There are many reasons why residential real estate investors are looking to shift from purchasing single-family homes to multifamily apartments. Competition levels, financing, and finding value are some of them. One of the main reasons is due to the economies of scale. It’s easier to manage one 203-unit complex versus 203 individual single-family homes (SFH). And it’s more profitable. So, what’s involved? How can investors make the change scaling from SFH to multifamily successfully?
Buying multifamily housing (MFH) is a more involved type of investment and may be more stressful and expensive than purchasing an SFH as a rental property. That’s why many investors decide to start with buying SFH and work their way up to MFH. However, to cut down on the learning curve, it might make sense to consider jumping into multifamily investing from the get-go.
Multifamily housing made up of one to four units is considered residential, while an MFH of more than four units is generally classified as commercial property. Residential MFH can be less expensive, as applicable laws and tax structures differ compared to commercial. Residential multifamily (up to four units) is financed with residential debt and is quite similar to residential in its strategies and financing. Commercial multifamily is financed with commercial debt and appraised through a value formula, not on comparable properties.
Commercial real estate valuation is based on this formula:
Value = Income ÷ Rate of Return
More specifically, it is:
Value = Net Operating Income ÷ Capitalization Rate
This allows operators to force appreciation, and leverage can multiply appreciation even further. This is the reason why most of the wealthiest people in the world invest in commercial real estate.
To be sure, larger MFH takes more preparation and can be overwhelming to a new investor. But no matter what an investor decides, there are several necessary steps to take before jumping in. How can one get started in scaling from SFH to multifamily properties?
Know the area
The geographic area of the investment property can play a large part in the cost of the property, the amount of rent that can be charged, and the type of potential tenants. This, of course, affects the bottom line of every investor, and if there is a certain budget to work within, it’s wise to find a geographic area that fits the budget.
Certain areas are much more expensive for ALL types of housing than others, which must be kept in mind when researching where to purchase. The cost of living expenses per geographic area is a good indicator of the investment amount needed before considering a purchase.
I was doing due diligence on a multifamily property in Charlotte, North Carolina, once. The stats online showed high crime rates and low income. But we found the area to be much nicer than the numbers showed. Upon speaking with a police officer in front of a new Barnes & Noble, we learned that the neighborhood had dramatically improved over the past three years. He said those statistics used to be true, but they weren’t anymore. If we had just gone by the numbers, we might never have visited and would have missed a good opportunity.
It’s critical to review the whole neighborhood carefully. Investors should drive around the vicinity of the property and do a 1-3-5 analysis. This review means that investors will drive every street in an increasing radius from the property and make observations. Is there evidence of drugs? Seedy buildings? Urban blight? Investors should connect with the local police to get their honest assessment of the property and the neighborhood.
Investors can check out the Neighborhood Scout website to get up-to-date neighborhood statistics. It provides information on property crime, violent crime, schools, income, and other important demographics. This is invaluable information for the first pass of evaluation. Advance Guide Pro or Premium members get a nice discount on this service.
Establish a team
Real estate is a team sport, so at a minimum, the landlord should work with an attorney versed in real estate, a property manager with experience in managing an MFH, a mortgage broker and insurance broker, and a general contractor.
A partner can hold more than one role. For example, a multitasking partner might be a contractor and, therefore, repairs or manages the property themselves. Or, if an attorney is a partner, the legal factors will be done routinely. While it’s not a requirement to have a partner who can also perform one of these roles, it’s always a bonus.
Whichever methods work best should be chosen, either a team or partner approach—or even both—as there are many facets to successful MFH investing.
When investing with a sponsor, investors need to take the time to get to know them. There is a whole process of digging into the details of their life, business, company, track record, and more. No one should neglect this!
Also, investors should consider who the property manager will be. What is their record, and how will they take care of the property? Landlords should look over any documents and equip the property manager with the latest lease agreement compliant with state and local guidelines.
Define a strategy
Investors must have a defined strategy when buying MFH properties. The choice of property, whether residential or commercial, the amount of down payment, the return on investment, and the overall amount of time needed to ensure profitability always must be considered—as well as approximately how long to hold it for.
It’s critical to think about planning not just how to pay initially but also the overall profit picture years down the road. Closing costs and needed repairs to the property in question should also be factored in.
Get your finances in order
Whether an investor keeps a property forever or is looking to resell somewhere in the future, there needs to be some strategy for this.
Landlords should decide whether they want to sell the property soon or if refinancing should be done upfront. While this is only an estimate, it will help plan how much financial resources and time will be needed to put into the property until a new one is purchased. Sufficient working capital to sustain the investment property until sale must be maintained, and a profit margin upon sale should be estimated beforehand. Property values go up and down, and selling in a down market won’t lead to much sales profit. So, investors should always prepare ahead financially for unforeseen circumstances.
More on multifamily from Advance Guide
Hire an underwriter
Every property purchase must have a thorough underwriting. Mortgage underwriting is the process during which a lender (whether a bank, broker, or credit union) decides if the investor qualifies for the mortgage they need to buy a property. First, the underwriter will verify income, debt, and assets. They will then assess the property itself with an appraisal and title search.
Most banks and other financial institutions are strict in underwriting, as the lenders are truly taking on the responsibility for the property in case of casualty or default. So, for someone with no experience with commercial property underwriting, it is advisable to hire an experienced analyst to do the underwriting.
Investors should perform thorough research into loans and mortgage solutions. Percentage rates can go up and down based on variable factors, such as time of year, location, length of mortgage and loan, and other factors. It does help to speak in-depth with several dependable potential lenders. At least at the beginning, it may be useful to enlist the aid of a commercial mortgage broker to help find the best solution.
Gather financial statements
Investors need to make sure all financial statements are the most recent—not just the pro forma (the projected financial statement). The financial history of a possible investment is just as important as—if not more critical than—the predicted future earnings, which are pro forma. The seller must supply income and expense statements and the actual rent roll from the past to make an informed decision before purchasing any MFH investment.
Consider tax implications
Taxes should be a part of the equation when purchasing any MFH investment. These must always be factored into the total yearly costs of the property acquisition.
Taxes will vary by location, and some geographic regions have many different types of property taxation—from municipal to state to even school district taxes. The amount of tax depends on the millage requirements based on the price of the property.
In general, taxes usually do not go down—but they can. They tend to either remain the same or go up based on the rates established by the local tax jurisdiction. To establish the history of taxes in any geographic location, inquire at the local tax assessment office, where all records of such type will be kept.
Appeal taxes if necessary
If a property owner feels that the taxation is too high, they may appeal through the local tax assessment office. While the reduction is not guaranteed, it may be worthwhile to try. A knowledgeable real estate attorney can advise here.
It’s always wise to research the history of the taxes to determine if an appeal would assist. For example, any renovations done by a previous owner may have led to a tax increase, and knowledge is power in an appeal situation. Many individuals each year appeal their taxes.
Some municipalities and states have only certain times of the year when tax appeals can be done. And again, a trip to the tax assessment office or a discussion with an attorney who will do this is almost a must-have before purchase.
Grow your portfolio with multifamily
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Perform due diligence
Investors have to keep in mind that MFH has more of a profitability margin because of the increased number of units and hence scalability. Prices of residential properties are based on the comps, whereas commercial designation pricing is based on the net operating income (NOI). This includes all expenses and any necessary repairs or upgrades. This does not include taxes.
Higher interest rates can exist for MFH, and banks may have stricter lending requirements. Due diligence of the highest degree is needed for this type of investment since lenders will want a precise valuation on the part of the investor before proceeding to lend. Most commercial lenders typically require a minimum debt service coverage ratio of 1.25X.
For those considering making this leap, there are a few things to know about multifamily investing, whether it is an active or passive investment. Please understand that these issues are not all make-or-break for each project.
1. Cash flow vs. appreciation
True wealth is defined as acquiring assets that produce income. Appreciation is a bonus. If projected returns are all based on a compressing cap rate and other paths to the growth in value, with less-than-adequate cash flow along the way, it may be a house of cards that will eventually collapse, especially in the current tumultuous environment.
2. Overreliance on interest-only debt
Interest-only debt boosts the project cash flow in the early years. But will the project produce positive cash flow without interest-only debt? This is not critical, but if the debt is interest-only for a few years and income shrinks during those years, investors could find themselves in a world of hurt when principal payments kick in.
And don’t think this couldn’t happen. Have you been to New York City lately?
3. Debt service coverage ratio
The debt service coverage ratio (DSCR), aka the debt coverage ratio (DCR), is the ratio between the pre-mortgage payment cash flow and mortgage payment. Banks mandate about a 1.25 DSCR or higher. If new cash flow is $12,500 per month and the principal and interest total $10,000, then the standard is met.
I recommend investing in projects that are significantly above the standard. I look for DSCRs in the range of 1.5 or above. A recent mobile home park we invested in has a DSCR of above 3.0, and our portfolio as a whole right now is at about 2.3. This is a 130% margin of safety, which I call my “good night’s sleep” ratio.
4. Inflated projections
Does the pro forma project rent and occupancy increases in year one? Does it rely on 5% rent increases annually while costs only increase at standard inflationary levels of about 2%? Watch out.
Stress-test this pro forma to see how the deal would perform with flat rent, lower occupancy, and unexpected maintenance costs. I’m speaking from experience.
5. Breakeven occupancy
Suppose occupancy is at 88%, and investors assume it will go to 96%—but what if it drops to 80%? Or less?
Reviewing the breakeven occupancy in conjunction with the DSCR is a way of evaluating the real margin of safety of the project. But physical occupancy is not a complete picture of the situation. Investors must consider economic occupancy.
6. Economic vs. physical occupancy
Physical occupancy is the percentage of units with tenants. Economic occupancy is far more important because it tracks the percentage of fully paying tenants. Some tenants may be delinquent. Others may be staying for free (staff, security, etc.). Some tenants may get discounted or free units due to marketing concessions. It is possible to have a physical occupancy percentage in the mid-90s and economic occupancy in the mid-80s. Trust me, I’ve seen it.
My friend Brian Burke, a 30-year MFH veteran, told me about buying a distressed Houston-area apartment complex in the wake of the Great Financial Crisis. He got it for about half of the prior owner’s price. What could go wrong? Brian said that about a quarter of the tenants moved out, and another quarter quit paying.
He had to offer concessions to fill units. As a result, his economic occupancy was below 50%. Brian struggled with this project for many long years, but he eventually made a profit from it. And his decision to pay expense shortfalls for years out of his pocket showed his shining integrity.
7. Pro forma vs. actual financial statements
Brokers and sellers love to talk about what could be. Sure, that is sometimes possible. But investors are buying what is now. So they should be careful not to presume about the future because there are no guarantees on their plans to raise income and cut expenses.
Speaking of which, sometimes the market rents across the board are listed as the highest rent that has ever been achieved on a single unit. So if the current owner has raised the rent from $900 to $950 on a single unit or two, they often report that as the market rent. Investors shouldn’t be fooled into believing it will be easy to raise all the rents to that level.
8. Insurance loss runs
I was performing due diligence for a property, and I learned that there had been one death and one serious injury in the past seven years. They were both flukes, but the seller’s insurance policy had been canceled, and his new policy was highly inflated—about four times what one would expect. This doesn’t have to be a deal killer, but don’t ignore this; the same rates and issues may be passed on.
9. Thorough inspection
When performing the property inspection, a team of two should walk every inch of the property. One person, a maintenance/construction type, and the other, a careful note-taker, should go through a detailed checklist when inspecting each unit. This information is needed to make the final decision, and investors shouldn’t be afraid to walk away.
Once, when we were under contract to acquire a 180-unit apartment complex in Tennessee, we were in the middle of a long day of inspections when I got a call from one team member. He invited me to come to the basement below one of the buildings, where he had discovered a serious mold issue. It turned out to be in that building and half of the buildings in the complex. The owner denied any knowledge of the mold. We had a nonrefundable deposit, and the only path to a refund was to prove fraud by the seller.
We called various local inspectors and actually found one who had inspected the property a year before and provided a pricey quote for mold remediation. He sent us 85 photos to prove it. The owner quietly refunded our money, and I’m guessing he was relieved that we didn’t report him or pursue him further. The broker was obligated to disclose it to future buyers, so we were satisfied with that.
10. The actual value of add-ons
We owned a multifamily property in Lexington, Kentucky, a few years ago, and a nearby apartment complex did extensive, expensive, and beautiful upgrades to their property. They expected to raise rates from $800 to about $1,050 per month. They failed to get those rent increases because the area wouldn’t support it.
They had apparently dropped millions on this program, and I doubt it paid off. And note that when they dropped their prices back to the $800s, it made it very hard to get the rent increases on the less-than-beautiful units.
Before counting on rent increases from renovations, investors should test a few units to ensure their theory is right.
11. Potential for unexpected expenses
Once, I put together the budget for upgrades to an apartment community we were acquiring. I thought that a 10% buffer in the budget would be adequate, but we decided to go with 20% just in case—an extra $100,000.
It’s a good thing we went with the higher number because we had an unexpected repair of $107,000 for a water main break. If 2020 has taught us anything, it’s to be ready for the completely unexpected. The unthinkable. The unimagined.
12. Cap rate
The cap rate, or capitalization rate, is a formula that estimates how much an investor can make from a property. It looks like this:
Cap Rate = Net Operating Income (NOI) / Purchase Price × 100%
Net operating income is the gross rental income minus expenses (such as vacancy, taxes, insurance, maintenance, other expenses). This is the formula:
NOI = Gross Rental Income – Vacancy, Taxes, Insurance, Maintenance, Other Operating Expenses
Investors must remember that the lower the cap rate, the more expensive the property. The higher the cap rate, the cheaper the property. Some may be comfortable with the current multifamily cap rates, but I’m not. Even as the author of a book on multifamily investing, I’m holding off on investing in apartments at this point in the cycle.
Sure, cap rates may be compressed further. But if investors are counting on that to make the deal work and rates go in the opposite direction, they may be ruined.
Overall, it might seem complicated to undertake scaling from SFH to MFH, but it isn’t. There are many benefits, and it doesn’t hurt to at least try one deal. Once investors go through the process, improve upon it, and then move on to the next property, they will find that MFH can be manageable. Having a “team” and/or partner is a big step in the right direction and can streamline the process. Again, due diligence and a well-thought-out, complete strategy before purchase will reward a wise investor with a source of stable income for many years.