Buy and Hold 101: How to Evaluate Investment Properties
Want to get your feet wet in the multifamily real estate business as an active investor but not sure where to start? Buying and holding an apartment is one of the easier real estate investment strategies, so it may just be perfect for you!
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What Is Apartment Buy and Hold?
Buying and holding is essentially purchasing an apartment that’s already in decent condition, and then holding it for a long period of time—typically 10-plus years—before selling for a profit. Most often with this strategy, the apartment was either recently constructed or renovated.
Pros & Cons of Buy and Hold Real Estate
Like anything else, buy and hold has upsides and downsides. Here’s what you need to consider.
- Easier – Buy and hold does not require any extensive renovation, so it’s great for active investors who are just getting started.
- Natural Appreciation – Holding an apartment in a city with a growing population and residents with ample disposable income will allow you to increase the rents quickly and sell at a higher price.
- Steady Long-Term Cash Flow – If the property is already in decent condition, then you won’t have significant capital expenditure for years, which means consistent income for you!
- Longer Investment Period – A buy and hold investment typically takes 10-plus years to allow time for the natural appreciation to become significant. Most investors who choose this investment strategy want steady, long-term cash flow.
- Lower Investment Return – Its risk is lower, but its return is also lower—typically around 10% IRR.
- Limited Forced Appreciation – Since there is no extensive renovation, the property’s value isn’t artificially increased like that of a value-add property.
Comparing Apartment Buy and Hold in Two Different Regions
Here we’re going to compare the return of a buy and hold property in a high-growth region and in a low-growth region. A high-growth region typically has low cap rates and high rent appreciation rates, whereas a low-growth region has the opposite.
Before we start comparing the numbers, let’s go over what a cap rate is.
- Short for Capitalization Rate (k)
- k = NOI / Purchase Price; NOI = Net Operating Income
- A higher cap rate means more cash flow annually for the same purchase price
- A lower CAP rate means less cash flow; however, for the same increase in NOI, the selling price of a low-cap property appreciates faster relative to that of a high cap
- k = (NOI + x) / Selling Price; x = increase in NOI
- Selling Price = NOI / k + x / k
- Based on the equation above, lower cap rate means higher selling price
- Cap rate differs from region to region, but a fast-growing region typically has a lower cap rate
Example Property 1: Los Angeles, California
The city of L.A. is a fast-growing region with a low cap rate. Below are some of its variables and what the investment return of an apartment buy and hold in this city could look like.
- Cap Rate (k) = 4.50% for Class B
- Rent Appreciation = 7%
- Unit Price = $350,000/unit for Class B, so NOI/unit is about $15,750/year
- $10 million can acquire about 28 units
- IRR: 9.91%
- Average Cash-on-Cash (CoC) Return: 5.99%
Investment Property 2: Columbus, Ohio
Compared to Los Angeles, the city of Columbus is a relatively slow-growth region with high cap rate. Below are some of its variables and what the investment return of an apartment buy and hold in this city could look like.
- Cap Rate (k) = 8% for Class B
- Rent Appreciation = 3%
- Unit Price = $77,000/unit for Class B, so NOI/unit is about $6,160/year
- $10 million can acquire about 130 units
- IRR: 9.98%
- Average Cash-on-Cash (CoC) Return: 9.03%
The Bottom Line
As shown in the investment summaries, the 10-year IRRs for both cities are about the same—9.91 percent for Los Angeles and 9.98 percent for Columbus; however, the payback for Columbus is spread throughout the investment period as cash flow, while the payback for Los Angeles is heavily dependent on the selling price.
Whether to invest in a fast-growing city with low cap or a slow-growing city with high cap depends on your investment preference and risk tolerance.
If I want a relatively low-risk investment with steady income, then I’d choose to invest in a high cap region similar to Columbus. On the other hand, if my goal is to make a higher return in a shorter period of time, then I’d choose to value-add or develop in a high-growth region like Los Angeles, because lower cap rate leads to more appreciation.
One thing to be aware of is the exit strategy, because it can be difficult to sell your buy and hold property if it’s in a very high cap and zero-growth region. Ideally, you want to find somewhere with 6 to 8 percent cap and 5 percent or more annual rent growth.
Any additional questions about buy and hold I can answer for you? Which investment strategy do you think suits beginners well?
Please comment below!