In Part 1 and Part 2 of this series, we discussed the definitions as well as what factors decrease the useful and physical life of a commercial building. In this article, we examine a specific property type of commercial real estate that has important deviations from a “typical” older commercial property: residential rental property. We will explore why residential rental buildings (primarily apartments) have shorter economic useful life expectancies and what the main limiting factors in extending a property’s economic useful life is.
Economic Life of an Apartment is 27.5 Years
When considering the purchase of an older residential rental property (such as an apartment) it is important to understand that the useful economic life of an apartment building is significantly shorter than that of a commercial building.
As a reminder, the IRS allows 27.5 years over which you can depreciate residential rental buildings and 39 years for retail and other commercial structures. This shorter depreciation schedule was established to encourage construction of new rental housing, however, it also reflects the fact that residential rental structures have a significantly shorter useful lifespan than commercial structures. The tax code presumes that the useful life of a residential rental building is only 70% of the useful life expectancy of a commercial building.
What factors contribute to a shorter useful life for residential rental housing properties?
Wear and Tear, Neglect Are Accelerated in Older Residential Rental Buildings
Commercial buildings are generally occupied only 12 hours or less per day, five days a week, and maybe eight hours during the weekend. However, apartment buildings are operated seven days a week, 24 hours a day. This additional operation time will naturally increase the building’s wear and tear.
Retail and commercial building tenants sign multiple year leases, while an apartment lease is generally limited to one year or less, producing more turnover expense. The typical office building ownership generally provides janitorial service which allows ownership access to the inside of the tenant space. This affords the ability to see how the tenant is caring for the rented space. In contrast, an apartment resident is generally not required to maintain the inside of the apartment with the same care that is required of a commercial tenant. And, because ownership is not responsible for the daily cleaning of the inside of the apartment, the building owner is generally unaware of any maintenance and insect issues existing until the tenant moves out.
Unlike retail and commercial buildings, apartments are often occupied by families with children and children are hard on properties. Also, tenants of a commercial building have an economic incentive to keep the property in good condition because they typically have customers coming in and out of their office, warehouse, store, etc. They want it to look presentable and impressive, otherwise, they risk turning off potential or existing clients.
As a general rule, the older that an apartment building is, the lower the monthly rent that can be charged. Common exceptions to this rule include older apartments that are very well located or are architecturally iconic. Additionally, older buildings tend to attract less affluent renters who have a tendency to move more often, which in turn makes older apartment buildings even more expensive to operate.
Income is Needed to Extend the Life of an Older Residential Building
An older building needs constant repair, correction, and/or replacement of wear and tear items, appliances, and motors near or at the end of their useful lives. The older the building is, the more substantial the need for cash flow to cover these mounting costs. And if the cash flow levels off or diminishes, the building’s needs cannot be met. This results in needed repairs and replacements not being made and this neglect further shortens the building’s useful economic life.
Can Monthly Rents be Raised Enough to Extend the Useful Economic Life?
There are factors beyond the control of a buyer that govern the buyer's ability to raise rents. Below are three indicators which make up a Due Diligence Rental Rate Analysis. These indicators help determine the ability to raise monthly rents enough to extend the useful economic life of a residential rental property.
The average annual income of a renter within the submarket determines the limit of what the renter can afford. The accepted financial rule of thumb is that a renter should not pay more than 25% to 30% of annual gross household income on rent. For example, if a family has a gross annual income of $40,000 the optimum monthly rent would be $833 per month ($40,000 x 25%/12 months) up to $1,000 per month ($40,000 x 30%/12 months).
The phrase “a rising tide lifts all ships” applies to monthly apartment rental rates as well. Contrary to popular belief, older apartments do not drive down rental rates of the newest and nicest apartments. In fact, just the opposite is true. The monthly rates of the newest and nicest apartment property in the submarket determines the rental rates that older properties can charge.
Vacancy Rate Trends
If submarket vacancy rates are 5% and trending lower, across the board increases in monthly rental rates will follow. When submarket vacancies reach 8% and are expected to trend higher, “move-in” concessions (including free rent and waived fees) and even reductions in monthly rents will follow.
If the property’s usefulness and desirability have been initially analyzed and the Due Diligence Rental Rate Analysis concludes that rents can be raised to cover planned initial upgrades, future maintenance, and planned future capital renewals, the buyer will know that they can extend the property’s economic useful life well beyond his or her expected holding period. If this is not possible, the buyer would be better served to find a more advantageous opportunity elsewhere.
- Counting the Costs When Purchasing a 25-Year or Older Building - Part 1
- Counting the Costs When Purchasing a 25-Year or Older Building - Part 2
- 5 Ways To Invest in Commercial Real Estate
- What Is a Commercial Bridge Loan and How Does It Work?
- What is the Average Rate for a Commercial Bridge Loan?
- Tips For Getting The Best Commercial Bridge Loan Financing
- 8 Reasons for CRE Receivers to be Appointed...Even if No Monetary Default Has Occurred