Buying Small Apartments : Profits and Pitfalls of a Landlord

If you’re thinking about buying your first rental property, there’s a good chance you may be considering the purchase of a duplex or small apartment building.

Your idea is a good one: Many small rental buildings can be purchased with a small down payment and they’re usually easy to buy and sell. They also help you build equity to eventually make a larger purchase, while teaching you the basics of property management.

But don’t make the mistake of thinking that owning and operating a small rental complex is an armchair experience.

“Too many people don’t realize that residential property requires a tremendous commitment of time, energy and effort,” says Klara Katersky of Katersky Financial, a Woodland Hills-based syndicator who made a fortune by investing in small apartment buildings. “It’s not cost-effective to hire a manager for such a small property, so you’ll have to do it yourself--and still find time for your spouse, kids and full-time job.”

Even before you go out shopping for a duplex or small apartment, it’s important to decide exactly what you hope to achieve by purchasing it.

“Determine whether you want the property primarily to diversify your assets or whether you’re looking for steady monthly income,” says Lawrence A. Krause, president of the San Francisco-based financial planning firm Lawrence A. Krause & Associates Inc.

“If you want monthly income, you’ll have to make a pretty big down payment--maybe as much as 45%,” Krause adds.

You might be willing to settle for a break-even cash flow or small monthly loss, provided you will be able to write off your losses, or the property’s appreciation potential is extremely good, or you plan to live in one of the units to lower your own housing costs.

Once you’ve decided what you want out of your investment, it’s a wise idea to go to a bank and establish a line of credit. “If you find a real good deal that’s going to move quickly, it’s good to have instant access to $5,000 or $15,000,” says Corey M. Patick, chief executive of Stockton-based Gibraltar Community Builders, one of the state’s biggest apartment developers and owners.

“You wouldn’t want to lose a bargain just because you couldn’t make a $5,000 deposit,” Patick adds.

Most experts say you should look for a building that’s near your current home, primarily because you’ll personally have to manage the property and perform most maintenance duties. “Management firms usually want 5% to 10% of your gross monthly income, and that can mean hundreds of dollars a month out of your bottom line,” says Patick.

A good real estate agent can be useful, but make sure the broker has sufficient expertise in buying and selling income property in your target area. Patick suggests getting referrals from knowledgeable investors or calling agents who have several “apartment for sale” advertisements in your local newspaper.

Some of the best apartment prospects are often near new commercial developments, says Linda Falcon, a realtor with Century 21/Medallion Realty in West Los Angeles.

Good Transportation

“New office buildings and better stores help promote a better living environment and higher prices,” Falcon says. Other items to look for are a good transportation system, recent renovation jobs and easy accessibility to parks, entertainment facilities, churches and synagogues.

The condition of the building should reflect its age: Although a run-down duplex or apartment may present a bargain, you must consider how much it will cost to upgrade the building so you can raise rents to market value.

In order to properly evaluate a potential acquisition, the seller will need to provide you with certifiable information about the building’s annual rental income and expenses, Falcon says. If any of the tenants have long-term leases, you’ll need to consider terms of those leases when estimating future rental income.

Although your realtor should be able to help you determine whether the property is fairly priced, it’ll help if you know a little about the factors used in pricing apartment buildings and the terminology you’ll hear as you shop for an apartment.

Capitalization Rates

Rental income--what you collect now and what you can collect in the future--is the primary factor in determining the value of any type of income-producing property. Although there are several methods of income analysis, the most popular method is known as the property’s capitalization rate.

You calculate your cap rate by taking the building’s annual net income figure and dividing it by the proposed purchase price of the property. A building that provides $18,000 in annual net income and is listed for $190,000 has a cap rate of 9 1/2%; an apartment with $25,000 in net income listed for $240,000 has a cap rate of 10.4%.

Is 10.4% a fair return on your investment? It depends on a number of factors, including the riskiness of your investment and the yields of alternative investments.

You are taking a bigger risk--and will want a bigger return--if the property is in a borderline area, vacancy rates are climbing or major repairs may soon be needed. You’ll also want a larger return if other forms of investment--be they real estate, certificates of deposit, or stocks and bonds--are providing comparable returns with less risk and fewer headaches.

Compare Other Properties

On the other hand, you may be willing to accept a lower cap rate if the property is in exceptional shape, there are few or no vacancies and property values in the area are rising sharply.

Compare the cap rate of your potential acquisition to the cap rate of similar buildings in the area that are available or have recently been sold. You should be able to obtain those figures through your realtor or directly from the sellers. By making such a comparison, you can learn what kind of return other investors are demanding, and you can determine whether you’re paying a fair price for your own building.

The task of thoroughly evaluating the purchase of an apartment or duplex is particularly important today because the tax benefits of owning an apartment have been reduced by tax reform and property values in most areas aren’t rising as quickly as they did in the 1970s.

“You can’t depend on double-digit inflation to bail you out of a bad or marginal real estate investment anymore, so you’ve got to analyze a deal more than ever before,” says financial planner Krause.

Raise Rents Often

Once you’ve purchased a property, make sure you run it like you would any other business. Raise rents as often as possible--and as much as possible--and don’t delay in making needed repairs.

“Some owners, especially first-timers, get too friendly with their tenants,” explains Katersky, the real estate syndicator. “Then they don’t want to raise rents as much as they should, so monthly cash-flow suffers.”

In addition, Katersky says, the resale value of a poorly managed property will be reduced because the new buyer won’t pay as much for a building that needs extensive repairs or has below-market rental income.

“A lot of times, just minor improvements can provide good rental increases,” says Thomas C. Trimble, senior vice president for Emeryville-based real estate giant Consolidated Capital Cos. For example, Trimble says, you might be able to raise rents by simply adding a new coat of paint, upgrading the landscaping, or installing new carpet.

Reducing Expenses

You may be able to lower monthly expenses by adding extra insulation to reduce energy bills, repairing leaky faucets and by getting at least three bids from contractors or repairmen when you can’t do a job yourself. “We put all of our jobs out for bid,” says Trimble, “and it saves us a lot of money.”

Expenses can be further reduced by installing individual utility meters or by taking a tougher approach toward tenants who don’t pay their rent or are chronically late.

Although tax reform has scaled back on many of the benefits of owning rental property, the write-offs it can provide are still important. For example, most duplexes and apartments can be depreciated 3.64% a year over 27 1/2 years, a tax benefit that most other forms of investments don’t provide. Owners who actively participate in the management of their property can also use up to $25,000 a year in losses and credits generated by the property to offset other forms of income, providing that their adjusted gross income doesn’t exceed $100,000.

In addition, you can still defer taxes on the profits of a rental property by swapping it for a similar building--as long as you follow new guidelines of the IRS.

Enroll in Courses

Of course, there are many other intricacies involved in buying, managing and selling duplexes and apartment buildings. Experts suggest you enroll in at least one college-level course on income-producing property before you plunge into a real estate deal. Many colleges offer such courses as part of their curriculum or through inexpensive extension classes.

You might also consider taking courses that will prepare you for a real estate licensing examination. Some brokerage firms operate real estate schools and will reimburse your tuition charges if you eventually go to work for them.

Many apartment investors have obtained their real estate license because it gives them direct access to important information about available properties and allows them to quickly find out when attractive properties are put up for sale. And, by acting as your own broker, you can save on your commission costs and make money by selling other people’s property for them.

Several good books on investing in apartments and other types of income-producing property are available at your library or local bookstore.

Among the better ones are “Investing in Residential Income Property” (Douglas M. Temple, Contemporary Books, Chicago), “Investing in Real Estate; How to do it Right” (Dennis M. Brouner, Longman Group, Chicago), and “The Smart Investor’s Guide to Real Estate” (Robert Bruss, Crown Publishers, New York).

Make sure, however, that any book you buy has been revised to reflect changes brought on by the new tax legislation and today’s lower inflation rate.