Investing in Multi-Family Real Estate

As an investor, securing stable, long-term, passive income is the key to financial success and a lucrative investing career. Even in this economic climate, Multi-Family real estate investments are doing well and much better than other classes of commercial real estate. Conceptually, it is easier for individual investors and small investment firms to wrap their heads around multi-family as a natural extension of single-family homes that they live in / rent out. Fractional passive real estate investments have made this segment even more attractive because investors can diversify their investments across locations, durations, investment types (core, core-plus, value-add or opportunistic), etc., MF comes in various shapes and sizes:

• Apartment Complexes
• Condo Buildings
• Duplexes/Triplexes
• Townhouse
• Flats

This article is intended to help real estate investors understand the what, why and how of passive multi-family investing, especially the fractional type of investing.

Why should MF be part of your real estate investment portfolio?

As a segment, multi-family properties are financially reliable assets that gradually appreciate over time, helping investors diversify their investment portfolio and generate a steady source of income. With proper asset selection, multi-family assets can have below-average risk with above-average returns. There are several advantages to investing in apartment complexes:

Cash Flow

One of the biggest benefits of investing in multi-family homes is the reliable monthly cash flow from rental income. Even if you have a few units empty, multi-family assets have multiple tenants paying rent, dampening the impact of empty units. Since leases are typically year-long, multi-family properties provide a steady cash flow.

Portfolio Diversification

Multi-family real estate investments should be part of any well-diversified real estate portfolio. Given the concentration of multiple units being in the same premises, one can achieve economies of scale for operational costs. In a larger real estate portfolio, a few multi-family investments offer better returns than single-family homes scattered across a very wide geography because of operational costs; this is typically what investors find as they graduate from buying single-family homes and renting out. Diversification is easier to achieve since multi-family properties are in every part of the country, especially with fractional investing where one can buy a fraction of property at various high growth locations across the country.

Tax Benefits

Investing in multi-family real estate offers attractive tax benefits. You can deduct expenses to manage, maintain and repair your multi-family property. These include utilities, property management, maintenance, mortgage interest, insurance premiums and marketing costs. In the long term, you can take advantage of real estate depreciation and cost-segregation tax benefits as your building and appliances age.

Asset Appreciation

The appreciation of a multi-family property may depend on many aspects but a sizable number of them are within your control. Property upkeep and maintenance to keep the property at or better than other properties in the comparable class, better rent appreciation through higher rents, keeping the management & maintenance costs in check by spreading them across multiple properties, cost segregation, upgrade of amenities with their income streams, etc., are fully controllable, increase cash flows and have a high impact on valuation. Fractional investing across a multi-location portfolio enables the investor to diversify away some of the risks while unlocking potential to achieve better risk-adjusted-returns.

What metrics are most important in evaluating Multi-Family investments?

Selecting a profitable Commercial Real Estate (CRE) investment requires experience, time, and precision. An investor should examine about ten metrics to assess the attractiveness of a multi-family real estate investment covering areas like income, operational expenses, free cash flows to cover financing costs and return as a percentage of investment. For in-depth coverage of metrics, refer to Common Metrics Used To Evaluate Real Estate Investments.

Net Operating Income (NOI)

NOI is the income earned by the property after deducting operating costs and expenses. NOI metric is used to derive a capitalization rate, which estimates returns on the investment. In short, you can use this metric to assess the likelihood of your MF investment being profitable. The investor should look for ways to maximize NOI.

Capitalization Rate (CR)

This metric is effective in measuring the operational attractiveness of an investment and comparing it against other potential investment opportunities. Capitalization Rate, or Cap Rate as it is normally referred to, is the ratio of NOI to the purchase price of the asset, expressed as a percentage. In general, when selling a property, a lower cap rate indicates that you can get a high price for the asset; while buying, a higher cap rate indicates that you are getting a better bargain, for commensurate properties and locales.

Operating Expense Ratio (OER)

OER represents the asset’s operating efficiency; it measures the cost of operating a property compared to the income brought in by the property. Obviously, higher OER is better, when comparing similar properties.

Occupancy Rate (OR)

Occupancy rate is the ratio of the number of rented units to the total number of rentable units in the property, expressed as a percentage. A higher occupancy rate is better; improving OR is a key goal of the stabilization phase of a multi-family property.

Cash Flow

Simply, it is the operating expenses subtracted from the net revenue. It is an immediate indicator of how well your property is performing currently and likely to perform in the future.

CapEx

Capital Expenditures are one-time expenses that go towards maintaining/improving a property. Capital Expenditures are typically incurred to increase the ROI of the multi-family investment.

Loan To Value (LTV)

Your loan-to-value ratio measures your property’s appraisal value against the loan amount landed for the property. This real estate metric allows lenders to determine the riskiness of an investment proposal.

Debt Service Coverage Ratio (DSCR)

Investors/firms must show that they have sufficient income to cover debt obligations. The Debt Service Coverage Ratio (DSCR) measures an investment’s free cash flow to cover debt obligations. Investors require a DSCR of at least 1.25x to be eligible for multi-family investments.

Gross Rent Multiplier (GRM)

The gross rent multiplier metric helps determine the number of years it would take for the property to pay itself in gross received rent. Lower GRM is better when comparing similar properties.

Internal Rate of Return (IRR)

The Internal Rate of Return is a metric used in financial analysis to estimate the profitability of an investment. An IRR projects the returns earned on the amount invested in a multi-family property. IRR considers both the timing and amount of cash flows associated with an investment, as well as the time value of money. When comparing different investments, the higher IRR is better, given a similar risk class. For multi-family, typical returns are in the 12–15% range. The higher the value added through capital and operational investments, the better the IRR will be.

Differing Quality of Multi-Family Assets

When considering a multi-family property, an investor may want to determine the class of each property. Categorizing a property is dependent on geographical and physical characteristics. Here is a qualitative index categorizing properties according to geography, risk, and reward:

• Class A: The highest quality buildings in the market and area. These were built within the past ten years with luxurious amenities and are occupied by high-income tenants. Class A properties often have the highest rent and price per square foot. These properties are typically located in central business districts (CBDs) or urban residential areas. Class A properties are typically managed and have little to no deferred maintenance issues.
• Class B: These assets are usually older than ten years. These buildings are not always professionally managed. These properties have deferred maintenance but are well-maintained. Class B properties are “value-add” properties, if renovated can improve the quality/appreciation of the property. These properties are on the fringe of a primary market or on the outskirts of downtown.
• Class C: Typically, older than 30 years and situated in economically depressed areas. Class C properties require general renovations and have outdated amenities. They are located in middle-income areas and rent significantly below Class B properties.
• Class D: These properties are well over 30 years old and located in “fringe” markets. Class D properties require extensive care and offer very few amenities to residents. They house low-income tenants and have the lowest price per square foot. It is operationally challenging without knowledge and experience.

Do note that investors consider multiple factors when selecting an investment. A successful multi-family real estate investment is not solely dependent on its class but its management and decision-making.

Fractional Investment in Multi-Family Properties

As a CRE investor, passively managing a property whilst generating a handsome rental yield is a dream for all investors! Fractional investing allows you to hold a “fraction” of multiple multi-family investments spread across locations and classes, enabling the investor to diversify away some of the risks and deliver higher risk-adjusted returns. There are attractive benefits to passive fractional real estate investing, the most important ones are listed below.

Lower Barriers to Entry

By splitting the cost of an asset among various investors, fractional real estate investment significantly decreases barriers to entry. This allows investors with as little as $25,000 to gain access to high-quality real estate in investment portals like RealtySlices.

Reduced Financial Risk

By owning a smaller percentage of the property, fractional property investment reduces portfolio risk for individual investors. Suppose the property incurs damage, as a limited partner. In that case, it proportionately affects your share of investment in the property without impacting the rest of your portfolio, thus reducing overall risk through diversification.

Increased Liquidity

Fractional investment in real estate provides increased liquidity, as it is easier to sell a part of the property than its entirety. Therefore, this allows investors to sell their investments if needed. Please note that government regulations and policies in the investment prospectus impact the ultimate liquidity of your fraction of the property.

Professional Property Management

By pooling resources, passive investors gain access to professional property management services, reducing management costs, and making only prudent capital investments which lead to improved capital appreciation of the asset.

Common Mistakes made when evaluating Multi-Family

Failure to stick to your Budget

It is a common mistake to let emotions influence investment decisions, especially when a seemingly impressive offer arises. However, taking the time to do proper due diligence through market research is essential to ensure a successful investment. It is important to review each deal and not rush into any decisions.

Relying too much on Future Appreciation

Do not fall into the trap of counting on future appreciation of a property unless there is enough evidence for a high confidence decision; even then, validate your assumptions with other knowledgeable people/entities. There is no way to predict future appreciation, so it is important to base investment decisions on metrics such as cash flow, IRR, and NOI, and see how each of your assumptions, if they come to pass, will alter the metrics. Always consider the probability of an event happening and the impact of such an event on the MF evaluation metrics. If these suggest unsustainable revenue for the investment, it is best to walk away.

Going it alone

Deciding to invest in multi-family is a huge step and it can be a good one. Most first-time investors make the mistake of going in all alone. You need a nuanced, experienced set of co-investors and/or expert advice to go in with you, to minimize risk. Platforms like RealtySlices enable you to go in to the investment with investors who are looking for similar outcomes like you are; comprehensive investment information is provided along with standardized metrics, ability to participate in interactive sessions with the developer floating the investment to make sure you are getting into the kind of investment you want to, and network with like-minded investors. There are several ways to research a property, from referrals, from friends, to listening to podcasts and going to meetups. Do your research, you will be well on your way to successfully investing in your first multi-family property.

Insufficient research

Finally, while assessing the attractiveness of a property for investment, multiple factors should be considered while investing. These include background checks of the seller and property, knowledge of alternate investments and financing approaches, the ability of the property to generate free cash flows, the ability to sell the property easily if you so desire, etc. There are several risks to investing in multi-Family property. Thorough research, inquiry, and selection, you can identify brilliant investment opportunities.

Key Takeaways

Investing in Multi Family can be very lucrative in terms of risk-adjusted-returns. As mentioned in the article, thorough research in terms of asset selection, valuation, value-add strategy, management by metrics, and effective exit, are quite complex and time consuming. Fractional investing through platforms like RealtySlices enables investors access to a wide selection of investments presented in a comprehensive and standardized manner along with the pros-and-cons of each investment as listed by respective sponsors. Most importantly, RealtySlices enables passive fractional real estate investing, with the complex aspects being executed by professionals while the investor can diversify their multi family portfolio with a smaller pool of investment. Check out RealtySlices to learn more about fractional real estate investing, diversification of your portfolio, and driving towards maximizing your risk-adjusted returns.