Originally posted on March 10, 2011 by John Dessauer
An apartment building is typically built by builders and/or developers. The challenge with that is the fact that builders typically build buildings with little regard as to the demographics of the area. This in my opinion, has been a big mistake. It’s the very reason why some apartment buildings have gone as “non-performing” in metro areas that have been built fairly recently.
Anyone looking to build an apartment building has to look at the apartments from an investors point of view. The builder should be considerate of four major things. They are:
1. Growth and Development of an Area – How the employment outlook is in an area is a key component in the supply and demand model that apartment buildings thrive on. Apartment buildings should not be built in an area where there is long-term stagnant growth. The management of the apartment building in a no growth area will have higher expenses than normal in attracting and maintaining tenants. Because of this, the Net Operating Income of the building will suffer, hence continually losing value. Only build in areas of strong long-term growth.
2. Competition – What is the competition in the area with apartments? What type of amenities are most desired in the area? Builders often flood an area with Class A apartment buildings when the real need is in the Class B range. Take a look at the demographics of an area along with information about income levels, rents, occupancy rates, and housing market stats. The builder needs to understand if the market is flooded with apartments in general or even a particular style. In other words, if the need is for entry level apartments is greater than that of luxury apartments, then that’s what should be built.
3. Occupancy/Vacancy – When occupancy rates are on the rise, it is an indication that rental units are in demand. Builders should have a plan to build particular models that are needed within a market. When builders fill that need, investors are usually there to purchase the newly constructed buildings and get them occupied. This is call absorption within a market. When Vacancies are high, absorption with new units entering the market happens at a snails pace.
4. Rents – This is the final thing a builder needs to look at. If the average rents are $800/month for a 2 bedroom unit in a given market building the builder should work backwards from those numbers. The builder should annualize the income from the building and apply the appropriate vacancy rate in the area. He then should consider about 45% of the gross income goes to expenses. Once you have your income and expenses you can now understand what the Net Operating Income is. From there you can figure value. If value is obtained, then the builder can then budget how the construction and development cost compare to real market value. The builder can then figure the margin from the sale of the newly constructed building and repeat the process.
An apartment builder that keeps these points in mind, should be very busy in the coming years. Currently, supply is stagnant at best. Demand will be increasing from the Echo Boom generation. Echo Boomers will completely change the multi-family industry, according to a recent report by the Harvard Joint Center for Housing Studies. In the next 10 years, Echo Boomers will create more than 2 million households from the ages of 24-35 years of age. That particular segment of the market place is dominated by renters.
Builders taking notice to the ideas presented here are going to be able to create a long, sustainable career in building apartments. Adding units to a market where apartments can’t keep up with demand is gong to keep builders busy for a while. Done right, builders should be smiling all the way to the bank.
“Remember, wealth has nothing to do with money, success has everything to do with failure, and life is as simple as you want to make it.”
– John Dessauer