional amenities provided or income streams not related to the core business of renting apartments.
For value-add active investors this list may provide a good path to increase the profitability of your apartment complex. If you already are implementing some of these methods, then perhaps you can adjust your execution in a way that makes it more efficient and profitable.
Rental Revenue – The gross rental revenue line represents the amount of income that a property makes from its core business of renting apartments. This is literally the amount of money that the tenant pays to rent the apartment. Depending on the size of the apartment building this operating income section may be accounted for differently.
Cash Basis Revenue
For smaller buildings (typically under 70 units) it is very likely that the number presented is recorded under a cash basis – this means the revenue amount you see on the income statement is the actual cash that the property manager gets each month.
Accrual Basis Revenue
For larger buildings the income statement may be done on an accrual basis - this means that the property manager will accrue a gross amount for the expected rental income that should be received for the month based on in place leases or expected market rental rates.
Gross revenue, however, may not always equal the amount of cash that is deposited in the bank each month. Renters may pay late or not pay at all, or the property manager may not be able to lease a property for the full market rental rate expected. Property managers may account for this difference between the gross expected revenue and actual revenue with contra-revenues such as “loss to lease” or “Vacancy.” Loss to lease represents the difference of expectations vs reality – the property manager expected to be able to rent a unit at a certain market rate however the lease they were able to sign with the tenant was less than that amount. This is an economic vacancy. Another type of economic vacancy relates to tenants that don’t pay or pay late.
In the most common sense when you hear about vacancy you may think of a building that is not occupied. This is called physical vacancy as opposed to economic vacancy (when a building is occupied but receiving less revenue than expected.)
Other income ranges from items directly related to the payment of rent such as late fees to offering additional services beyond just a rental of an apartment unit. See below for some of the top sources of other income for an apartment community.
Late Fees – When a renter pays their rent late, it is common that an additional fee be applied as a penalty for the late payment. Late fees can be a good source of revenue and lead to collection of more total revenue than what is contracted on the leases in an apartment complex. Caution should be taken however as a significant amount of late fees may be an indicator of other problems at the property. Further if the property uses an accrual accounting system, the accrual of late fees may not equal the collection of cash for these fees.
Pet Fees and Pet Rent – If pets are accepted in the apartment complex then charging a one-time pet fee and/or on-going pet rent may be an additional source of income. This additional pet fee can also serve to offset additional maintenance costs that may be created by accepting pets.
Parking – Parking spots can be a prized commodity depending on the location, proximity to other amenities or the renter’s apartment, and if it is covered or not. Renters are willing to pay more for positions that have perceived greater value. An apartment complex owner can charge renters a fee to have a specific space assigned for the renter’s exclusive use.
Laundry – Convenience of being able to do your laundry at any time of the day and close to your apartment is a selling point for a rental. The addition of a coin, card, or app integrated laundry room in the apartment complex can be a source of income from residents looking to do their laundry at a convenient location. If a laundry hook-up is already provided in unit then there may be opportunity to charge a fee for rental of the washer and dryer equipment.
Utility Bill Back Fees/RUBS (Ratio Utility Billing System) – Depending on the apartment there may be certain utilities included in the rent. At some apartments, the renter will pay the utilities directly. In between these two ends of the spectrum exists utility bill backs or RUBS. A utility bill back occurs when the apartment complex shifts the costs of certain utilities back to the resident. Ratio Utility Billing System represents a specific method used to calculate utility usage such that the appropriate amount can be charged back to the respective apartment.
Vending Machines – Vending machines can be a low maintenance way to earn more revenue.
Storage – If space and budget allow, property owners can add storage space and provide these to residents for a monthly fee. Often renters have more belongings than they need – storage space allows them to securely and conveniently store these items near their apartment.
Event Space Rental – Apartment communities with large common space may be opportunities to earn rental income for residents that want to host events. There may be additional revenue if the space can be rented by non-residents as well. This may not just be a event hall only – there could be opportunities to rent out gyms, playgrounds and other areas of the apartment complex.
Cable/Internet Provider – Cable and internet providers often make contracts with large apartment buildings. As part of this contract these utility companies will provide a percentage of revenue to the apartment complex.
Valet Trash, Cleaning and other Luxury Services – As you can see, convenience is a recurring theme for the different amenities provided. Property managers can charge an additional fee to residents for taking their garbage from their unit as part of a “valet trash” service.
Additional services such as home cleaning can be provided directly from the property management company or subcontracted out to a licensed cleaning agency. This same concept can be applied to various other convenience needs that residents may have such as furniture set up, grocery deliveries, dry cleaning, laundry etc.