There is a lot of debate around what is the best real estate investment strategy out there & you'll get different responses based on who you talk to. But there is no denying the fact that here are some reasons on why I think multifamily is a great investment to consider
1. Forced Appreciation
In residential real estate, the value of your home is based on "comps", where the appraiser finds homes that have sold in the recent past & are similar in size, amenities, # of bedroom & bathrooms, etc. to your home and are within a certain proximity to your home & comes up with a value for your home. The homeowner really doesn't have much control in driving the value of their home.
In contrast, commercial real estate like multi family apartments, the value of the property is purely based on the net operating income(NOI) that is generated by that property & has no bearing on what some other similar property sold for since it is very hard to compare commercial properties based on size, amenities, etc. NOI is basically Gross Income minus all operating expenses, excluding debt service
The formula for calculating the value of the property is
Property Value = NOI / Cap Rate,
where Cap Rate is the rate of return an investor would expect for an all cash investment. As you can see, if NOI goes up, for the same cap rate, the corresponding property value goes up too.
Let's look at a property in a market with a 6% cap rate, whereby it increases its NOI from 500K to 600K
Current value = $500,000 / .06 = $8,333,333
New Value = $600,000 / .06 = $10,000,000
As you can see, an experienced sponsor can do a number of things to the property to increase gross income & decrease operating expenses, like reducing utility costs, better property management team, increase tenant satisfaction thus decreasing tenant turnover, etc. which in turn increases the value of the property
2. Accelerated Depreciation
Owning real estate investments in general provides a number of tax benefits, but Accelerated Depreciation is a technique that is more prevalent in the commercial arena, due to the cost involved in calculating the depreciation using this method.
Depreciation, as most of you know, is the process by which IRS lets you write off a portion of the value of the property against the income generated by that property, based on the fact that all assets have only a certain useful life before it needs to be replaced & currently it is 27.5 years for residential & 39 years for commercial.
Accelerated depreciation or "cost segregation" on the other hand, is a technique, by which IRS allows, all the non-structural elements of the building, i.e., desks, chairs, boilers, cabinets, etc. to be depreciated over an accelerated schedule of 5, 7 or 15 years providing a much larger depreciation in the early years of ownership instead of spreading it over 39 years. This is genius!!
Astute operators bring in professionals who do a cost segregation study, that costs thousands of dollars, and come up with the maximum depreciation amount that could be used to offset the income that is generated by the property, which in turn drives better return to investors.
A lot of the times, especially during the early years of the investment, it is not uncommon to get cash flow distributions throughout the year & at the end of the year, one might get a partnership K1 for tax purposes, that shows a "paper loss", one reason being the large depreciation that is passed through to the investors.
3. Economies of Scale
Compared to single family homes, multifamily offers huge economies of scale in several areas. It is lot easier & cheaper to main tin a large apartment with 200 units, compared to 200 single family homes spread out throughout the country. There is one roof to fix, one larger lawn to mow, a couple of A/C units to maintain, you get the point. Property managers typically will have in-house maintenance crews on payroll, which helps reduce the cost, rather than dealing with 3rd party contractors.
Property management companies will lower the cost of in-house property managers, the more units you have under management. Property managers typically charge around 5% of collected rent for multifamily, compared to 8% - 10% in the single family space.
As far as rehab is concerned, contractors typically offer better pricing, the higher the number of units that needs to be rehabbed as well as the cost of materials will be cheaper, since you can negotiate better pricing from material providers like flooring, roofing, appliances, etc., since now you are ordering in bulk
I don't mean leverage here, in the traditional sense of getting a loan, though that is very much the norm in the multifamily space. I mean leverage in the sense of leveraging time, effort, experience. It takes a lot time & effort, to analyze 100's of deals, make offers on numerous deals to finally get a property under contract. Since multifamily investments are typically done through syndication, where an experienced syndication team is doing that for you, you are leveraging their time & expertise to find the best deals.
You are leveraging their financial backing to get a large commercial loan that requires a much higher down payment of 25% - 30%, much higher reserves that is required, a higher networth that is required to sign on the loan docs, since most of the lenders would require you to have a networth equal to the amount of loan which typically is beyond what most of us can come up with.
You are leveraging their time, to manage all the rehab that is required, do all the maintenance on the property, deal with tenants, lease the property after a tenant moves out, pay taxes, sell the property at the end, etc.
There are number of other benefits with multifamily investments, like inflation protection, diversification, compelling risk-adjusted returns, etc., which might be a topic for another blog post, but, here I wanted to highlight some of the top reasons I invest in this amazing asset type.
Do you agree with these or have other reasons that you can add to this list? Please leave your comments below.