What’s the difference between investing in condos vs. multifamily buildings?

Let’s begin with a few definitions.

An apartment typically refers to a suite of rooms forming one residence, in a building containing many similarly structured units.

A multifamily building is a rental apartment building where the entire building (and all of the apartments inside it) is under the same ownership. These are more commonly just called “apartment buildings.” A multifamily building can have two apartments or it can have 200. Multifamily buildings are very common in US cities, but quite atypical abroad.

In London, for example, multifamily buildings tend not to exist. Instead, nearly all buildings are condominium projects and individual investors or occupants own each of the units and either rent them out or live in them. This is more akin to what we refer to in the U.S. as a condominium: an apartment that is part of a building where each apartment has a different owner.

When big institutions like pension funds or endowments invest in apartments, they almost always buy multifamily buildings.

When individual people invest in apartments, they usually buy condominiums. That’s because in Manhattan, the average apartment costs $2MM. So a multifamily building, even one with only 5 or 10 apartments, often costs upwards of $10 to $20 million dollars, beyond the reach of nearly all individual investors.

Multifamily buildings tend to trade on the basis of cap rates. A cap rate, short for capitalization rate, is a measure of yield. If you take all the rents a building earns and subtract all of the expenses, you would calculate the property net operating income or “NOI.” A cap rate is merely the NOI divided by the purchase price. The higher the cap rate, the higher the current income from the property. For example, if a property has $100,000 in NOI and sells for $1 million, that is a 10% cap rate. If it sells for $2 million, that’s a 5% cap rate. Apartment buildings in Manhattan tend to trade at 4% cap rates. That means that a building generating $100,000 in NOI would be worth $2,500,000.

Why should you care about all that math?

Because cap rates have been, and still are, the way multifamily apartment buildings are priced.

Condominiums, on the other hand, typically are priced on the basis of price per square foot. In Manhattan right now, condos sell anywhere from $900 per square foot on the low end to $5,000 or more for very, very high-end, luxury buildings (like on Billionaire’s Row.)

While condominiums generally do not trade on the basis of cap rates because they are typically marketed to end users, we can still calculate the imputed cap rate on a condominium. We simply estimate the rent and expenses of that apartment, and do the math in exactly the same way, subtracting out condo maintenance fees and real estate taxes. While multifamily buildings tend to trade at 4% cap rates in Manhattan, condominiums have traded at or below a 3% cap rate for the past 15 years.

So why would a smart investor — with many choices — invest in condominiums?

A smart investor in deep thought over her investment choices.

A few reasons:

1. Supply & Demand Inefficiencies: As discussed above, the demand for condominiums is not solely determined by economics but also by housing needs. Currently, the for-sale market is softer than the rental apartment. There is currently more supply than demand for condominiums, so the prices reflect that imbalance. There are opportunities to take advantage of over-supply on the buy-side and under supply on the sell-side.
2. Arbitrage: Condominiums reprice more quickly in both rising and falling markets. This makes for more arbitrage opportunities. While volatility might feel like a bad thing, the best traders know that volatility creates arbitrage opportunities where smart, methodical investing can improve returns.
3. Cherry-Pick the Best Units: Certain units within a building are more desirable, rent more quickly and ultimately sell for higher prices than other units within the very same building. Sometimes the reasons for that price disparity are obvious, for example, when a unit has better views, a better layout or is on a higher floor. But the reasons might also be less obvious, and using our investment models, we can pinpoint exactly which units make the best long-term investments. By investing in individual units, we have the luxury of cherry-picking the best and building a diversified portfolio comprised solely of units which are most likely to outperform.
4. Liquidity: Individual condominium units are far more liquid than apartment buildings. If we need to sell a condominium, there’s always a plethora of buyers (at a price) and a transaction can close more quickly.
5. Management: Condominiums in full-service buildings have on-site porters and maintenance staff to support tenants. For a landlord, it’s like having a management staff through a shared expense (through maintenance expenses.) Owners of condominium units also do not have to deal with repairs and maintenance to building level components such as elevators, roof, boilers, and other mechanicals.

We believe in a buy and hold strategy for real estate but as a financial investor, finding opportunities within a longer term cycle can be the difference between market returns and out-performance.

At Compound, our residential real estate investment strategy is not limited to condominiums; in the near-term, both our human investment professionals and our computer-driven algorithm are seeking the best investment opportunities in that asset class. However, as market conditions change, our strategy will evolve. We will continually review and refine our investment model to optimize the portfolio for long-term capital appreciation and strong returns.

To learn more about Compound, visit our website here.