Multifamily real estate is one of the most popular types of commercial real estate investments. This is largely because investors can understand and relate to residential housing – after all, most people have lived in an apartment or owned a home at some point in life.
Familiarity aside, there are many other significant benefits associated with investing in multifamily property. Investors looking to minimize their risk and maximize returns are hard-pressed to ignore the benefits multifamily has to offer.
What is Multifamily Real Estate?
Multifamily real estate is generally defined as any property with two or more rental units. In reality, properties with two- to four rental units are classified, for investors’ purposes, as residential real estate. It isn’t until a property has five or more units that it becomes classified as “commercial” real estate. This is largely due to the financing mechanisms available for properties with 2-4 units vs. 5+ units and how lenders classify each type of property.
The size of a multifamily property can vary widely. Duplexes, triplexes and quadruplexes represent the smallest-scale multifamily properties. At the other end of the spectrum are large apartment complexes that can easily include 250+ units per property. In some cases, multifamily properties will have multiple apartment buildings within the same property. These complexes can have several thousands of apartments in total.
Owners of multifamily real estate can include individuals, small investor partnerships, private equity funds, institutional investors, and real estate investment trusts (REITs).
Why Invest in Multifamily Real Estate?
There are many reasons to invest in commercial real estate of any kind, including office, retail and residential. However, there are certain benefits that are uniquely associated with multifamily investments. Read on to learn more about the top reasons to invest in multifamily.
Simplicity and Stability
A wise investment maxim states, “Focus on protecting the downside and the upside will take care of itself.” This is especially true as it pertains to investing in multifamily real estate. In general, unless someone drastically overpays, overleverages, or grossly mismanages an apartment building, investors’ downside is typically protected.
This is because, unlike investing in something like a tech startup, multifamily real estate is simple and considered a stable asset class. Everyone needs a place to live, and increasingly, there is not enough supply to keep up with demand. Moreover, providing rental housing is relatively straightforward. There are prototypes investors can use to build and/or renovate apartment buildings based on the characteristics of the local market, and once constructed, the units can be leased using a standard lease agreement.
Moreover, multifamily offers greater stability than other real estate assets given the structure of these leases. Most apartments are leased on a one-year basis. The risk of a tenant leaving can be mitigated by having leases roll over at different periods throughout the year.
Multifamily offers greater stability than
other real estate assets given
the structure of these leases
This is much different than how other assets are leased, which may rely on a single tenant occupying a building for an extended time (5-10 year leases for commercial tenants are not uncommon, for example).
If that single-tenant leaves the building the landlord may experience a significant disruption in cash flow while they try to release the property to another single-tenant. Alternatively, the landlord may be forced to invest in a subdivision of the space to lease to multiple tenants—something that comes with its own costs.
Consistent Cash Flow
Multifamily investors benefit from leasing to many tenants, often dozens or hundreds of tenants at any one time. As noted above, through thoughtful management, leases can be staggered to ensure there is limited turnover at any given point in time. Therefore, if and when a tenant inevitably leaves, even if that unit sits vacant for a while, the total impact on cash flows will be minimal as the landlord will continue collecting rents from the many other tenants in the meantime.
Multifamily cash flows have proven resilient
even during economic crises.
Multifamily cash flows have proven resilient even during economic crises. For example, during the recent COVID-19 pandemic, the government has shown its willingness to support the multifamily market with agency loan programs and tenant subsidies as needed. This is because housing is considered a basic, fundamental need. Faced with a serious threat to the housing market, the government (federal, state and local governments alike) will likely step in to stabilize the multifamily industry.
One of the reasons investors are drawn to multifamily real estate is because residential real estate is a product type with which most can relate.
The average person will have rented an apartment at some point in time, and therefore, understands the basics of leasing and maintaining a rental unit. Most have owned their own homes, as well, so they understand the costs of improvements that are necessary to keep a property in good working order.
When compared to other product types, like office buildings or retail centers that usually have highly customized, nuanced leases, multifamily stands out as one of the most familiar and relatable real estate asset classes.
Easy to Underwrite
Compared to other investments, including other commercial real estate asset classes, multifamily property is generally easy to underwrite. For example, an office investment may require complex projections and expert-level knowledge about micro- and macro-economic drivers. However, with a little practice, most investors can run the basic math on a multifamily deal to determine whether in-place and/or market rents can cover the expenses, including projected mortgage payments, needed to generate a sufficient return.
Diversification is key to lowering investment risk, and investing in multifamily real estate is an excellent way for investors to diversify their portfolios outside of stocks, bonds and other more traditional equities.
This is true whether someone chooses to invest personally in a small rental property that they self-manage, or whether they passively invest in a real estate fund, syndication or large multifamily REIT that owns thousands of apartments across the country.
One of the ways in which diversification lowers investment risk is by providing several sources of investment returns that behave differently from each other over time.
While one investment may have a bad year, another – especially one that is not correlated with the others – may outperform and offset those losses with a gain.
As evidence: according to data provided by NAREIT, apartment REIT returns had a meager 27.9 percent correlation to the S&P 500 index between 1994 and 2000. A positive correlation means that the annual returns tend to move in the same direction each year, and the higher the correlation, the more tightly the assets tend to be.
The chart below displays annual returns on the S&P 500 and apartment REITs between 1994 and 2000. Of significance, there were five years in which the S&P 500 posted negative returns. In three of those years, those who had invested in apartment REITs would have helped to offset their losses with a positive return. Moreover, there were many years in which the returns on both the S&P 500 and apartment REITs were both positive, but the returns for apartment REITs drastically outpaced the returns from the S&P 500.
While correlation and return data are difficult to provide on an asset-by-asset basis, the key takeaway is that multifamily has proven an excellent hedge for those looking to mitigate associated with their more traditional stock and bond investments.
Breadth of Opportunities
Another benefit to investing in multifamily real estate is that there are many ways to do so. For example, someone can opt to personally own and manage multifamily real estate or they can choose to passively invest in real estate. It depends on how much time, experience and effort they want to invest in a deal.
There are also different multifamily niches for investors to consider, ranging from student to senior housing.
Lastly, the widespread availability of multifamily housing means that there are opportunities to invest in many different geographies. A person looking to further diversify their multifamily portfolio may decide, for example, to invest in a 55+ senior housing community geared toward retirees in the Sun Belt, as well as several garden-style investments in the Rust Belt, and then a separate tech-oriented multifamily project in Miami. Each of these investments will have a different risk/reward profile for investors to consider.
Ability to Leverage
Multifamily investors can benefit from the use of leverage – i.e., a bank loan, that can be used to finance a significant portion of the acquisition and/or renovation of a property. This requires investors to put less equity into each individual deal, thereby allowing them to spread their equity investments over more individual opportunities. For example, a property worth $10 million may be financed with $6 million in debt. Rather than investing $10 million in the acquisition of the property, only $4 million in equity is needed. The remaining $6 million that investors would have spent without leverage can be used to acquire other real estate assets (or really, to invest in anything).
While all commercial real estate can take advantage of leverage, multifamily tends to have the most attractive financing among all product types.
The reasons for this are twofold: for one, multifamily is considered a very stable asset class and therefore, lenders are comfortable putting debt on apartment buildings. Second, because housing is considered a basic need, the federal government has created loan programs (e.g., agency loans available through Fannie Mae and Freddie Mac) that provide highly attractive terms to multifamily borrowers.
Using leverage can enhance investors’ cash flow in the short-term and have a steady, wealth-building effect as tenants help to pay down the mortgage each month.
As investors build equity in the property, they can then leverage that equity to improve the property and/or to invest elsewhere. Best of all, when that equity is accessed in the form of a refinance or line of credit, the money is made available income-tax-free.
Hedge against Inflation
Multifamily investments are a great way to hedge against inflation as rents typically rise at least as fast as the rate of inflation. Of course, in an inflationary environment, an owner’s expenses may correspondingly rise as well. However, thoughtful planning can ensure that rents are rising faster than both inflation and expenses, and therefore, will help to strengthen the balance sheet and overall bottom line. One of the ways to ensure this happens is by using fixed-rate debt. Those who lock in low-cost, fixed-rate debt will have the same mortgage expense each year even as rents continue to rise. Whereas those with fixed income or fixed-income investments fear inflation, those who invest in multifamily often welcome it.
At the end of the day, regardless of investment type, it’s not what you make—it’s what you keep. This is one of the major draws to investing in multifamily real estate. Multifamily investments are highly tax-efficient.
The most powerful tax benefit is depreciation. Buildings eventually wear down and become “obsolete” over time. The IRS recognizes this and in turn, allows investors to “depreciate” their property. Depreciation functions like an “expense” even though it is not an actual expense that ever gets paid. This lowers an investor’s taxable income, even though they never paid out of pocket for the depreciation expense they are claiming.
Multifamily investments are highly tax-efficient.
For example, a dollar earned in interest in a savings account may be taxed upwards of 40% come tax time. That same dollar, if earned on a multifamily real estate investment, might not be taxed at all depending on the amount of depreciation an investor takes each year.
Standard, straight-line depreciation allows for investors to depreciate multifamily assets in equal amounts over a 27.5-year period. Alternatively, investors can use what’s known as a “cost segregation study,” which essentially identifies a “useful life” for each of the property’s physical attributes. This allows investors to front-load depreciation in the early years of ownership, which puts more money back into investors’ pockets sooner than if they had taken straight-line depreciation—or alternatively if they had invested in less tax-efficient vehicles.
The reasons to invest in multifamily real estate are vast. The asset class provides several avenues for individuals to be successful based on their own risk tolerance, goals, and investment horizon.
Are you considering adding real estate to your investment portfolio? Contact us today to learn more about Smartland’s investment platform, including why we feel that multifamily is the right product type, right now, for investors looking to passively grow their wealth.