Introduction & Benefits to Multifamily Investments (Part 1 of 8)

If you are fortunate enough to have access to capital, you are in luck. At the same time, you may find yourself completely overwhelmed. After all, there are many different ways to invest your money, and putting together a healthy, well-balanced portfolio can give you financial freedom and help you save for retirement.

For some, the greatest challenge is needing more money to invest. For others, it's figuring out the best way to invest it. After all, most of us only have so many dollars to invest. As a result, we must invest our money in ways that give us the best chance of success and the highest return while putting us in the slightest danger of losing it and fulfills our financial objectives.

Many potential investments can ensure the most significant growth of your limited investment dollars. Private equity investments in multifamily properties have been the most successful and satisfying for me in starting and running a family office. And after making several successful investments, I would like to share my knowledge and experience to help others. 

What Is a Multifamily Property?

A multifamily property has a broad definition. It is any property that allows two or more non-related families to live in two or more dwelling units. It is typically referred to as a property for long-term living, not to be confused with short-term properties, such as hotels or boarding homes.

As you can imagine, this is an expansive definition. It can mean many things, including:

• A building or home that has been divided into apartments.
• A duplex or townhome that allows multiple families to live in separate dwellings, each with its entrance and private living spaces.

In general, a multifamily property is a building where all the units are rental units and a single owner, either an individual or a legal entity, owns the entire property. 

Owning a multifamily property means that you are the landlord. As such, you will have to lease a property to a tenant. You will expect that tenant to pay you rent on time (usually once a month) and any other fees, like utilities. The specifics of each lease must be agreed upon before a property is rented. The landlord and the tenant are expected to sign a contract that spells out the rent prices, fees, and what the landlord is responsible for. There are also likely to be a lot of federal, state, and local laws that could affect how your lease is written and what a tenant can expect from their rental. 

Multifamily properties are vastly different. They include everything from a row home with two families to a massive apartment complex in a major city. Anyone can own a multifamily property, and many have figured out how to turn one property into several, turning their real estate investment into a huge business. 

At the same time, it's vital to understand that multi-property investments can go very wrong very quickly. For example, you may have a problem with an economic crash, a property-specific issue, or a legal issue with one or more tenants. Furthermore, multifamily properties are physical assets. These assets must be managed and maintained, and many people need to gain the expertise to do so. As a result, many people turn to alternative investment methods, like working with an expert real estate investment group, to gain the benefits of investing in a multifamily property without worrying about the challenges of managing the asset. 

What Are the Benefits of Owning a Multifamily Property?

The benefits of owning a multifamily property are extensive. More to the point, a multifamily property may offer significant advantages over traditional investment forms, like stocks and bonds. They include, but are not limited to, the following:

Stable Cash Flow

You will have a relatively good idea of your cash flow if you rent a property. You know that you owe a mortgage of $X, but you should receive a payment of $Y, leaving you with a profit of $Z every month. Do you own multiple rental properties? Even better, your cash flow is likely to increase. You should be able to take advantage of scalable properties that can allow you to make even more money. 

This cash flow should be relatively predictable. Rent is almost always one of the family's first bills, even for those experiencing hardship. This prioritization of spending helps to protect you from the dangers of non-payment.

Is this cash flow 100% guaranteed? Of course not, and the fewer units you own, the more risk there will be for potential issues with your cash flow, including vacancy rates or tenants who can no longer pay their rent on time. But if you own a multifamily home with at least 40 units, you can protect yourself from this risk by counting on other tenants to compensate for the lost income. Furthermore, you can have a defined process to protect you from non-payment, including working with appropriate attorneys and authorities to ensure you get your money and knowing when you may need to start legal processes to evict your tenant for non-payment. 

For illustration purposes, if you invest in a single-family home that costs $500,000, you might have to put down a 20% down payment of $100,000 and borrow $400,000 from the bank at a 4.5% interest rate for 30 years. We call this $100,000 of equity and $400,000 of debt. 

Now that you own the property, you look for the rental rate in the market and determine that the average for similar homes to yours is $2,500 per month. Therefore, gross annual rental income = $2,500 per month * 12 = $30,000 per year.

To calculate the total return for this property, we take gross rental income - total expenses - mortgage interest + change in property value.  

Some typical expenses include property taxes, insurance, and operating and maintenance costs. For this example, let's say it's $5,000 per year. 

Mortgage interest = $400,000 * 4.5% = $18,000 a year.

Therefore, the residual income of this property is: 

Gross Rental Income $30,000

Expenses - $5,000

Mortgage Interest -$18,000 

Residual Income = $7,000

Seven thousand dollars a year in residual income dollars divided by a $100,000 investment equals a 7% cash-annual return. 

To calculate the total return, we must add the change in property value, which as a rule of thumb, is 3% per year. That means the total return is 10% per year of this property. 

But as stated before, the fewer units you own, the more risk you have. Let's say that the tenant can no longer pay the rent, or there is a market downturn, and you cannot rent the unit at the same price you were hoping for, and your house is vacant for an extended time. In an extreme case, the gross rental income becomes $0; the expenses are the same, the mortgage interest is the same, and your residual income becomes $-23,000 per year or -23% annual return. A lot can go wrong at a breakneck pace. 

In my experience, this has happened too often for most invested in single-family homes to have scars/gray hair to know that the proper way to invest is like the professionals, through scale. And the research backs it up. 

Over the past 25 years, multifamily investment has had the highest average returns of any commercial real estate asset class. Investing in commercial real estate used to be considered a minor asset class (2%) for the most prominent institutional and endowment funds. Today, it’s a core allocation (+30%), indicating that investing in real estate is no longer an option; it’s a foundation.

Furthermore, multifamily had the highest returns of all property types over that period, with 9.75% average annual total returns. Followed by 9.61% for hotels, 9.57% for industrial, 9.44% for retail, and 8.38% for offices, much of it coming from cash flow returns.

This regular cash flow might be the best part about owning a multifamily property. Still, it is only one of several key benefits. 

High Demand

Multifamily housing complexes are widespread in the United States, particularly in urban areas. The sector includes 14.5 million units across 62 metropolitan markets with a population of over 1 million people. The total value of U.S. multifamily rental properties is over $3.3 trillion, making it one of the most attractive sectors for investors.

Recent financial and social changes have increased the number of people looking for shelter and the prices they are willing to pay to secure a place to live. The factors that created this high demand are likely to continue for years, including:

• Changing lifestyle preferences – Millennials, the largest generation in U.S. history, are disinclined to own a home. They are "renters by choice." A 2020 Zumper survey found that almost one-third do not consider owning a house part of the "American Dream." One-quarter of the renters surveyed declared that they never planned to buy a home. Unsurprisingly, one-quarter of those owning a house consider it a burden and wish they were renting instead.
• Major demographic shifts – Older people typically downsize their living space by moving into smaller homes or multifamily communities after raising families and nearing retirement. The sale of their current homes adds to the inventory of available housing. 
• High ownership expense – A 2018 study found that renting was less expensive than owning a home. The gap may widen as property taxes and maintenance costs increase.
• Increased financing costs – "In April 2022, 30-year fixed mortgage rates averaged nearly two percentage points higher than one year earlier. With the growth in home prices, the monthly principal and interest payment to buy the median-priced home was up about 50% in April compared with last April," says Dr. Frank Nothaft, Chief Economist of CoreLogic. A first-time buyer of a median-priced new house ($450,600) with a loan-to-value (LTV) of 80% ($360,480) with a fixed-rate 30-year mortgage will pay more than $420 each month for the 2% difference. 

All of this has massively increased home prices as the available supply of homes continues to shrink. Home prices rose 10.4% in 2020 and 18.4% in 2021; the 2021 increase was the highest in 34 years. These increases were even sharper in certain parts of the country.

Due to the high demand, landlords can raise rents without jeopardizing occupancy rates. Since multifamily rents are usually one year or less, property managers can quickly take advantage of strong demand. Conversely, the length of the leases dilutes the impact of sudden competition with a nearby property. Experts project that Class B and C properties, buoyed by residents fleeing the higher costs of Class A properties, will have more flexibility to raise rents over the intermediate term. Kriston Capps of Bloomberg notes, "The housing shortage is so severe that property owners likely don't need to charge max rents to make a bundle."

Driven by a lack of available multifamily units and access to higher-income renters, multifamily occupancy for the Class A, B, and C multifamily asset classes are above 97%, well above any year since the mid-1980s. While occupancy rates are likely to drop as new multifamily properties become available, remaining above historical occupancy average rates (95%-96%) for two to five years is expected.

Undersupply

The United States is currently experiencing one of the highest shortages of housing that it has faced in the past 45 years. This shortage exists for many reasons, including a lack of construction workers, supply chain issues, and the still looming ramifications of the Great Recession from a decade ago.

While new construction is unquestionably ongoing, it will likely remain slow in the short term. There are many reasons for this, as external constraints remain high on the market. Labor shortages still need to be improved, as there still needs to be more people working in various industries. Access to construction materials remains a problem due to supply chain issues. Furthermore, ongoing inflationary pressures still need to be improved, driving up the cost of housing and keeping the dream of homeownership out of reach for many. These factors will likely mitigate over time, but the odds are they will remain prevalent and problematic in the immediate future. 

The United States has not built adequate housing (single and multifamily units) for decades. As a result, the housing industry could not produce enough housing stock for the country's growing population. According to the Rosen Consulting Group, household formation exceeded housing production by nearly 3.2 million housing units from 2010 to 2020. NPR reporter Chris Arnold recently noted, "There's never been such a severe shortage of homes in the U.S."

The number of housing units added to the nation's inventory since 1965 is significantly low, 20% lower than the number of new households added during the same period. From 2010 to 2020, household formation exceeded housing production by nearly 3.2 million units. While new house construction has increased in recent years, it would still take more than 20 years to close the 5.5-million-unit housing gap at its current pace.

This shortage has had an impact on rental prices. Rents increased by 11.3% in 2021, with this percentage even higher in hotter real estate markets. What’s more, these price pressures show no signs of slowing.

The confluence of supply and demand forces determines real estate prices. When supply is greater than demand, prices drop, and vice versa. Therefore, considering both sides of the supply/demand equation is critical to understanding the likely direction of future prices and probable investment returns.

The annual increase of multifamily units–a substitute for individual houses-–has been insufficient to meet the increased need for shelter. According to the National Multifamily Housing Council, the country needs to add 528,000 new apartments yearly at different price points to meet the expected demand. However, since 1989, production has exceeded 500,000 units just three times.

The pace of new housing, including multifamily units, is unlikely to grow significantly in the next three to five years due to:

• Community resistance to new construction – The combination of regulations, municipal mandates, and zoning requirements, coupled with the emerging residential NIMBY (Not-In-My-Back-Yard) sentiment, restricts development, increases costs, and extends construction periods.
• Shattered supply lines – The Wall Street Journal reports that global supply chain woes have impeded the flow of goods and materials critical for home building, including windows, garage doors, appliances, and paint. As a result, prices for materials are increasing. John Paul Joy, a contractor in Philadelphia, notes, "Where we would pay $2.60 for 2-in x 4in dimensional lumber, it's now costing $6.84."
• Skilled labor shortages – The industry is struggling with significant labor shortages. Ed Brady, CEO of the Home Builders Institute (HBI), says, "The construction worker shortage has reached crisis level." Brady expects the construction labor shortage will intensify as other industries rebound from the COVID-19 pandemic and offer higher wages.
• Restrictive financing policies – As interest rates rise in response to the Federal Reserve's actions, lenders pass along the higher costs and raise underwriting standards for construction projects and sponsors. As a result, many small lenders and banks have reduced real estate construction portfolios, with private lenders assuming their role. Consequently, projects deemed "marginal" are less likely to be financed.

Many investors turn to single-family homes for rental as an alternative to multifamily properties. In 2021, the single-family build-to-rent (SF BTR) sector accounted for $1.5 billion, a minute percentage of the $335.3 billion in multifamily sales in the same year. Adding SF BTR properties will not increase the housing supply during the decade.

What does all of this mean? First, owning a multifamily will allow investors to have a highly lucrative and profitable asset for the immediate and mid-term future. Is this likely to stay that way forever? Of course not. Market forces will eventually catch up to the demand. New houses are being constructed to increase the available housing supply and thus reduce prices. 

However, real estate has also proven to be a highly lucrative asset that gains in value over the long term. As such, both short-term and long-term factors favor the idea that investing in real estate is a profitable one.

Outperforming Inflation

This chart demonstrates the historical performance of the different asset classes during periods of inflation:

Why did real estate outperform other popular asset classes in times of inflation? This effect can be attributed to several factors:

1. Real estate is a hard asset
2. Commercial real estate is a unique hard asset that produces passive income
3. Real estate leverage improves its performance against inflation 

Real Estate is a Hard Asset

Assets can be categorized as hard or soft assets. A hard asset has intrinsic value, whereas a soft asset only has a market value.

What has intrinsic value—that is, the value that exists regardless of hype or market opinion? Usually, we’re talking about something that is:

• Universally tradeable
• Limited in supply
• It can be used to produce goods and services
• Fulfills a basic human need

Several assets fall into this category: precious metals, commodities, natural resources, and real estate.

Gold is universally tradeable—every society has regarded it as currency, and it can be used to produce goods and services. The same goes for natural resources like oil and gas. Commodities like corn and cattle fulfill a basic human need for food. All of the above is in limited supply.

Real estate, too, is in limited supply. You can print more money or split a company’s stock, but no one can create more land (short of leveling a mountain or waiting for a volcanic island to form).

Furthermore, the structures you build on that land have their limitations—space, use, height—that create a different kind of scarcity within the asset class.

Finally, real estate fulfills basic human needs: shelter, agricultural land, and commercial space to do business.

Why does this matter? Because hard assets tend to increase in value with costs. After all, they are the materials for the goods and services people have to pay more. In addition to milk and gas at the pump, people must pay more rent or buy property. In other words, decreases in the purchasing price of the dollar increase the value of real estate.

Commercial Real Estate Is a Unique Hard Asset that Produces Passive Income

Real estate may be a hard asset, but so are gold, oil, and other commodities. What sets commercial real estate apart as a hedge against inflation? Won’t they all increase in value as the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) ratchet?

Yes, but commercial real estate is unique in generating rental income and creating passive cash flow. You can’t charge rent on a bar of gold or a barrel of oil.

Commercial real estate not only produces rental income, but as mentioned above, market rents tend to increase during periods of inflation, thereby increasing the cash flow even more.

Real Estate Leverage Improves Its Performance Against Inflation

Finally, commercial real estate performs so well during periods of inflation due to investors’ widespread use of leverage—in this case, commercial mortgages.

Inflation doesn’t cause your loan balance to get bigger on paper, but it does cause the debt to become less valuable, meaning what you owe the bank is less valuable too.

Let’s say an investor borrows $1 million to buy an apartment complex, and the CPI increases 5% as it did last year. The bank can't turn around and claim that the investor now owes them $1.05 million. They’re stuck with that collectible balance of $1 million, which now has the buying power $1.05 million had last year.

Add to that the increasing value of the property due to inflation, and we see the value of commercial real estate increasing while the price index of the debt decreases. Commercial real estate investors thus benefit from inflation on both sides of their balance sheet.

If the excessive inflation of the past year becomes a trend instead of an outlier, we expect to see the interest in commercial real estate increase over time, even as prices increase. Investors are sheltering and will continue to shelter their wealth in the asset class that outperformed all others during the inflationary cycles of the past.

Control Over Investment

When you have invested in the stock market or a similar financial asset, your control over the investment is relatively limited. You can buy more stock, hold the stock, or sell the stock. However, you cannot do anything else to improve the fortunes of the company whose stock you own.

You have more control when you own a multifamily property or any other type of real estate. You can choose how to market the property and set the rents. You can make renovations to the property that can improve your ability to market it, thus increasing the value and your income stream. You can consult with experts to better understand how to manage the property. You can contract with a property management company and wash your hands off the day-to-day operations. You can also sell the property and ultimately choose how much you sell it for.

Owning a multifamily investment gives you much greater control over the day-to-day management of an asset than almost any other type of investment. 

Asymmetrical Returns

Like any other financial investment, real estate will ebb and flow in value. However, over the long term, the value of the real estate increases more compared to other investments. According to the available statistics, multifamily property values grew by 19.6% in 2021. This growth was certainly higher than usual. However, the development of multifamily properties is still on an upward trend, with multifamily property values increasing almost every year.

An investment in a multifamily property is a solid one that will allow you to continue to reap financial rewards in the long term. Furthermore, these growth rates have traditionally outpaced the growth of other stock and bond markets and are likely to do so in the future. 

The graph below shows the ten-year risk-adjusted return, where stocks have a high return, high volatility at 11.98% return with 12.26% volatility; bonds have a low return, low volatility at 3.75% and 3.54%; and private real estate has high returns low volatility at 10.17% returns, and 2.98% volatility. Stocks and bonds have symmetrical returns, and private real estate has asymmetrical returns.

Access to Equity for Future Investments 

A multifamily property can be hugely beneficial for future investments. For example, let's say you own a multifamily property and have done so for a few years. As a result of your ownership, you have paid equity into the property. You then find another property that you want to invest in. You can pull equity out of your first property and use that equity to make a purchase, increasing the total amount of assets you own and creating an additional cash flow stream. 

Such a financial maneuver is not possible if you own stock or bonds. You'd have to sell a stock to buy another, thus losing one investment to gain another. 

As such, owning a multifamily home allows you access to the best of both financial worlds: You can build equity in a property but then pull that equity to make another investment while still keeping your cash flow.

Mortgage Supplement

Remember, a multifamily home can be considered a multifamily home even if you live in one of those properties. For example, let's say you live in a two-floor home and divide it so that you live on the second floor and have a tenant live on the first floor. You charge rent to the tenant. As such, the tenant is helping you pay the mortgage for the property that you live in. 

As noted above, renting a property opens your home to potential tax benefits. These benefits apply to rented properties, even if you live in them. As such, you're doing more than reducing your mortgage: You're also reducing your tax bill. 

Tax Benefits

There are extensive tax benefits to owning multifamily properties. These include:

• Depreciation –  ide of it—ages over time. You can write off depreciation on your taxes yearly, reducing the income you show from your profit statements. You can accelerate depreciation using specific accounting techniques, such as cost segregation. Conducting a cost segregation analysis, which is necessary for these circumstances, may be an expense that is very much worth undertaking.
• 1031 exchange – A 1031 exchange allows you to take the proceeds of selling one property and invest it in another similar property, also known as a "like-kind" property. There is no limit on how many times you can use a 1031 exchange. However, there are limits on the specifics of such an investment and the timing to exchange one property for another. 

Home improvements – Renovations can reduce your tax bill if you sell your property. Home improvements are a tax benefit, as your investment in your property may increase its sale value and the amount you can charge for rent. 

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