How Exactly Does An Apartment Building Make Money?
It's not very obvious how apartment buildings make money. Apartment buildings are not like corner stores or restaurants. You typically don't go in, swipe your credit card, and then leave. In fact, many people are not even aware that apartment buildings are businesses at all.
I've lived in apartments. I didn't consider much about how they may be making some owner or owners a lot of money. I just paid my rent. It was later in my real estate investment path that I understood how the apartment business operates. And once I learned, I instantly realized how superior apartments can be to single-family home investing. Let's look at exactly how apartment buildings make money, so that the next time you drive by an apartment complex, you'll start to see it for the business that it is.
A business is simply a way to make other people's lives better. - Richard Branson
Perhaps the best-known aspect of the apartment business is rental income. After all, most of us have lived in an apartment before, so we understand the basics: if you want to avoid getting thrown out, you pay your rent every month on the first of the month. Or else.
Rental income is the primary way that an apartment building makes money. The rents collected become the biggest chunk of the gross income for that month. Then, the mortgage and expenses are paid, leaving the net operating income, or NOI.
In other words, the NOI is your monthly profit. When you invest in an apartment building with a team, you split the NOI amongst the partners and investors.
For example, let's say you're an investor in a 250-unit apartment building. Rents average $1,000 per door, for a total gross monthly income of $250,000. Let's say that the mortgage is $75,000 and that expenses (maintenance, repairs, utilities, management fees, and more) come out to $125,000.
$250,000 (gross income) - $75,000 (mortgage) - $125,000 (expenses) = $50,000 (NOI)
In this case, your NOI is $50,000. If you owned this entire apartment building yourself, you'd be taking home $50,000 per month. Most likely, though, you are probably investing with a group of people, so that $50,000 is split amongst all the partners and investors, either on a monthly or quarterly basis.
While the rents are the amounts paid for renting and physically occupying the apartments, many apartment buildings also have other ways of making money, including through ancillary income.
These are all the little extras and amenities, like a coin-operated laundromat, vending machines, clubhouse rentals, reserved parking spaces, covered parking spaces, trash valet, shared wifi or cable, pet fees, and more. This is where apartment owners can get really creative, learn about the needs of their residents, and provide services and amenities of value.
For example, many people who live in single-family homes take for granted the fact that their Amazon packages can get dropped off right at their door. For apartment residents, however, having packages delivered and held can be a predicament, especially if there's not a dedicated space in the building for them.
This need presents an opportunity for the apartment owner to provide an amenity that would be very useful to tenants. The apartment owner might install and rent out package lockers, which provide a needed service for the residents, as well as additional income.
When you purchase a single-family home, you know that the value of your home is connected to comparables in the area. If the neighbor's three-bedroom home just sold for $475,000, your similar home is probably worth around the same amount. Even if you put in a crazy amount of upgrades, you'd probably be hard-pressed to get more than $525,000, depending on the market.
Apartments are different.
Apartment buildings are not valued on comparables, but rather, on the amount of income they generate.
Let's imagine you just purchased an apartment building that generates $20,000 per month in NOI. You work together with the property manager to increase occupancy, bring rents up to market rates, and decrease expenses. Over the course of a year, you're able to increase the monthly NOI from $20,000 to $30,000.
This might not sound like much, but, believe it or not, that extra $10,000 in monthly NOI means your apartment building is now worth $1.2 million more. Yeah, you heard me, $1.2 million
How does this happen?!
This is because in the apartment world, every additional dollar of NOI adds about $120 to the value of the property:
$1 (additional NOI/month) x 12 months x 10 (apply a 10% cap rate) = $120 added value
It should be noted that cap rates vary, so if your market is a 6 cap, you would replace the 10 with a 6 in our formula. In our scenario $10,000 of monthly income, multiplied by $120, comes out to $1.2 million. Now, you don't get this extra $1.2 million right away. It's not like the monthly cashflow payouts you get from the rents. This $1.2 million is in equity, so you only receive that once you sell the property, or do a cash-out refinance.
This is one of the reasons commercial properties change hands fairly often. Each owner comes in, implements their business plan to improve the property, then sells for a profit, and moves on to improve another property.
In order to accomplish these increases in value, the apartment owner and property manager must work together over time to optimize efficiencies. This drives up the NOI, thus maximizing the amount of profit you can get when you sell the property.
There's one more major way that apartment buildings make money, and that's through renovations, or adding value. The simple act of improving a unit doesn't make any money, by itself. Rather, think about the goal of a renovation. By improving a unit, you are providing a cleaner, safer, and better place to live. As a result, you will be able to charge more rent, as people are willing to pay more for nice places to live. Increased rent leads to higher gross income, which, in turn, increases the NOI. Increased NOI also leads to an appreciation of the property value. In this way, renovations can lead to both increased cashflow returns, as well as increased equity.
Further, if you also renovate the common spaces (e.g., improve the lighting, install new windows, improve the landscaping, get a fresh sign for the building, etc.), tenants start to take pride in their building and refer their friends. Passersby on the street start to take notice. And once that happens, you'll be able to further increase rents and decrease vacancies, thus further nudging up that all-important NOI.
A Note On Making Money
Here comes the man, uppin the rent, exploiting his tenants. Greedy landlords right? They are in it for themselves. There are slum lords for sure. That is not what we are talking about here. Do we want drug dealers, professional squatters living in our building, making life miserable for upstanding tenants in the building? What would happen if the owners didn't improve the units? The units would fall into disrepair. Appliances would age, floors would become discolored, and tenants wouldn't feel proud to live in those buildings.
The slum lords - those people should NOT be apartment owners. But, the vast majority of apartment owners are not. They're in this business to provide a great place for people to live and to make an impact on the communities they invest in, and yes make a decent life for themselves.
The fact that apartment owners can make money from apartments is a GOOD thing, because it ensures that they are properly incentivized in providing good, safe, and clean housing for their tenants.
As you can see, apartment buildings are not just places for people to live. Apartments are businesses. And just like restaurants and corner stores, apartment buildings provide a place for people to gather, to live life, and to make memories.
Some people think that making money is a bad thing and that it shouldn't be talked about. That somehow, because apartment owners are making money off people's rents, that they're only in it for the money, or that they're greedy and are exploiting their tenants. But think about it this way. What would happen if the owners didn't improve the units? The units would fall into disrepair. Appliances would age, floors would become discolored, and tenants wouldn't feel proud to live in those buildings.
These are the best types of businesses. The ones that make money, but also provide valuable services to people and communities.