September 28, 2022
When people think of real estate investing, they often imagine flipping houses for a profit. While this is a perfectly viable avenue for those who have the capital and experience to do so, it’s not the only option for those looking to make money in real estate. In fact, there are several different ways to make money in real estate without having to put huge amounts of cash or effort into an investment. One such method is through investing in multifamily properties. This guide will help you get started with multifamily real estate investing.
You’re probably familiar with single-family homes. But while single-family homes are great investments because their value appreciates over time, multifamily properties are better suited for investors who want steady cash flow. But what does the term “multifamily” mean? “Multi” obviously means “many”, so it means that there are multiple units on a property. The minimum could be two or more.
Apartment syndication is a subset of multifamily investing. And when we say “apartment syndication”, we mean the type of multifamily real estate investing where you syndicate (bring together) multiple individual investors into one project to acquire an asset that otherwise you would not be able to. You get the most benefits out of apartment syndication when you have five or more units. However, considering the paperwork, fees, and other expenses that come with forming an LLC for apartment syndication and raising funds, it makes sense to consider properties with a hundred units or more ($5M+ acquisition price).
Investing in multifamily real estate can be a great way to diversify your holdings and hedge against stock market fluctuations. It is an extremely effective way to protect your long-term assets and also help you increase the amount of cash flow you are making on a monthly basis. Here are the top three reasons to invest in multifamily real estate:
Let’s say, you want to get 20 single-family homes. In this case, you need to spend time and effort to find and vet 20 different properties, probably in completely different locations. Then you need to negotiate with 20 different people and pay 20 sets of various legal fees. As a result, your transaction costs make up a big portion of property value, not to mention the time and effort you spent to acquire these 20 single-family homes. Moreover, to scale to 20-30 single-family units, you need to have an infrastructure in place to service and maintain all these properties.
Multifamily allows you to scale into millions of dollars of wealth without being actively involved in managing tenants and properties. When it comes to single-family homes, their value, without a doubt, goes up with time. However, to build wealth, you would need a lot of single-family homes and, at some point, you will hit a ceiling and won’t be able to scale further because of the infrastructural issues.
CBRE did a study and looked at the performance of different asset classes within real estate and concluded that multifamily real estate is one of the most stable assets out there. The past couple of years has been a hard test for all real estate asset classes. For example, companies can just lock up their office buildings and move their employees to fully remote work. Brick-and-mortar retailers can shut down their businesses and move their sales 100% online. However, people will always need a place to live.
Another reason why multifamily properties are so stable is that rents keep going up over time. This fact is especially true in cities where the population is growing and the demand for housing is higher than the supply.
Unlike single-family properties, where you are at the mercy of market conditions beyond your control, the value of a multifamily building is directly proportional to the income it generates. Moreover, unlike single-family homes, your occupancy rates in multifamily properties don’t fluctuate as significantly when one or two tenants move out and we are yet to see a multifamily property with 0% occupancy.
During recessions, tough housing markets, and economic crises, people are more inclined to rent rather than purchase real estate. That’s why we can say that multifamily real estate is recession-proof. Rule No 1 of investing is not to lose your capital. With multifamily, you have the most stable, rock-solid asset you can find.
Many who started their real estate investing journey with single-family homes, at some point, found themselves equity-rich and cash flow poor. It happens because you get lots of equity that you can’t access for different reasons, such as tight financing. Cash flow becomes a problem too because if your tenants can no longer pay their rent or decide to move to another state, you have no income stream. However, you still have to pay your bills and mortgage.
When it comes to multifamily investing – it is an economy of scale. When you have many units on the same property it becomes much more efficient managing them.
There are tons of ways to generate cash flow with multifamily properties. Some of these are exclusive to multifamily properties that you won’t always find in a single-family home. Apart from generating predictable cash flow from the rents, you can also generate ancillary income by creating value adds, and making deals with phone and cable providers. ATMs, Laundry rooms, cell phone tower rentals, moving supply sales, etc. are some of the common ways multifamily investors monetize their properties in addition to the rental income.
In short, property management for single-family rental homes is much more challenging than for multi-family properties and is also more expensive if you calculate it per unit.
Multifamily property centralizes all your management, repair, and upkeep needs in one place, making them much easier and more efficient. For example, you have 20 single-family homes within the Austin Metropolitan Area. To execute repairs and resolve tenant issues you or your property manager have to commute between each individual unit.
A multifamily property makes it much easier by gathering everything in one place. Moreover, if you are not buying a bulk portfolio of single-family homes, you will have to deal with multiple negotiations, while with a multifamily property – it is done once.
In a single-family home, if you don’t have that property filled with tenants – you end up paying the entire mortgage. It’s all on you. Many single-family investors felt this pain and get desperate if their property remains vacant for several months. As a result, they end up getting the first tenant that comes in and such a decision can hurt for a long time.
With a multifamily property, you have hundreds of units So even if 10% of them are vacant – you are still getting cash flow. And cash flow is King.
When you have a single-family home, you only have one property or you have one property at a time. Each one of those has its own mortgage, its own insurance policy, and its own stack of paperwork. All of this costs time and money. Moreover, when you are a single-family home investor, your property is one of many for a property manager.
Another important point is that there is barely a single-family property in the US that you can buy for $50K and get cash flow off of that. Conversely, when you are one of the real estate investors that go in on a multi-family project, you can own a portion of a multifamily property with $50K and generate cash flow. Hence, you spread your risk across multiple investors and tenants.
When you invest in a multifamily property, you have hundreds of units under one or multiple roofs, under one mortgage policy, and under one insurance policy. Also, when you get above a hundred units, the economies of scale allow you to afford at least one full-time property manager on-site and one maintenance man on-site, taking care of your asset 24/7. As a result, you can build significant cash flow, well above what you get from single-family property investing.
It’s true that risks are inherent to any investment, but they don’t have to be with multifamily properties. With single-family homes, you have all your eggs in one basket. If that basket breaks, you might lose everything. However, multifamily investments can help spread out your risk more evenly, reducing potential losses.
Single-family homes are expensive to purchase and maintain, occupancy rates can go down to 0% overnight, and they fluctuate in value wildly. Multifamily properties are not without issues, but they offer a safer income, less stress, and more freedom than other types of real estate investments.
However, multifamily investing doesn’t come without its risks, some of which are:
Multifamily real estate investing has very contained risks when compared to single-family. In addition to the strong cash flow, multifamily outperforms other real estate sectors during times of downturns, making it a more stable investment.
When compared to the average single-family home, a multi-family property generally has fewer risk factors, such as a higher likelihood of foreclosure, tax errors, and financial mismanagement. Let’s talk about different aspects of multifamily financing.
Multifamily loans are considered commercial real estate loans. Therefore, as with any commercial real estate loan, the terms will depend on the merits of the sponsor, the source of the loan, and the quality of the deal. Due to the unique nature of commercial real estate transactions, financing terms will vary depending on the type of property and whether it is a new construction/value-add or stabilized property.
Traditional multifamily real estate mortgages would usually amortize over the course of 15- or 30- years, while short-term mortgages can be from six months to three years with a possibility to extend.
Commercial real estate lenders will usually require a deal sponsor to have at least a 20% down payment or equity in the deal. In other words, an 80/20 loan-to-value ratio. Deals that carry higher risks demand more down payment, sometimes reaching up to 65% loan-to-value. As with the financing terms, it depends on the quality of the deal, the track record of the deal sponsor, and the lending institution.
One of the metrics that lenders use when determining terms for multifamily property financing is the capitalization (cap) rate. The Cap rate is the net operating income of an investment property divided by its present market value. Usually, properties of the same class in the same location have similar cap rates. As a result, a specific market cap rate is quite easy to calculate using data from recent market transactions.
For example, a 100-unit rental building in Downtown Austin achieves an average of $3.500 monthly rent per unit, equal to $350.000 gross rental income per month and $4.200.000 per year. Suppose the annual operating expenses are $2.000.000, then the NOI of this multifamily property is $2.200.000. Using a market cap rate for the area of 3.75 percent, the current market value of this property is $2.200.000/3.75 percent, totaling $58.666.666.
We should highlight that the cap rate is not a substitute for traditional due diligence and valuation.
Suppose, an experienced deal sponsor is seeking to finance a Class B apartment building, he is most likely to look for a conventional bank loan or agency, (Freddie Mac/ Fannie Mae), or a life insurance company loan. These three usually have the lowest interest rates.
If the deal carries higher risk, a syndicator is less experienced or has less equity in the deal, then the borrower will most probably pay a higher interest rate.
Learn more about bridge loans vs. agency debt in this video:
There are multiple tax benefits that come with actively or passively investing in a multifamily property. Let’s take a look at some of them.
When you own or are invested in a multifamily deal – you are invested in a business. So everything related to running that business, from paper clips to anything you buy for that property, can be written off. One of the most powerful deductions is depreciation. This is how straight-line depreciation works:
Resident-occupied real estate has a lifespan of 27.5 years, according to the IRS. The land that it sits on cannot be depreciated and has an infinite lifespan. Suppose you buy a property worth $10.5 M and the land is worth $500K. According to this rule, you will be able to deduct 1/27.5 of the $10M = $363.636 from your property income each year. This allows you to show a loss on paper as a deduction. As a result, this deduction helps you eliminate some of the income from that property.
If you have a portfolio of other investments, you can apply these paper losses to other investments in your portfolio too. Therefore, our multifamily real estate investment can lower your tax exposure on other investments that you hold.
As a passive investor in a multifamily deal, the depreciation flows through in proportion to the ownership percentage that you hold in the deal.
Depreciation will not eliminate your entire tax bill, but there are other tools you can use that help defer taxes and accelerate depreciation.
Cost segregation is a great way to accelerate the depreciation of almost any commercial property, including multifamily real estate. Additional to the 27.5 years of lifespan IRS rule, there are certain items that make up the building, such as plumbing fixtures, cabinets, appliances, etc. that have a shorter lifespan.
To take advantage of cost segregation, you need to perform a professional cost segregation study. In this case, an engineer will come on-site, walk all the units, indoor and outdoor areas of the building and separate all the items from the overall value of the building and present you with a schedule for each individual item.
According to the IRS, many of those items have up to 7 years of useful lifespan. The cost segregation study identifies those items. Suppose the cost segregation study of your $10.5M multifamily property shows that there is $9M in building depreciation and $1M from personal property depreciation. In this case, we would take the $9M x 1.27.5 years and $1M x 1/7 years = $470.129. As a result, you have a significant saving compared to your initial $363.636 straight-line depreciation.
The only caveat is that to offset your depreciation and other losses against your non-real estate-related income, you would need to qualify for a real estate professional status. More on this here.
Another great way to defer the taxes on your gains is by using the “1031 like-kind exchange” to roll your gains and benefit from tax deductions for an indefinite period of time.
While most single-family real estate investors take an active role in the management of their investments—dealing with tenants, handling maintenance issues, and managing individual properties—passive multifamily real estate investment is entirely different. As a limited partner in a real estate syndication, you only need to provide capital. You don’t need to do any of the hands-on work, including acquiring, managing, and selling the property. Instead, you can let others deal with the headaches while enjoying a passive income stream.
Another advantage of multifamily investing is that the barriers to entry for passive investors are much lower than for general partners. Also, you don’t need to be a property management expert or have in-depth knowledge of real estate. The most essential factor is that you have a relationship with a deal sponsor, understand his background and ask the right questions before putting your money into the deal.
Last but not least, let us touch on what you should be looking for when investing in multifamily properties.
The location of the property will in most cases determine whether or not your investment property will increase in valuation. It’s best if you are able to buy multifamily real estate in high-growth areas so that you can get a higher return on investment. Ask yourself some of the following questions:
Is this property located within a high population area – which is growing rapidly? Have rents and occupancy reached their ceiling? Has your local economic climate remained strong, or do you foresee some economic risk in the coming year? Asking these questions and more like them is the only way to really discern whether or not a prospective property will make for a safe investment over time.
Learn more about some hot markets in this article.
Considering the financial risks and benefits of a multifamily property, having more residential units can increase your chances of a greater yield. A large number of residential units usually means greater stability, security, and diversification. Properties with 100+ units are typically the best-performing ones.
When evaluating a property, take into consideration that the current income and expenses are already being accounted for by the previous owner. Another simple way to figure out how much income you can draw from the multifamily property you are looking to buy is by knowing what your competitors are charging in rent.
REITs (Real Estate Investment Trusts) are publicly traded companies that specialize in commercial real estate investing. They own a diverse real estate portfolio: from office towers to homes for rent. They buy, sell, and operate a portfolio of properties and provide investors with real estate market opportunities.
When you invest in a publicly-traded REIT, you can gain exposure to a wide range of income-producing real estate without having to deal with the time and effort of managing such assets. However, investing in REITs is similar to stock, so you are not investing in an actual real estate asset, but in the stock of a REIT. Therefore, you can benefit from tax deductions that come with investing in real estate syndications.
If previously real estate syndications were lucrative and hard-to-get investment opportunities, our Marketplace is making it more accessible to all who want to benefit from passive real estate investment. The advantage of multifamily syndication is that you have direct ownership of your share of the asset because you are investing in the asset directly via a group investment. Together with other limited and general partners, you own an LLC that holds the multifamily asset.
As a result, you get all the tax benefits that come with real estate investing as well as more control over where you invest your money, compared to REITs.