Your Guide to Investing in Multi-Family Real Estate
There is no getting around it; medical burnout is real. Whether you’re an anesthesiologist, general practitioner, or a cardiologist, you probably don’t have much free time to keep up on the latest tech IPO or commodity crisis. However, this lack of time does not have to lead to a lack of ROI for your investment portfolio. There are several ways to generate positive, passive returns using commercial real estate, even if you’re busy working with patients or research.
Before we dive into why you should consider the benefits of multi-family real estate, we need to spend a minute describing what it is. (Not to worry, unlike some other asset classes, it’s pretty self-explanatory.)
Multi-family real estate is any dwelling-space that encompasses more than one family. An investment opportunity in a multi-family property is you acting as a landlord and receiving monthly rent from several families or the tenants in your building.
It’s important to note that multi-family real estate can come in a large variety of different forms in different communities, from simple duplexes and triplexes to apartment buildings and luxury high rises.
As an accredited investor, we highly recommend you focus your multi-family real estate investments on the latter (apartments and high-rises) if you choose to pursue this form of investment. There is great value in spreading your investment risk across more rentable units.
Alright, now that basic definitions are out of the way, it’s time to get into the good stuff: why should you seriously consider adding multi-family real estate to your portfolio? What advantages will it give you in the long run in terms of expanding and preserving your wealth?
We’ll give you 3 excellent reasons to invest in multi-family properties versus single-family homes.
Low Volatility: Multi-family real estate is a lower-volatility investment based on historical returns compared to other popular asset classes, for example, stocks. This means that your investment capital will be producing passive income for you, while also providing stability not always found in the stock market, bond market, or in some of the alternative markets.
Excellent Inflation Hedge: When inflation goes up, the stock market goes down. So, another major advantage for multi-family properties is their superiority as an inflation hedge. If inflation goes up, your lease agreements automatically raise rents to offset its impact on prices and the purchasing power of money.
A Powerhouse of Scalability: And finally, we’ve arrived at one of the best reasons to invest in multi-family properties: their superior scalability. Think about it. If you’re a single-family real estate investor with one home, you have to buy a whole separate house to generate another source of rental income. But if you’ve gone down the path of multi-family real estate investing, all you have to do is finance a single apartment building and you have dozens of sources of income.
Check out our blog posts to explore the different reasons why multi-family real estate investing is more attractive than the single-family approach.
Since multi-family real estate is likely a new asset class for you, we’ll review 2 key questions that you should ask yourself before committing capital to any multi-family properties. Also, keep these questions in the back of your mind as general “investment rules of thumb”, since they apply to any other asset class you might be considering.
Question #1: What do historical rates of return look like for this asset class, and is it resilient in a crisis?
Historical rates of performance for multi-family real estate are quite strong. To get a true picture of the historical performance of any asset class, you should look back at its 10 and 20-year averages (and even further if you’re in the mood to be extra thorough, but we’ll stick to those for now).
For U.S. apartments, the average 10-year rate of return has been a very respectable 6.08%, while 20-year averages have been even stronger at 9.27%. When you consider that savings account interest rates are at an all-time low and factor in stock market volatility, average returns like that start to sound pretty appealing.
Question #2: What tax advantages will this asset class give me?
The strategic tax advantages of investing in commercial real estate are many and varied. First off, you’ll have a huge range of real estate tax write-offs available to you. You can easily find comprehensive lists of write-offs you can take advantage of in the course of some basic online research. However, a few of these include maintenance and management costs (this will most likely take the form of a professional team), insurance premiums, marketing costs and other business expenses, utilities and repairs.
Another major tax benefit you can expect to take advantage of as an investor in multi-family real estate is the depreciation tax break. Even though the value of a carefully chosen commercial property should only increase with time, the IRS operates on the assumption that it will depreciate due to the aging process.
This deduction covers all properties in the United States but was based on aging buildings that fail to appreciate. It is easier for the government tax agencies to make a blanket assumption than it is to collect, update and maintain the appreciation or depreciation data for hundreds of thousands of apartments and high rises and tax each owner based on frequent assessments.
In other words, the simple phrase “depreciation tax break” shouldn’t scare you off from commercial real estate. If you invest properly, you could very well have an appreciating asset on your hands rather than a depreciating one.
Location is a key criterion when you invest in real estate. There are also several other criteria that can impact the performance of your real estate investments.
Ideal locations can also vary by investor. Not everyone is going to agree on what is an ideal location. Sometimes it takes vision to determine what could be versus what is there now. For example, a lot full of weeds could become a city’s newest high-rise apartment complex.
Keep in mind there’s no “one size fits all” type of answer to the question of where you should invest in commercial real estate.
Having said that, these are a few of the key questions you should be asking about location.
Question #1: How does the job market look?
This is an extremely important point of consideration when evaluating an investment in real estate that produces rental income. And, it breaks down into a few critical sub-points. For instance, is the job market growing or shrinking? Are people entering or leaving the city? What are the primary demographics of new rentals in that city? Do the available jobs pay enough to afford your rental rates?
Another key point to consider is the number of industries in your property’s area: is there a healthy diversity of different industries flourishing as a group, or is there just one dominant employer (auto, military, etc.) that could take a massive downturn depending on economic or political events?
Question #2: What’s the price/rent ratio for commercial properties?
The price/rent ratio of an area functions like the price/earnings ratio of common stock. In other words, it’s a quick shorthand method of determining the overall profit potential or attractiveness of a particular area’s rental real estate rates.
The higher the price/rent ratio, the less ideal an area is for investment. (It stands to reason you are looking for low prices and high rents.)
To calculate the P/R ratio of an area, simply put its average property price over its median annual rental rate. It’s an easy and convenient benchmark you should keep in mind as an investor in any kind of real estate.
We should also spend some time outlining the precise benefits that you receive when you invest in multi-family real estate versus single-family real estate. Single-family real estate is what many real estate investors opt for. But, it is important to note, this preference may be their only choice. They are the landlord and renter of a property along with the local bank.
Investors can add commercial real estate to their portfolio through crowdfunding websites, and those companies certainly do provide an important service in terms of opening the playing field to other investors. But as an accredited investor, you have a very unique and very powerful opportunity to scale your real estate portfolio in a way that the average real estate investor cannot.
So, having made that distinction, let’s get into a few of the more important differences.
Difference #1: Forced appreciation hugely favors the multi-family commercial investor over the single-family investor.
The first major difference we’ll get into between the two types of real estate investment is the increased ability you have to leverage the power of forced appreciation. Before we get into the comparative differences, a very basic definition of forced appreciation would be any improvement made by a landlord or property owner that increases the value of that individual’s property.
In the case of a single-family investor, forced appreciation might take the form of adding a backyard swimming pool, building a guest cottage in the backyard, finishing an unfinished basement to add more living space to the house, and several other types of improvements.
If you’re an investor in commercial properties like apartments or high rises, forced appreciation might take the form of adding a community pool, building a playground area for your tenants’ children, or adding a communal game room that your tenants can access.
So, in either form of investment, forced appreciation is a possibility, and it’s definitely something you should seek to take creative advantage of – that is add features that increase the value of your property.
The realities and benefits of forced appreciation massively favor you as a multi-family real estate investor.
How, precisely? It’s simple but powerful. Imagine you’ve invested in a single-family home and rented it to a family with two children. Next, you decide it’s time to force appreciation on the home by adding a swimming pool, spa, and gazebo. Unfortunately, you only receive rent from one family who has to absorb all of the construction expenses. How much additional rent can one family afford if they are the only renter?
If, however, you’ve chosen to invest in multi-family real estate, adding that same pool in the back of your apartment complex would allow you to increase the rents of each and every one of your tenants, since the pool serves as a communal amenity. Do you see the sheer potential in terms of scalability?
A single-family investor would have to buy, improve and rent dozens of homes to get the same appreciation impact that a multi-family real estate investor would achieve in one fell swoop, with a single commitment of capital. Clearly, multi-family real estate investors have a greater ability to leverage and benefit from forced appreciation.
Difference #2: Your monthly cash flow as a multi-family commercial real estate investor is often superior to a single-family approach right from the start.
If you’re investing in single-family real estate, it’s often a slow start. For many investors, it’s a very involved process and learning curve just to make and then realize cash flow on their first investment, that they never get to the stage of real estate investing where its cash flow potential truly becomes apparent.
We’re referring, of course, to the stage of having a comprehensive real estate portfolio. That’s when the cash flow really kicks into gear.
The problem? Well, as we’ve said, for most real estate investors the upfront hassle can be overwhelming and discourage them from persevering, analyzing deals, and building a portfolio with multiple properties.
If multi-family real estate isn’t profitable enough for you on its own merits, then we’ve got another alternative for you: opportunity zone investing. With the introduction of the Tax Cuts & Jobs Act of 2017, the Opportunity Zone legislation was unrolled, to encourage private investment in economically underserved and underprivileged areas (known in the legislation as “Opportunity Zones”). And investing in multi-family real estate in an OZ has some major financial benefits.
If you invested in a multi-family property in an OZ, you would be entitled to a range of highly effective tax-sheltering and wealth-producing benefits. For instance, you could benefit from capital-gains deferment, tax-free growth, and many other benefits, not to mention the satisfaction of knowing you were directly involved in fostering economic growth in an underserved community.
It’s also key to note that these benefits are time-related and incremental. For example, the longer you retain your investment in an OZ, the greater the percentage of your investment that’s sheltered from capital gains taxes.
A recent whitepaper from Freddie Mac even indicated that a multi-family real estate investment in a Qualified Opportunity Fund could produce an annual return of 12%, as opposed to an 8% return on a similar investment in a traditional multi-family investment. The bottom line: while the legislation is still relatively new and some of it may be revised by subsequent administrations, you should certainly consider investing in an OZ. You could be grandfathered if you act sooner than later.
There is no single investment strategy that works for everyone. That is why people diversify their investments. They want to be in the right place at the right time with at least part of their assets. If they could predict future returns, they would not have to build diversified portfolios that include multiple asset classes.
One of those asset classes should be multi-family real estate. It has some unique characteristics that are not shared by other asset classes. The benefits are even greater if you are an accredited investor.
From greater tax breaks and more write-offs to superior cash flow, scalability and control over appreciation, investing in multi-family real estate opens the door to a wide range of strategic financial advantages that single-family real estate investing simply cannot match in terms of effectiveness and long-term impact on your net worth.