Multifamily properties are the bread and butter of real estate investing, but finding the right deal to add to your portfolio can be daunting. Use this ultimate guide as a primer for getting started in the world of multifamily investing.
Kent Ritter is an experienced multifamily investor and operator helping you to build real wealth through real estate syndication. Learn More
Advantages of Multifamily Property Investment
Several facets of multifamily investing attract those looking for steady income and relatively low risk. As you’ll see below, some multifamily properties are riskier than others, but they generally produce steady income and remain in high demand.
Surprisingly, the larger complexes are often the least risky even though they are more expensive. This is because each unit represents an additional revenue stream, and owners can better absorb unexpected vacancies or other interruptions in rental income when most units are occupied and current with rent. Large complexes also have the benefit of a lower cost-per-unit thanks to economies of scale of operational and administrative costs.
The multifamily industry also benefits from a continued shortage of single-family homes. In markets where SFH demand exceeds supply, home prices increase. Consequently, even fewer people can afford homes and remain in rentals.
Of course, not everyone who lives in apartments does so out of necessity. Increasingly, Americans appreciate the low-maintenance and extreme convenience they find in apartments.
Tax Benefits Increase Profits
Multifamily investing becomes more appealing when one takes taxes into consideration. In general, real estate investing offers many tax benefits to owners and investors. Those same advantages apply to multifamily investing.
Depreciation, especially accelerated depreciation, 1031 exchanges, and the capital gains tax rate all reduce tax liability and increase profitability for owners and investors.
For even more tax savings, consider investing in real estate through a self-directed Roth IRA (SDIRA). SDIRAs can own real estate, and as long as all income from the property remains in the SDIRA, all profits will continue to grow tax free. Make sure you talk with your IRA custodian and accountant about UBIT (unrelated business income tax) to understand if the deal you are looking at could be subject to that small extra tax.
Classes of Apartment Buildings
Finding the right complex or multifamily project to begin your multifamily career can be time consuming. One way that investors can narrow down their hunt for suitable investments is by focusing on a specific apartment class. We use a four-tier classification system based on age, condition, amenities, and location to distinguish building types.
Class A Apartments
Class A multifamily properties are by far the nicest, at least from the tenant’s perspective. They are a low-risk, low-return option for investors, making them a great form of passive income.
Several features are common to class A buildings. First and foremost, expect them to be very new, likely built or substantially remodeled within the last ten years. Additionally, they are in the most expensive neighborhoods, like the central business district or downtown. Expect high-end finishes, excellent amenities, reliable tenants, and low vacancy. Essentially, they are a turn-key operation.
Class B Apartments
Class B apartments are a value-added investment. Investors work with these properties to improve them to command higher rents and increase the property value. As a result, you will often see class B properties as the subject asset in real estate syndication.
Class B buildings are still in good condition but are 10 to 20 years old. As such, renovation and upgrades bring a lot of value to transform the aesthetic of the building. Amenity upgrades, improved management, and repositioning in the market all improve the building’s value and income potential.
Class C Apartments
Class C multifamily properties are another value-added investment opportunity. They are both older and in poorer condition than class B properties, which gives investors ample areas for improvement. Unlike class B properties, the renovations are likely to be more than just cosmetic. The older class C properties may require structural repair and substantial capital expenditures to pull in more reliable tenants and more expensive rents.
Class C buildings do face challenges in finding the most profitable niche. They are generally in less popular neighborhoods, so excessive upgrades may not pay off if tenants refuse to consider the area.
Class D Apartments
Finally, class D properties are an opportunistic investment that we would only recommend to those skilled and experienced in the multifamily industry due to the extreme risk they harbor. They are among the oldest and most dilapidated buildings, but even stellar renovation may not be enough to be profitable. Unfortunately, they are often in blighted parts of town that are unappealing to tenants, no matter the upgrades or amenities added.
Class D properties are often a home of last resort for those suffering from economic instability. They will require large injections of capital to make them habitable and attractive to tenants with steady income.
Multifamily Property Investment Opportunities
Fortunately, investors have many investment methods by which they can reap the benefits of the multifamily industry beyond single-handedly buying an apartment complex. Here are a few options to consider no matter your budget.
Consider REITs for Low-Stakes Investment
For the cost of a single share, you can start investing in multifamily real estate. REITs, or Real Estate Investment Trusts, are companies that own and operate real estate assets. REITs may specialize in nearly any type of property, so look for ones that specifically deal in apartment buildings.
To maintain their tax-advantaged status, REITs must return at least 90 percent of their profits to shareholders in the form of dividends, so they are a popular investment product for passive income generation without a lot of effort. The downside of REITs is you may not receive the same tax advantages as other real estate investments. Additionally, they often move with the rest of the market, so seldom create the portfolio diversification that most real estate investors want.
Become a Real Estate Syndication Limited Partner
For those with a little more money to invest, real estate syndications are a preferable option. Syndications are companies that raise capital for a real estate project via a small pool of investors called limited partners.
For limited partners, after finding and vetting the syndication, the investment requires little to no further effort. The property, including its purchase and subsequent operation, will be entirely handled by the project’s sponsor. Because the sponsor brings expertise and knowledge to the table, we like this option for newer investors ready to take bigger steps into the multifamily industry.
The compensation structure varies for each project, but the sponsor usually estimates the return that the LP can expect on top of the capital repayment. Syndication documents clarify how and when investors are paid.
When evaluating a syndication, consider the length of time that your funds may be inaccessible and whether that fits with your investment goals. While many syndications hold a property for five years, they often repay a portion of your initial contribution after only a year or two when they finish renovations and refinance the property.
Directly Purchase a Building Alone or with Partners
After developing some experience with multifamily properties and knowledge of the unique market that they work in, some investors prefer to take full control by buying the building themselves or with partners.
If going this route, consider asset protection before taking any steps to buy a property. This may include forming an LLC to protect personal and other business assets or creating a trust to avoid connecting the property with your public persona.
Use the Capitalization Rate to Quickly Compare Values
The methods for valuing an apartment complex are different from the appraisal process you may be familiar with from buying a single-family home. Instead, we rely on several financial metrics to assign value and compare properties to each other.
Because we care about a multifamily property’s ability to make a profit, the income approach is one of the best ways to determine value. Through the due diligence process, buyers get to see a myriad of financial data to assess the value. But for a quick comparison of a property’s value based on earning potential, we rely on the capitalization rate (cap. rate).
The cap. rate compares the net operating income to the purchase price of a property and helps us swiftly compare the revenue of one property to another. Lower cap rates indicate a more expensive property that is likely to be in a good location and growing market. Higher cap rates represent more projected revenue compared to price, but typically in smaller markets or a less desirable part of a city
How to Buy an Apartment Complex
Whether you are buying a multifamily property on your own or investing through a syndication to leave it to an expert, knowing the apartment buying process helps flesh out the bigger picture of the multifamily industry.
In many ways, the purchase process will look similar to buying a single-family home. You will look for a property, make an offer, obtain financing, go through the due diligence process, and close the transaction. However, given the investment size, some transaction elements, particularly obtaining financing and reviewing due diligence documents, are much more substantial.
Start Searching for Financing Early
Obtaining suitable financing can often be the trickiest part of purchasing an apartment complex. Generally, loans through Freddie Mac and Fannie Mae are ideal funding options due to their long terms and reasonable interest rates.
For smaller deal sizes or for investors looking for the flexibility to refinance the property to pull cash out of the deal, community banks can be a great lending option. These banks work on relationships, so it’s important to start building a personal relationship and building your credibility early.
Expect a More Complex Due Diligence Process
Several financial and physical reports comprise the due diligence process when purchasing an apartment complex. The process is a vital time for the buyer to evaluate whether the property is a worthwhile investment.
The buyer gets more detailed information regarding the financial performance of the complex through a financial audit report, market report, lease audit, and appraisal. Of course, it is also a time to carefully consider the physical condition of the property through the property condition assessment, unit walk, and environmental site assessment.
Your lender uses this information to confirm the underwriting assumptions, but the potential buyer should also use these new details to assess whether the property fits into their business plan.
Multifamily properties have a place in any portfolio. Of course, when planning an investment strategy, remember that more significant investments often yield greater returns. To find out more, call us with any questions you may have.