The steady income from rental payments, ability to increase property value, and continuing demand make multifamily properties attractive investment opportunities. If you’re new to multifamily investing, this guide will teach you everything you need to know, so you can decide if it’s right for your portfolio.
Kent Ritter is an experienced multifamily investor and operator helping you to build real wealth through real estate syndication. Learn More
Why Invest in Multifamily Properties?
Investing in real estate is no small commitment. The value of money against time is a constant balancing act, as is potential reward versus possible risk. Multifamily properties are an industry favorite for their performance in those balancing acts. Of course, no property type is suitable for every investor, but there is much to appreciate about the perks of multifamily properties. Here are some reasons to consider multifamily investing in your portfolio:
The IRS considers rental income to be passive income, even if the average landlord would say otherwise. This classification creates tax advantages discussed below, but the colloquial meaning of passive income is equally important. The bottom line is that multifamily assets generate ongoing, regular income from monthly rent payments and tenant fees.
Multifamily properties can develop stable income generation with many units on a staggered lease schedule. As the number of units rises, the income disruption from a vacancy or unit turnover decreases. These two factors create steady, passive income for investors entitled to proceeds.
One of the biggest draws of multifamily investing is the concept of forced appreciation. Investors can actively work to increase a property’s income and value to accelerate appreciation. Most syndications will look for underperforming or undervalued properties that they can then improve to increase value. Common ways to force appreciation include increasing rent, adding facilities and services, reducing property expenses, adding more fees, and renovating the property. This is where real wealth is created.
Compared to other investment options, multifamily real estate offers even more bang for the buck, thanks to the fact that much of the profits can be sheltered from taxes.
The amount of income generated from multifamily real estate investments that is subject to taxation is reduced by amortization and depreciation. Accelerated depreciation allows owners to front-load the depreciation deduction and take it over shorter periods, sometimes only five years, rather than the usual 27.5 years.
Many multifamily investments are intended to only last 5 to 8 years, so accelerated depreciation is a fabulous way to shelter income. In addition, in many real estate deals, an investor’s depreciation share may completely offset the income they receive from preferred returns.
Efficiency & Scalability
Multifamily properties are more efficient to operate compared to single-family homes, which is why few people create a real estate empire of single-family houses. As the number of units increases, the per-unit cost for maintenance, groundskeeping, and property management typically decreases. In addition, employing a team of professionals allows owners to invest in more properties on a larger scale.
The grander scale of multifamily assets also makes them more appealing to lenders, because more income is likely. As a result, buyers can typically find more lenders with better terms and fewer restrictions than someone purchasing a single-family home.
Ongoing Market Demand
Perhaps one of the most decisive factors contributing to the ongoing popularity of multifamily properties is the reliability of the market. Housing remains one of the most basic human needs, and as of the end of 2020, Freddie Mac reports that the United States has a housing deficit of nearly 4 million units. There are currently more people renting now than at any point since 1965, with about 37% of the population renting.
Types of Multifamily Properties
A multifamily property is any property with multiple units meant to house more than one family. For example, a duplex is a small-scale multifamily property—and so as a large-scale apartment complex with hundreds of units. While the number of units is essential for minimizing per-unit costs, multifamily properties are categorized based on the property’s features rather than size alone.
Classifications factor in property age, location, condition, amenities, landscaping and more. Here’s what you need to know:
Class A Properties
Class A properties are the best of the best. They are less than ten years old in most markets. They may also include older but updated properties in highly desirable areas like downtown areas or central business districts. Expect high-end finishes, exclusive amenities, and of course, the highest price tags.
These buildings are often purchased with an eye toward the steady rental income and ever-appreciating real estate value. However, unlike the other classes, renovations and upgrades offer little room for improvement to increase property value or rental rates.
Class B Properties
Class B properties have been built within the last 20 years or are older and recently renovated. The exterior, finishing, and amenities should be decent but not as modern and upscale as those in the class A property in the market. Consequently, class B properties command lower rents than class A properties.
Class B properties are investor-favorites like class C properties, because rent and value can be increased through renovations, upgrades, and new amenities.
Class C Properties
Class C properties are among the most popular multifamily assets for investment because they offer room for improvement. These properties are typically older, usually built within the last 30 years, and likely have a long list of deferred maintenance.
Class C assets bring in less rent per unit, both due to the visible age of the building and units and the lack of amenities. As such, they can be great opportunities for value-add investment to increase occupancy and rental rates.
Class D Properties
Class D properties are the bottom tier of multifamily classification, because they have much room for improvement. Given their lack of desirability, they are generally chosen by tenants out of necessity rather than preference. As a result, the rents will be low and turnover high.
Expect poor physical conditions for these older properties. They are usually victims of deferred maintenance on top of below-average initial construction quality. Class D buildings are in the least desirable parts of town with little public transportation, empty storefronts, and lower-ranked schools.
Key Considerations for Multifamily Assets
Surprisingly, the purchase process for a multifamily property is similar to that of a single-family property. Offer and acceptance remain much the same. However, buyers find the most significant differences when obtaining financing, determining value, and going through the due diligence process. Here are some key considerations to keep in mind when vetting potential multifamily investing deals:
Financing a Multifamily Property
Financing the purchase of a multifamily dwelling allows investors to leverage debt to earn the most income. In general, multifamily property loans require less money down than single-family properties due to their proven, on-going earning potential.
Fannie Mae and Freddie Mac, also called agency loans, are two significant sources of multifamily financing. Agency loans can fund up to 80 percent of the property’s value and usually come with low-interest rates, making them an industry favorite. The agencies do not make loans directly—instead, they buy the loans from approved lenders.
The government also ensures multifamily loans through the FHA. FHA-insured loans can fund up to 90 percent of the property’s cost and be amortized for 35 years.
Valuation of Multifamily Assets
Wise investors always keep tabs on the value of a multifamily property, which does not end with the successful purchase of a building. Accurately assessing a property’s value is vital in the early stages when comparing potential properties against each other for investment opportunities and for securing financing. Accurate valuation is also critical as you look for ways to increase a property’s value before selling it. Finally, an accurate valuation ensures that the owners receive the maximum possible profit when the project terminates.
Using Capitalization Rate to Value Properties
The most important figure for determining a multifamily property’s value is the capitalization rate, also known as the cap rate. The cap rate reflects the expected rate of return for an income-producing property.
To calculate the cap rate, divide the net operating income (NOI) by the current market value. The resulting number is expressed as a percentage representing the expected annual yield.
Cap rates are best used to compare similar properties to each other quickly. It’s important to note, however, that cap rates leave out some important factors like debt service and income tax—so it should not be considered an expression of pure profit.
The Due Diligence Process
During the purchase transaction, the buyer of a multifamily property gets a good look at the finances and operation of the building as a business. The numbers and information gleaned from the reports will be used to confirm or modify underwriting assumptions in the financing process. This information will give the buyer the opportunity to gauge the business’s health.
During the due diligence stage, a variety of professionals will provide financial and physical reports of the subject property. Traditional disclosure documents include a financial audit report, market condition report, lease audit report, appraisal, internal property condition report, and site survey, among others.
Multifamily Investment Opportunities Beyond Direct Investment
Purchasing a multifamily property often requires a significant upfront investment that is beyond the reach of many individual investors. Additionally, operating and managing a property requires a lot of work that can be very time-consuming and stressful. The good news is that investors with more limited capital and time still have plenty of opportunities to get involved in multifamily investing. Some of the most popular alternatives to purchasing and operating a multifamily property yourself include real estate syndications and REITs. Here’s what you need to know:
Real Estate Syndications
In a real estate syndication, a group of individual investors pool their capital through an overarching project sponsor to fund a large-scale real estate project. Individual investors make a monetary contribution to the project and are paid out based on the terms of the deal. The individual investors will not have to worry about day-to-day project planning, cash flow management, employees, staffing, or any of the more complicated parts of the project. Instead, the sponsor handles all of the actual work involved in the project, while individual investors enjoy a passive return on their investment.
Investing in a multifamily real estate syndication is a great option for investors in the $50,000-$100,000 range. Investors usually receive some of the first profits and are paid according to an up-front, transparent payment structure identified in pre-funding documents. The investment horizon for syndications is typically 3 to 8 years, and passive investors usually receive a K-1 to pass on the tax benefits of the project.
Real Estate Investment Trusts
Real estate investment trusts (REITs) are another way for investors to add multifamily real estate to their portfolios. REITs are companies that invest in specific types of real estate assets, such as multifamily properties. Investors can purchase shares of the REIT in much the same way that they would purchase stocks or bonds, receiving a return on their investment based on the performance of the REIT.
Minimum investments may be more attainable for investors with smaller amounts of capital, and REITs are also more liquid assets that can be bought or sold at the investor’s discretion.
Whether through direct investing, syndications, or REITs, multifamily investing offers the potential for steady passive income and property appreciation that can match if not outpace inflation. If you think that multifamily properties are right for your portfolio and would like to learn more about how you can invest through a real estate syndication, contact Kent Ritter today.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More