Apartment Case Study

I run simulations on commercial buildings around the country on a regular basis because I enjoy continuing to keep a pulse on the market.  I came across a property for sale last week in a growing North Carolina city.

The property is a large apartment community with 2010 annual revenue of $2,880,258.  The total annual expenses for the community (not included the cost to finance the property) were $1,235,685. 

Revenue: $2,880,258
Expenses: ($1,235,685)
= Net Operating Income: $1,644,573

As a manager of commercial real estate, the only thing you are in control of is the Net Operating Income (NOI).  Your goal is to increase revenue and decrease expenses.  The NOI is the income an investor would bring in every year if they paid cash for the property.

The second component, used to determine the purchase price for a property, is what return on their money an investor needs to receive $1,644,573 every year. 

This is determined based on the mood of the market, something a commercial manager has no control over.  For example, the current asking price on this property is $26,000,000.  This means the seller is hoping someone will purchase the property for only a 6.33% return. (cap rate)

Purchase Price: $26,000,000
Annual Return On Investment: * 6.33%
= $1,645,800

To keep the analysis simple I will avoid a discussion on the debt owed on the property, currently around $20,000,000.

Is 6.33% a strong return for an apartment community?

The first component of this answer is determined by looking at the quality of the building, the employment base and growth in the area, and the potential to increase NOI through improved management.

The second component is where a 6.33% return stands against other investment opportunities.  This asset, along with every other stock, bond, commodity, or piece of real estate around the world is competing to receive a portion of the total global capital available to invest.

If a real estate investor has the ability to combine both strong management (ability to increase NOI) and has a fluent understanding of this global financial marketplace they can become a lethal force.

I personally believe that 6.33% is not currently a strong enough return to take on the risk of ownership in a building.  Why?

The global benchmark used to determine interest rates is the ten year US government treasury bond, which currently just fell below 3%.  Most loans are determined based on the ten year treasury plus some sort of "spread" to determine the price banks or investors will lend.

It is my contention, a topic discussed thoroughly on this site, that the 10 year bond will rise dramatically over the next few years due to the United States' insolvency, inflation, and the fact that it is already extremely expensive based on historical standards.

When that time comes it will be a surprising blow to real estate investors who today are pricing in all time record low rates "forever." The patient investor must step back and understand that this dynamic cannot continue forever and that overpaying for an investment using a tremendous amount of debt is a deadly combination.