Investing in Multifamily: The Ultimate Guide
Multifamily is a great choice for those wanting more financial stability. This article discusses why investors believe multifamily is a secure investment.
What is Multifamily?
Multifamily is a real estate class that has multiple rental housing units. The units are contained in one or more buildings within one complex. Multifamily units can be on top of each other or side by side.
What’s the difference between a single family home and a multifamily home?
A single family home can be rented, but it lacks some of the characteristics that define a multifamily home. Multifamily has an individual address per unit and private living spaces such as an individual entrance, bathrooms, kitchens, and utility meters. Those living in multifamily will have less privacy than those living in a single family home due to sharing walls and community areas.
When evaluating multifamily, investors look at it as a business and consider the future needs of tenants, expenses, and income potential. Some investors start off with converting a large single family home into individual units. An advantage of looking at income potential is that it can help you qualify for a mortgage and higher loan amounts if you purchase a multifamily home.
What are the benefits of investing in multifamily?
Multifamily real estate can be an alternative for those wanting a more stable investment vehicle. It is a great investment for investors looking to take on a more active role in growing their money, rather than putting their money into a potentially volatile investment fund.
In real estate, more than one strategy can be utilized, and luckily, we have many favorable housing markets in the United States, where we can diversify our investments. Investing in multifamily rental properties is the preferred strategy for those looking for an additional source of monthly income, along with portfolio appreciation.
Below are some of the many benefits to investing in multifamily real estate:
While the cost of a multifamily property can be in the millions, it is more likely to be approved by a bank for financing than a single family home. The reason is due to multifamily real estate generating monthly cash flow.
Even if the property has some vacancies, or late rent payments from tenants, the investor should still have enough cash flow to cover the mortgage loan payment.
Therefore, the foreclosure rate on a multifamily real estate property would be lower, thus less risky for the lender. Lower risk will reflect in a more favorable mortgage interest rate for the investor or landlord.
Economies of Scale:
This is a huge advantage when trying to scale your business. I find it much easier trying to collect rent from 30 tenants in my apartment building rather than running all across the city to collect from my single-family homes. It is easier and more cost effective to have more units under one roof.
Growing your Portfolio:
Investors can grow their rental property portfolio exponentially by investing in multifamily (particularly commercial multifamily) versus single family homes. Negotiating a deal with one seller for a multifamily complex versus multiple sellers for individual rentals is more efficient. You would only have to conduct due diligence for one property instead of visiting many properties, potentially in different sides of town, or all around the country. This inconvenience can be avoided by investing your capital in a multifamily complex.
The IRS allows real estate investors to depreciate the value of a building over 27½ years. You can write off that year’s portion of the depreciation as an expense and reduce your taxable income. Depreciation typically includes the cost of the building and improvements less the amount allocated to the land.
Multifamily investors are allowed to accelerate depreciation, itemizing each component of the building separately via a cost segregation analysis. That means an engineer comes out to analyze the parts (from the carpet, to the windows, to the landscaping, to the roof) and create a custom depreciation schedule.
On a regular schedule, many of these items would have a shorter useful life than the building as a whole. The amount you can deduct is typically calculated based on the federal depreciation table and MACRS class lives for the property. You can ultimately depreciate up to 90% of the building’s value over 7 years. These benefits allow landlords to grow their cash flow and maximize their tax savings during their holding period. Interest payment costs due to mortgage loans during construction can also be deducted.
You can increase your cash flow by writing off interest from taxable income. You can also deduct any credit card interest or interest from a loan if the funds are used for property repairs, or anything related to property ownership, or retaining tenants.
What are the different Multifamily classifications?
It is crucial for investors to understand that each multifamily class represents a different level of risk and reward. The class investors choose can influence the stability of a property investment over time, as well as its growth appreciation.
Below is a breakdown of the most common multifamily classifications:
- Higher end and luxury apartments
- Usually less than 10 years old
- White collar tenants
- Average rents are high
- Little to no deferred maintenance issues
- Offers upscale amenities such as a community building, fitness classes, luxury co-working spaces, EV charging stations, etc.
- Located in desirable economic area
- High quality construction with best in class materials
- Typically have highest valuations per door and lowest market cap
- Can be 10-25 years old
- Good quality construction
- Typically well maintained
- Many have a mix of white and blue collar tenants
- Good for appreciation rather than cash flow, but they generally have more cash flow than a Class A property
- May or may not be professionally managed
- Investors can add value by renovations and improvements to common areas. Can upgrade property Class to B+ or A
- Typically at least 30 years old
- Limited and dated exterior and interior amenities
- Many have a mix of blue collar and low-income tenants
- Most attractive to cash flow investors because they offer the best cash flow
- Improvements show some age and deferred maintenance
- Some Class C properties need significant renovations and repairs to achieve steady cash flows for investors
- Built more than 40 years ago
- Many Section 8, government-subsidized tenants
- Generally located in lower socioeconomic areas
- No amenities
- Marginal construction quality and condition
How much does it cost to maintain multifamily real estate?
There are many costs associated with running a multifamily property. Below are a couple of factors to keep in mind:
An operating expense is an expense a business incurs through its normal business operations. Operating expenses are vital to calculate because they affect the net operating income (NOI) of the property.
- Property Management
- Property Taxes
- Sewer and Trash
- Repair and Maintenance
Repairs & Maintenance
Many investment properties will require repairs that have been deferred for years. If repairs are ignored, the value of the property decreases and it could hurt your occupancy rates. Nobody can predict the exact maintenance costs for a property, but you can estimate the costs. Below are two formulas widely used by successful landlords:
- The basic percentage formula. Fannie Mae recommends that property owners allocate 2 percent of the property’s value for maintenance. If you have a $5,000,000 property, be prepared to spend about $100,000 each year in basic maintenance to keep the property in livable condition, or about $8,333 per month.
- You can also budget 1.5 to 2 times the monthly rental rate each year for maintenance costs.
Invest in amenities that are offered by your local competition. However, there are associated costs such as: increased insurance rates, the cost to run and maintain the new amenities.
Tenant turnover impacts you in two ways: lost revenue and the expense (and time) to get the unit rent ready. If you are renting an apartment for $800 per month, the rent is $26 per day. If the apartment takes two weeks to turn, you’ve just lost $364, not to mention the money you spent fixing up the unit.
Poor Performing Employees
There are different levels of poor performing employees, from lazy to incompetent to criminal. Not having the right management team can cost you loss of revenue, tarnished reputation, and expensive legal matters.
Capital expenditures, commonly known as CapEx, are funds used by a company to acquire, upgrade, and maintain a property. Here are some examples:
- Hot water heater
- Driveway replacement
Are there different financing options for a multifamily real estate purchase?
There are multiple options for multifamily financing. The interest rates, terms, and loan amount limits can vary depending on the type of loan product and the lender.
For example, conventional multifamily mortgages have terms of 15 or 30 years, and government-backed multifamily loans can be given for periods of 5 to 35 years. Short-term mortgage loans can range in terms of 6 months to 3 years, with one year being the most popular term.
Should you hire a property manager for your multifamily?
A property manager can help the management of your multifamily investment easier. They will collect the rent, manage any repairs, and communicate with tenants on your behalf. Property managers can be especially helpful if you are investing in an area you are unfamiliar with since they come with knowledge of the local market.
What is the outlook for Multifamily in 2022?
“Throughout 2021, strong economic conditions and changing migration patterns have pushed multifamily market fundamentals to record-breaking levels. The economic and multifamily recovery is expected to continue through 2022, although COVID-19 is still with us, which could cause fresh waves of economic uncertainty that will likely persist throughout this year.” – Freddie Mac