The End of the Apartment Flipping Era

?The Case for Long-Term Apartment Investing

Recently I was at a real estate event and talked with a group of experienced owners that have owned real estate for 30 to 50 years. These owners mentioned that they see a lot of groups come and go, but the people that stick around are the ones that are buy and hold investors and look at real estate as a long-term play and not a simple get rich quick scheme. They all mentioned that using highly leveraged short term bridge debt was the biggest mistake they see investors make. They also mocked the investors that flip apartment buildings (think a 2-5 year hold) and tout big returns to their investors. It's interesting to hear from these investors and certainly worth considering their experience. In fact, as I reflect on the smartest people that I know in the industry – the one’s that have stood the test of time, they all think long-term and avoid the recent apartment flipping trend that swept the nation.

Investing in multifamily properties has long been a cornerstone strategy for real estate investors seeking to build sustainable wealth. While the allure of flipping apartments for quick profits in 2-5 years is tempting, the long-term benefits of investing for cash flow significantly outweighs the short-term gains. There are 3 big things I hear from passive and active investors that they are looking for:

1.???? Cash flow

2.???? Tax advantages

3.???? Taking advantage of excellent risk adjusted returns.

The problem lies in the execution. Most investors want the above, but then get distracted by the lure of the high IRR that the apartment flipping offers – the shiny object. What they fail to consider is that the apartment flip is wrought with high risk, low cash flow, and big tax implications. That is all good when the market is white hot and appreciating rapidly, but when the music stops, apartment flippers are left without a chair.

Strong Cash Flow Grows Equity

One of the most lucrative aspects of investing in multifamily apartments is its strong stable cash flow. This is the backbone of a good deal. Cash flow pays the bills and cash flow grows equity. The problem with apartment flipping is that oftentimes there is no cash flow or even negative cash flow. The goal is to create as much equity as possible, but equity does not pay bills. Run out of time, run out of money or as we're seeing today your debt changes, interest rates spike, and suddenly you’re struggling to pay the mortgage.

With long term debt we're able to lock in our loan at a debt service coverage ratio of 1.25 or better yet 1.5 or greater. That means that the net operating income is 1.5 times greater that the debt payment. Oftentimes investment groups that are completing a value-add apartment flipping strategy get into deals with under a 1.0 debt service coverage ratio, which means they have to dip into reserves just to pay the mortgage.

Now, I don’t want to completely mock this type of investing. This can be a great strategy; however, it adds a great amount of risk to the deal. Here's the biggest problem that I see happening. A lot of groups are purchasing stabilized properties and then using aggressive assumptions with aggressive lending to squeeze into a higher return. In my opinion, this strategy is best deployed on distressed properties and with a long-term outlook in mind. Do it right and the sponsor can refinance after stabilization into attractive debt, while giving some or all of the investors capital back.

The Stability of Long-Term Fixed-Rate Debt

Multifamily properties have the best debt products available in the commercial real estate world. Take advantage of them! ?This provides stability with long-term fixed-rate debt. When you secure a mortgage with a fixed interest rate, your monthly payments remain consistent and are not subject to the whim of the market. My company Endurus Capital has loans locked in as low as 2.7% vs bridge debt that is over 10%. This predictability allows us to accurately forecast expenses and manage cash flow effectively.

In contrast, floating rate bridge debt, often used with apartment flipping, carries variable interest rates that can fluctuate with market conditions. This variability can lead to unexpected increases in financing costs, squeezing margins, and increasing the risk of financial instability. As interest rates rise, like they have over the past 24 months, the cost of servicing floating rate debt can skyrocket, eroding profits and potentially leading to financial distress. Now investment groups will purchase a rate cap for an extended period of time, however, all that they were doing is simply prepaying for the interest rate risk. Those rate caps are only locked in for a short period of time, typically 1-3 years. The loan is also short term, usually 2-3 years with the opportunity to extend the loan, as long as the lender agrees to do so with additional fees. This all leads to highly expensive and risky loans.

Tax Benefits of Holding Real Estate Long Term

Long-term real estate investment offers significant tax advantages that can enhance overall returns. Some key tax benefits include:

1. Depreciation: The IRS allows real estate investors to depreciate the value of their properties over a set period, typically 27.5 years for residential real estate. This non-cash deduction can significantly reduce taxable income, thereby lowering tax liabilities. There are other legal tactics to front loading that depreciation as well through cost segregation and bonus depreciation.
2. 1031 Exchange: Investors can defer capital gains taxes by reinvesting the proceeds from the sale of a property into a similar type of property through a 1031 exchange. This allows for the growth of real estate portfolios without immediate tax penalties.
3. Long-Term Capital Gains: Holding a property for more than a year qualifies the investor for long-term capital gains tax rates, which are generally lower than short-term rates applied to properties flipped within a year.

Now, if a group owns the property for over a year, they likely can get by with taking advantage of the long-term capital gains and depreciation. Here’s the rub, though. When you sell the property, you will have to pay back the depreciation losses and pay the capital gains tax. You also need to pay your state income tax. As a former house flipper, I found this to be a very expensive way to profit from real estate. That lucrative 18% IRR that you went with suddenly doesn’t look as good as that “less attractive” long-term 8-10% cash flow deal with equity upside at a sale in the future.

The Safety of Long-Term Buy and Hold Strategy

Real estate, especially multifamily properties, has historically been a reliable and appreciating asset class. The long-term buy-and-hold strategy provides several layers of safety and stability:

1. Steady Income Stream: Multifamily properties generate consistent rental income, providing a reliable cash flow that can weather economic downturns better than many other investments. There’s a lot of bad news right now in the multifamily world, but that’s based on risky loans and risky business plans, not stable cash flowing assets.
2. Inflation Hedge: Real estate values and rents tend to rise with inflation, protecting investors’ purchasing power. This makes multifamily properties an excellent hedge against inflation.
3. Risk Mitigation: Unlike the volatile nature of stock markets, real estate markets are relatively stable. Multifamily properties, with hundreds of units generating income, spread the risk of vacancies and non-payment, ensuring a more secure investment.
4. Flexibility: With a long term strategy, you’re not forced to sell to be successful. At the same time there is the agility to sell if it becomes lucrative. With a short term 2-5 year strategy, time is your enemy. You are at the mercy of the markets that you cannot control.
5. Operations: The short-term strategy is not positioned for long term success. If an operator is stuck with a property long-term, their business plan is broken and they are digging out of a hole.
6. Debt hedge: As mentioned above, debt is a huge risk and the most common forms of debt used for short term apartment investors/apartment flippers is bridge debt, often even layered with mezzanine debt and preferred equity. This is the opposite of low risk.

The Hybrid Flip

Value-add investing can be a great strategy. You can buy a distressed or outdated asset, renovate, and create a ton of equity and cash flow. With a light value add, simply complete the renovations with cash and then either add a supplemental or refinance if you want to pull some equity out. I'm going to contradict myself a bit here. Using bridge debt can be a tool with a distressed asset (not a light value add), but you need to underwrite it very conservatively for a long term refinance. The better tool would be to use local bank financing and then refinance. The biggest issue with the apartment flip is that it doesn't allow you to be nimble. Having a long-term lens on allows you to be nimble. After completing the value add, you are able to sell or refinance and hold long term.

Final Thoughts

While the prospect of flipping apartments for quick profits can be enticing, the long-term benefits of investing in multifamily properties for cash flow are far more substantial and sustainable. The stability of long-term fixed-rate debt provides financial predictability, the tax benefits enhance overall returns, and the inherent safety of a buy-and-hold strategy secures your investment against market volatility.

Investing in multifamily properties for the long haul not only builds enduring wealth, but also offers peace of mind, knowing that your investment is in one of the most stable and historically appreciating asset classes. A case can be made for the Apartment Flip to make up a portion of your portfolio, but for those looking to create lasting financial security, the long-term multifamily investment strategy is undeniably the superior choice.

To your success

Todd Dexheimer