Many investors who are interested in diversifying their portfolio, will come across real estate investing at some point during their research. Real estate, is best known as a great source of recurring cash flow, in addition to being a superior hedge against inflation. The problem that usually follows the discovery of investing in real estate, is how to actually do it.
There are dozens of strategies for investing in real estate. Many of the popular strategies include; flipping houses, wholesaling properties, short-term rentals, and single-family rentals. More advanced real estate investors might choose; retail, office, or industrial properties as their asset class of choice. Another popular real estate investment class, over the past few decades, has been multifamily real estate.
Multifamily real estate has been an attractive asset class for years, because of its simplicity. Most people have lived in an apartment or rental property at some point throughout their life and they all have many similarities. There is a kitchen and at least one bathroom. Most rental units will have a bedroom(s) and an additional living space. Occasionally, in expensive cities; there might just be one room that incorporates the kitchen, living area, and bedroom. These units are commonly referred to as studios.
The operations of a multifamily property are very straightforward. Tenants will rent a unit from the landlord; typically using an annual lease. Tenants are required to pay the landlord a set amount each month; for use of the rental unit. Tenants are usually expected to pay their own utilities while the landlord is responsible for the upkeep of the property. This leasing strategy is much simpler when compared with more complex commercial leases; allowing for a lower barrier to entry for new landlords.
What is Multifamily Real Estate Investing?
A multifamily property is any property with more than one residential rental unit. Small multifamily properties would include; duplexes (2 units), triplexes (3 units), and quadplexes (4 units). Once a multifamily property has 5 or more residential units or has at least 1 commercial unit (commonly referred to as mixed-use); these properties are now considered commercial properties. From the perspective of a casual observer; a property having 4 apartments versus a property having 5 apartments, might not be a big deal. However, it dramatically changes how investors, lenders, insurance companies, and other real estate professionals, analyze the investment, the returns generated, and the overall value of the property.
Most new multifamily investors will start with 2–4-unit properties and then grow from there. The main reason for this is that the financing is better, easier to be approved for, and the amounts required for down payments are smaller. A triplex might sell for $300,000; requiring a down payment of 20% or $60,000. Compare this with a 6-unit apartment complex that is selling for $500,000; requiring a down payment of 25% or $125,000. The 3-unit investor will also have the ability to get a 30-year, fixed-rate mortgage while the 6-unit investor will most likely only be able to obtain a mortgage that fixes the rate for 5 or 10 years; and then requires a refinance. The 3-unit investor has less risky debt.
How to Start Investing in Multifamily Real Estate?
Investing in multifamily real estate can be a very profitable endeavor but, how does a new investor get started?
The first step is identifying your end goals for investing in real estate. What are your 5-, 10- and 15-year goals? Is it monthly cash flow, the ability to leave a job, maybe leaving an inheritance to your family, the freedom to travel, or a combination of them all?
Next, is to perform a self-assessment. The self-assessment is crucial since it allows potential investors to review all of their abilities and resources while identifying where they might fall short. Maybe you have a demanding job, that pays well but, limits your free time. Maybe you have a less demanding job; however, you lack financial resources. Possibly, you sold a business and have a sizeable amount for investment but, you have never purchased a piece of investment property and are overwhelmed by having to manage properties, tenants, and repairs.
After a self-assessment, an investor will have an honest opinion of what types of properties and projects they will feel most comfortable purchasing with their available resources. The next question for the potential investor is what multifamily investing strategy will they be utilizing.
House Hacking
Is by far one of the most popular multifamily investment strategies. This is mainly due to the fact that investors are able to employ this approach with minimal funds. House hacking is the purchasing of a 2–4-unit property, living in one unit while renting out the others. The purchasers usually use an FHA mortgage that features a low down payment, in addition to the fact that buyers typically are allowed to include the income generated by the other units in their mortgage application; therefore assisting borrowers with mortgage approval.
Once an investor has purchased a multifamily house hack; they are able to live in one unit, rent out the other units, and that helps to minimize their monthly costs, as they perform repairs and updates to the property. As the repairs and updates are completed, investors are able to raise rents and increase the value of their property.
Commercial Multifamily Properties
For new investors with more capital, jumping right into commercial multifamily investing might be the best course of action. These investors will be targeting 5+ unit multifamily properties, requiring them in most cases to provide a down payment of 20-30%. Commercial multifamily properties are valued differently than 1–4-unit properties, where their net operating income (NOI), determines what the value of their property is.
Commercial multifamily investors have the ability to increase their net operating income by making their properties more efficient and profitable. These investors will be in search of properties with below market rents, high expenses, and absentee managers and owners who in many cases, purchased the property years ago and since then, they have done minimal updates and rent increases. A property similar to this allows investors the ability to “force appreciation.” This is the practice of increasing the property’s cash flow and value, by identifying additional income opportunities. These opportunities are typically centered around, minimizing expenses (hiring new vendors, becoming more efficient) and also increasing income (renovating the property, upgrading units, raising rents, adding new services to the property, and charging for them).
One of the main benefits of commercial multifamily properties is the economies of scale. This occurs when investors purchase larger properties, with more units and it exponentially increases when investors buy additional properties, preferably in the same market. Investors are able to obtain better pricing because of the sheer size of their portfolio. For example, a property owner with several apartment buildings is able to negotiate better rates for; property management, landscaping, contractor services, vendor services, and materials, to name a few.
After completing your goal planning, self-assessment, and strategy selection; start following the checklist below in order to begin the actual process of investing in multifamily real estate.
The Market
Choosing the market is the basis for buying a multifamily property. Most new investors will buy a property near where they live, without much research. This may work fine; however, without research, it is a gamble. Novice investors are notorious for purchasing properties in stagnant markets since they are only looking at monthly cash flow.
A seasoned real estate investor has a much different process. They look for markets with growing populations, growing job markets, and markets where crime has been consistently decreasing. Markets that meet these criteria are markets that will have growth for decades to come. When there is growth in a market; properties will not only provide recurring, monthly cashflow to the owner but, they will also appreciate it.
The Location
Once you have recognized a market, it is now time to start identifying a sub-market, all the way down to potential neighborhoods where you would like to invest. New multifamily investors will usually look for less-than-ideal areas to invest in since they are blinded by the potential cash flow and returns that have been highlighted by the property listing broker.
Seasoned investors want to buy in good neighborhoods that are growing. These are well-positioned neighborhoods; near commercial, retail, grocery, and restaurant establishments but, not necessarily next door to them. They are looking for properties that will warrant “credit tenants” or tenants with stable incomes (long-term jobs) and good credit scores. This will ensure that tenants pay rent on time while respecting the property and their neighbors.
Creating a Team
After the location has been determined, the next step is putting together your team. This doesn’t mean you will be hiring all of these people now however, it allows the rest of your buying and investment process to run smoothly since you will not have to look for professionals when they are required.
The first member of your team should be a full-time, commercial real estate broker. This broker should focus on the location you have identified and should also be dealing with the types of properties you are looking for. This broker will be instrumental in bringing you potential properties to purchase; in addition to being a wealth of information, they will also be a valuable source of team member referrals.
The second member of your team should be a property manager. Preferably, they should have 10+ years of experience, in your market, managing your target property types. The best way of finding good property managers is from real estate brokers and referrals from other landlords. Make sure that the property manager has an office near where you will be buying properties. This will make it easier for them to have a more hands-on relationship with your properties but, it also means that they most likely have many other units under management in that area. A good property manager will assist you before ever purchasing a property. Bring properties that you are ready to submit offers on or have approved offers on to their attention. Let them review them and ask for their feedback. During due diligence, hire them to perform the due diligence with you. They will know exactly what to look for, and once they find a problem, they will know how to fix it, and what it will cost.
The next members of your team will be attorneys. Real estate investors should have a relationship with both; a real estate attorney and a litigation attorney. The real estate attorney is the most important attorney at the beginning of your investing career; and the attorney you will be using most often. The real estate attorney should have experience with; rental real estate, tenants/evictions, and commercial real estate. This attorney will draft all of your commercial real estate purchase and sale agreements, review leases and contracts, in addition to handling your tenant evictions.
The litigation attorney will mainly be used when there is a lawsuit or the chance of a lawsuit. A litigation attorney is also a great source of advice for assessing your legal exposure and answering questions. It is not imperative from the start that you find a litigation attorney; however, it is important that as you grow your real estate portfolio and your net worth, you begin a relationship with one. Your real estate attorney will most likely be able to refer to you a knowledgeable litigation attorney.
The next step is finding good mortgage lenders and mortgage brokers. The type of mortgage lenders and brokers you should be seeking out will depend on the type of properties you are looking at purchasing. Most good mortgage brokers have a specialty, this could be; 1–4-unit rental properties, commercial multifamily, or a specific class of commercial properties (industrial, retail, office, self-storage, mobile home parks, etc.). Find a broker(s) that specializes in your target property type, and build a relationship.
Similar to mortgage brokers, lenders have their own fortes. An investor that is interested in purchasing multifamily properties, valued under $1 million, should seek out local banks and credit unions. These local institutions will be more receptive to financing properties of this size. With that being said, as you reach out to different local banks and credit unions, you will quickly realize what lenders will be a good fit, and what lenders are not interested in your target properties. I have found banks that only lend on commercial properties if they will be occupied by the owner; for example, a professional office building or office condo, occupied by the owner’s practice. Other banks may only be interested in financing certain multifamily properties or will provide a low loan-to-cost, requiring a larger down payment from the investor. The only way of knowing what the local lender has an appetite for is to reach out and speak to someone in their lending department. Once you have identified potential lenders, start building relationships with them.
Another important member of your team will be your accountant. Similar to your attorneys, the more money you make, and the more your portfolio grows, the more often you should be speaking to them. The accountant needs to have experience with rental properties and commercial real estate. If you operate any other businesses; make sure they have other clients in similar businesses. Check to make sure that they are familiar with the accounting software you will be using. Receiving referrals from other rental property owners is one of the best ways of finding a good accountant.
An extension of your accountant is a good bookkeeper. As your business grows, you will be using your bookkeeper more and more. Bookkeepers are relatively inexpensive and they will help to simplify your life. Instead of spending dozens of hours trying to learn how to set up and use your accounting software, pass it off to your bookkeeper for them to handle. You will be more valuable to your business by increasing the bottom line.
Once you begin to underwrite potential properties, you will quickly notice that insurance premiums vary greatly; from property to property, and from policy owner to policy owner. To assist with your insurance needs, will be an insurance broker who has experience with insuring rental properties.
The last team member will be a property inspector. After an investor has a property under contract and is performing the due diligence, the property inspector will be brought in to perform a thorough physical inspection. As mentioned previously, you will also have your property manager involved in the process; however, the property inspector is focused more on the current physical condition of the property. The property manager may walk the units with you but, they will be assisting you with reviewing leases and tweaking your business plan. The potential new owner should also be walking the property with the inspector; taking a number of pictures and speaking to current tenants.
The Potential Rental Income
When you are underwriting a property, you will see the current income of the property and the per-unit rental rate. Next, review the area rents of similar properties and apartments near the subject property. What is the difference in rental rates? How much do the two comparable properties and individual units differ? Is one updated, or is one slightly bigger or slightly smaller? What is the condition of the actual property? The goal is to get as close to a comparable as possible. This will allow you to accurately estimate what the “lose to lease” is, or the gap between the current market rents and the average in-place rents of the subject property. The gap signifies the potential revenue that is not being captured by the current manager and owner. Typically, the longer an owner has owned a property; the wider the loss-to-lease gap is. It is important to note that new owners looking to maximize the profitability and value of a new property investment, will most likely need to perform renovations. The level of renovation will be determined by the rent comparables of the area.
The Expenses
After reviewing the income potential of the property, the next step is to review the property’s expenses. There are 5 main expenses that you want to not only review but also verify when underwriting and ultimately purchasing a multifamily property.
1. Property taxes. Property taxes are always an estimate since it is very difficult to know exactly how a city or county will reassess property taxes after a sale. Nevertheless, there still are methods for getting an accurate estimate. First, check the tax assessor’s website and see if there is any type of calculator or formula for estimating taxes after a sale. Second, call the tax assessor’s office and speak in generalities about what a property might be valued at; never mention the actual property address. Third, might be hiring a tax consultant. In larger multifamily purchases, this is normally done by the seller’s broker but, if a buyer wants a more exact estimate, they might hire one themselves.
2. Insurance. Insurance prices have been skyrocketing in many places throughout the United States. Contact your insurance broker to receive an actual quote for the subject property.
3. Property management. During underwriting, use your property management numbers and then see how this compares to the property management numbers from the seller. Property management costs will vary and are mainly dependent on the individual portfolios of the buyer and seller.
4. Repairs and maintenance. These line items will tell a potential owner what work has been recently completed at the property. When comparing repairs and maintenance with the capital expenditures section, potential owners will see how much updating has been done (capital expenditures) versus just repairing and patching (repairs and maintenance). For example; if you see large numbers for HVAC repairs and maintenance but, nothing under the HVAC capital expenditure line; it could be the case that the current owners have been spending a lot of money on fixing HVAC issues, instead of actually investing money into new HVAC systems. Not that every HVAC system needs to be replaced but, there are most likely some that will need immediate attention after closing on the property.
5. Utilities. During due diligence, get copies of the last 12 months of all utilities that are paid by the owner. This will include; electricity, water, trash, etc. Verify that the numbers are correct by checking with these utility companies; either online or by phone.
The Seller
Every buyer wants to find a motivated seller; the problem is that many apartment owners with monthly cashflow, are not forced to sell their property. This is very different from a single-family homeowner who is behind on their taxes and their water was just disconnected for nonpayment. The apartment complex owner may want to sell and move on with their life but, in most situations, they are not being forced to sell. If it takes them 3, 6, 9, or 12 months; they will not be negatively affected. I am not saying that there are no motivated multifamily owners; just that there are a fewer number of them.
Investing in Multifamily Real Estate
Investing in multifamily real estate is not for the faint of heart. Investors need to spend many hours reviewing markets, and neighborhoods and underwriting dozens of properties. Underwriting includes several different steps; reviewing rents comps versus current rents, estimating repairs, reviewing expenses, and creating a potential business plan for the property.
A business plan for a multifamily property will outline the changes that are necessary for repositioning the asset. Typically, these changes will include; repairing deferred maintenance, changing property management, updating the common areas (lobbies, hallways, property grounds, etc.), renovating apartments in order to achieve maximum market rent, adding additional income streams (coin-operated washers and dryers, vending machines, valet trash services, etc.), and changing vendors and contractors with better, less expensive ones. Most parts of the business plan will be completed in the first 12 months of ownership, while apartment renovations could take several years. During the investment holding period, most if not all, tenants will be replaced with higher-paying tenants as the units are renovated and leased.
Once a buyer has identified a potential property, they now need to start the process of obtaining financing and performing due diligence. After due diligence has been completed and the financing has been secured, the buyer will close on the property and now the work really begins.
Multifamily Real Estate Investing
There are several benefits to investing in multifamily properties. These would include:
1. Increased property cashflow from multiple tenants
2. Cashflow volatility is minimized because multifamily properties have many tenants
3. The cashflow from multifamily properties makes it easier to afford a property manager
4. Economies of scale. As a portfolio grows, the per-unit expenses decrease.
Regardless of the numerous benefits of investing in multifamily properties; there are also a few drawbacks. These would include:
1. More capital is usually required to purchase a multifamily property versus a single-family
2. Multifamily properties require more maintenance and management
3. Multifamily investments are sought-after assets, with consistent competition for good properties.
Investing in Multifamily Real Estate Syndications
The prospective multifamily investor may change their mind about purchasing an apartment complex themselves once they understand all of the requirements and responsibilities that are involved with owning multifamily properties. If this sounds like you; passive real estate investing might be the best route for investing in multifamily real estate.
One of the most popular methods for passively investing in real estate is through a real estate syndication. Group investing, more commonly referred to as real estate syndications, are the combination of two groups of people, the deal operators (investment managers) and the passive investors. The passive investors have one responsibility, which is to provide the capital required to purchase and renovate the property; while the deal operators handle all other aspects of the investment. Passive investors receive regular distributions and monthly updates, while the deal operators manage the entire process; from underwriting and purchasing to renovating and selling. The perfect investment for a busy professional.
Multifamily Real Estate Investing Books
There are hundreds of multifamily real estate investing books on the market today. Many of them are simply sales pitches by so-called “gurus” in order to sell their expensive coaching programs.
Here are three of our favorite multifamily real estate investing books, that are a must-read for any new or experienced multifamily investor.
– The Complete Guide to Buying and Selling Apartment Buildings
This book is required reading for any commercial multifamily investor. It outlines how seasoned multifamily investors force property appreciation by purchasing multifamily properties and making changes that increase the net operating income; which is the foundation of value-add multifamily investing.
– Crushing It in Apartments and Commercial Real Estate: How a Small Investor Can Make It Big
A beginner’s guide to purchasing apartment buildings. The author outlines his background as a teacher who was looking to build some additional side income that eventually lead him to own a multimillion-dollar real estate company.
– The ABCs of Real Estate Investing: The Secrets of Finding Hidden Profits Most Investors Miss
This book discusses all aspects of investing in multifamily real estate. The author began his career in real estate as a property manager, before making the switch to multifamily investor.
Multifamily Real Estate Investing Podcast
There are thousands of real estate podcasts today; including hundreds of multifamily podcasts. Being able to find the best multifamily real estate investing podcast is a difficult feat. One of the most popular multifamily podcasts, beginning in 2019, is the Global Investors Podcast.
The Global Investors Podcast is a twice-weekly podcast that dives into all aspects of real estate investing; with a focus on multifamily real estate. Host Charles Carillo interviews a successful investor every Wednesday and then on Saturdays, he publishes a short strategy episode called “Strategy Saturday”.
Charles began investing in multifamily real estate in 2006, and since that time, he has invested in thousands of multifamily units, worth hundreds of millions of dollars. His decades of experience offer listeners a unique perspective on real estate investing.
The show is available on dozens of podcast platforms, in addition to being available on YouTube.
