Following up on my previous post “Advantages of Multi-Family Property Investing”, nothing is ever risk free and there are two sides to EVERY investment. How each investor overcomes or mitigates a disadvantage is what separates the mediocre from the great investments. The following are some things to consider before investing in Multifamily Property.
1. Investment amount:
Although the per unit cost is typically small, apartments are only sold as a whole, making the entry cost to purchase a building higher than some are willing or able to meet. Since the larger the property the more economies of scale there are, for an investor to reap the highest returns the larger the property they should purchase.
Solution 1: Finance
Because financing is backed by current government programs, mortgaging a part of the property with attractive terms is still very possible in today’s market. However don’t expect the process to be easy, and in the best case you are looking at a maximum loan of 70% of the purchase price. The time it takes to obtain financing can leave many of the best opportunities from distressed sellers out of reach as well. And the more the leverage you use to purchase the property, the higher the risk you take with the additional expense of a mortgage.
Solution 2: Group Ownership
It’s an age old principal, if something costs $300,000 but you only have $150,000, than get another person with $150,000 and partner. The principal is commonly used in real estate and is called syndication. There are legal issues to work through when putting together a group to purchase property but with a good attorney, common investor goals, full disclosures, and a bit of pre-planning; group investment can be a huge win-win for everyone involved.
2. Acquisition:
Apartment buildings are considered closer to a commercial transaction than a residential single family home transaction. For one, it is very “buyers beware”, properties are usually sold as-is so proper due diligence is essential. Plus, there is not a large open market for apartment buildings as there is for homes. Very few properties are openly advertised on the web or in any MLS system (there are some but not many). A lot of properties are listed with brokers but for a variety of reasons the broker doesn’t, or isn’t allowed by the seller to openly market the property for all to see. So you won’t locate the majority of properties on the internet or advertised extensively. A buyer really needs someone “on the ground” contacting building owners directly and networking with local brokers to find the best available deals.
Due Diligence:
BUYER BE AWARE! There are much fewer if any protections a buyer has in the realm of commercial real estate. A smart buyer has to request and review all kinds of documents that confirm a seller’s “story” on the property, then independently confirm rental rates, vacancy rates, capital improvements, and a whole host of other things as part of due diligence. Trust but confirm! Again, being on the ground or having someone on the ground, with a vested interest, is the best way to handle due diligence.
Solution 1: Invest locally in what you know
If you are able to do all the due diligence yourself, this is the best way to go. I’d still recommend working with a local agent that can plug you into the market and assist you with diligence though. This of course limits you to certain areas and requires a larger investment of your time.
Solution 2: Group Investment
When investing in a group, the group will have a sponsor that acts as the CEO of the investment. The sponsor should of course be local, and be the person on the ground with the experience and connections to find, and properly underwrite a deal on behalf of the investors. Of course making sure the sponsor has a vested interest in the short and long-term prosperity of the investment is crucial to aligning the group’s goals with the sponsors.
3. Management
With any third party manager there will always be an inherent conflict of interest between the manager wanting to rent and manage the property for the least amount of effort and time and the owners desire to rent the property in the least amount of time, but for the highest amount possible. This conflict should be a very important issue to the owner of an apartment building not only because they are not realizing all of the income possible, but as mentioned in the “Advantages of Apartments…” blog, any potential rental income not realized directly affects the value of the property by a large multiple.
Solutions to this issue are similar to that of acquisitions. Either the investor should be close to the property or invest in a group structure with a local sponsor.
4. Capitalization Rates
Remember, when buying and when you eventually sell a property the capitalization rate that investors are demanding at any given time will directly impact how much your property will be worth. There is no way to determine exactly what cap rates may be in the future, there are however several ways that an individual can mitigate changing cap rates.
Mitigation Strategy 1: Value Add
By increasing the value of the property through improvements and cutting operating costs, large value gains can be made on mismanaged or ignored property. Fixing up, increasing rents, decreasing vacancy and reducing costs can cause a property’s value to be increased substantially even if cap rates rise. By also jumping property class levels, improving a “C” property to an “B+” property, an investor may perceive the risk of your property to be less, and thus will demand a lower cap rate than someone looking at “B-“ or “C” properties.
Mitigation Strategy 2: Time Exposure
By limiting the time you hold on to a property you are exposing yourself less to changing cap rates over time. Many people make a very good return by purchasing, improving and re-selling apartment buildings with 2-5 year holding periods for just this reason.
Mitigation Strategy 3: Buy Right!
Historically cap rates for multi-family buildings have been relatively low. During the boom apartments could sell as low as a 2% or 3% cap....but in today’s market where the general public may perceive much higher risk in the apartment market than they should, cap rates can be as high as 8%+ (adding in today’s low cost of leverage these 8% cap rates can translate into double digit cash on cash returns). So buying at a high enough cap rate is critical to mitigating the downside.
Mitigation Strategy 4: Plan for the Long-Term
By planning or expecting for an extended long-term hold you simply don’t have to worry about short-term cap rate changes, the best defense is to simply hold onto the property, enjoy the monthly cash flow and wait out the market until the next cycle comes around.
