Should I Invest In Multifamily? (5 Reasons Why in 2020)

Apartment houses
Apartment houses

Growing Demand for Housing: A Place To Call Home

Multifamily Apartment Investing needs to be a key part of every portfolio. Put simply: This is because multifamily is a required resource

In prosperous economies or down economies people will always need a place to live. This is even more true in the workforce or affordable housing space (more on this later). As the economy has grown since 2008, we’ve seen a huge rise in the number of renters, with consistent growth year after year (Source). 

During the 10 year period following the Great Recession, the number of renters increased by over 23 million while homeownership saw less than a 700,000 increase (Source). In other words, even as the economy climbed out of the recession, into one of the strongest bull markets in history, the rental demand continued to increase. 

According to CBRE, “U.S. multifamily property rents declined less than those of office and industrial properties during the 2001 economic recession and their growth rate was considerably higher post-recession.” (Source

They go on, “Multifamily rents have outperformed those of the other major property sectors during and after the 2008-2009 recession in three ways. The sector experienced the lowest level of rent decline, the fastest recovery to pre-recession peaks and the longest post-recession period of rent growth.”

The data shows that generally the demand for multifamily continues to rise when times are good and when times are bad. People will always need a place to live and multifamily apartments have become one of the preferred options for many Americans. 

Do Millennials & Baby Boomers Need Multifamily?

The above is only compound by the behavioral data of both Millennials (born 1981-1996) and Baby Boomers (born 1946-1964). 

The U.S. Census Bureau data shows that renting represents the most frequent type of housing for Millennials. There are many reasons for the largest generation in U.S. history to prefer renting over owning. First, they tend to value mobility and flexibility over the benefits of owning. The steadily rising median home prices also make homeownership a tough option for many. 

Nearly 1 in 5 Millennials say they plan to rent forever according to a recent 2019 survey by Apartment List (Source). This is reflected by dramatic differences in homeownership. In the survey, 64% of the overall population owned a home, while 31% of Millennials aged 25 to 29 own, and those aged 30 to 34 only 45% own.

According to the U.S. Census Bureau, “Last year, Millennials headed 18.4 million of the estimated 45.9 million households that rent their home. By comparison, only 12.9 million Generation X and 10.4 million Boomer households were renters. Among households headed by a member of the Silent or Greatest generation, 4.1 million were renters.” (Source)

According to a survey by Freddie Mac, by 2020 over 5M Baby Boomers expect to rent their next home (Source). As this shift continues to grow, more baby boomer households will move to renting because of the advantages of being closer to the city, hassle free maintenance, access to services and a home that is easier for them to take care of as they downsize from their big suburban homes. Apartments give them the ability to easily move within the same cities or closer to family, which the Freddie Mac data indicated was their top two preferences – making it much more flexible than owning. The plus for multifamily investors is that unlike Millennials, Boomers tend to stay in units longer than their younger counterparts. 

For the next 10 years, over 11,000 Americans will turn 65 each day (Source), which will lead to some of these Boomers making the decision to enjoy the advantages of renting. 

The Upside of Workforce Housing

Workforce Housing is housing for anyone making 60-120% of the area median income.

Workforce housing generally can be thought of as housing that is affordable to the moderate and middle-income residents, including households earning anywhere from 60 to 120 percent of the area median income, according to (Urban Land Institute). Others define workforce housing as “affordable” if housing costs are no more than 30-40% of income. 

The core to the definition is housing that is affordable to the middle income earners of a community – typically including tenants like teachers, police officers, your professionals, constructions trades, retail and service workers. This housing is located in proximity to employment centers, making it ideal for workers. 

These are often Class B and Class C apartments that serve tenants priced out of buildings with fancy amenities of other high-end complexes. One of the long-term advantages of investing in workforce housing is increased demand paired with a lack of supply. The number of housing starts, or new multifamily apartments being built, is dramatically skewed to Class A Luxury buildings. This is for multiple reasons. One of the biggest reasons is it’s becoming more cost effective to build luxury housing, thanks to the growing cost of building. Often investors are able to purchase Class B and Class C buildings below replacement cost or the cost of building new. 

Not only are we catering to a population who desperately needs more affordable housing options, there is a higher demand with lower supply. In the long run, this is favorable to our investor partners.  

Multifamily Management Upsides (Economies of Scale)

Operators report advantages to more units under one management team.

Commercial multifamily has a huge advantage over other forms of residential real estate because of the economies of scale. For example, with a 100+ unit building, the multifamily investors are able to spread out their risk across multiple units. When one unit is vacant out of 100, it’s a small fraction of the total income when compared to 1 vacant single family home or even 1 of 10 homes. 

This extends to managing the buildings and expenses, and overseeing that the business plan is executed at the highest level. In larger buildings, operators are able to leverage management resources across multiple units, each with similar layouts, fixtures and finishes. Maintenance is therefore more cost effective and in turn increases the value of the property and profit in the deal for investors. 

When work is being completed on a larger building, the cost for the work is spread out across the income of many units. It is often more affordable per square foot than when done in the single family space. 

With this advantage operators are able to effectively enter multiple markets quickly because with a large enough core number of units the operators can afford to hire high quality management. It seems counter intuitive, yet often operators report that it’s easier to manage 100 units with a quality team than to manage 1 or even 10 units yourself with a property manager. 

Preferred or Superior Financing 

When compared to other types of commercial real estate, multifamily investments enjoy preferred funding terms and better mortgage rates. 

Commercial loans are underwritten and sized based on the asset’s projected net operating income (NOI), while residential loans are underwritten based on the creditworthiness and income of the borrower. For reference, a residential property is typically under 5 units. 

These commercial multifamily loans often see a lower rate of interest, longer amortization terms, as well as lower debt-service-coverage ratios (DSCR, or the amount of income compared to debt) compared to other asset types in the commercial or residential sector. For example a multifamily property could see a 4.5% interest rate with a 1.25 DSCR, versus an equally positioned Commercial Asset Type seeing a 5% rate with a 1.5 DSCR for a similar product. 

One of the other core benefits of investing in multifamily real estate as a limited partner is the reduction in liability. The operating team takes on the burden of liability for these types of investments, signing for the loan and holding responsibility for the asset. This is a big advantage many investors appreciate over investing in single family homes or direct ownership. 

Tax Advantages to Multifamily

There are a number of tax benefits multifamily investors incur. 

Look at the tax code as if it is a big map that the government draws, directing the public and business owners towards what activities they want us to do. They do that through tax incentives. 

Commercial real estate is a treasure chest on the map that offers many of its investors great tax advantages. (Before continuing, this should not be construed as tax advice. All readers must consult with a CPA to understand how these may apply in their specific situation.) 

Multifamily real estate investing offers multiple tax advantages with the three primary benefits most often talked about being: Depreciation, Cost Segregation, and Passive Income Tax Rate. 

Depreciation

Depreciation is the core tax benefit of investing in multifamily real estate. Depreciation is the process used to deduct the cost of buying income-generating property over many years. It works differently than other types of depreciation, as it gives you a tax deduction that decreases your taxable income each year. For multifamily apartments, this is spread out over 27.5 years, after subtracting the value of the land from the building to get the cost basis. 

Cost Segregation

This is accelerated with Cost Segregation as it allows owners to “accelerate depreciation,” a.k.a. take more of the depreciation earlier or upfront, on specific interior and exterior things over five, seven, or 15 years. 

This is done by performing a study on the property, separating the different assets within the property into buckets based on their depreciable life. The result is an investor can receive larger deductions much more quickly than just following the depreciation schedule on its own. This is further compounded by the Tax Cuts and Jobs Act of 2017, which can allow investors to take majority of the lifetime depreciation upfront in year one. This would result in write-offs in the range of 40-120% of the original investment amount. 

Finally, as a general rule of thumb, passive income and capital gains tax rates are typically lower than the federal income tax rates. What this can mean is that any of the returns passive investors receive when investing in multifamily real estate can be at a more advantaged rate than earned income. Together these and other benefits attract a lot of high net worth investors who are seeking to follow the map to the tax treasures that multifamily real estate investing can offer. 

Remember it is always recommended to consult a CPA to understand the impacts of investing on your specific situation. This is not tax advice. 

Smart Leverage & Returns

Multifamily real estate investing offers the advantage of using smart leverage to increase returns for both operators and investors. The key here is “Smart Leverage.” As Robert Kiosoki stated in his book Financial IQ, leverage should only be used when there is control. Multifamily real estate investors get the benefits of leverage to increase returns with the upside of control. Plus the passive investors receive these benefits without the downside risks of signing on the loan or carrying the liability. 

Leverage is an important advantage. By adding the use of leverage, the investor is able to radically increase their returns. 

This example will outline the dramatic impact here: 

Hunter and Mike are both looking to purchase a Multifamily Apartment that goes for $5M. 

Hunter plans to make a 10% down payment and take a $4.5M mortgage for the rest of the management at 5% interest annually. 

Mike wants to purchase the house for $5M cash today. 

When they both resold for $5.5M soon after. What were the results? 

Hunter was able to achieve a 55% return on investment, while Mike just a 10% return. Yes, Mike made more dollars, however imagine if Hunter had spread out Mike’s $5M across 10 properties with his ROI. It would dramatically outpace Mike’s. 

HunterMike
Down Payment$500,000$5,000,000
Debt$4,500,000$0
Cost of Debt$225,000$0
Sale of Asset$5,500,000$5,500,000
Profit$275,000$500,000
Return on Investment 55%10%

*Simple interest used for simplicity of this example. This does not represent investor expectations. 

Kiosoki goes on to elaborate how risky it is using leverage in the stock market, because as investors we don’t have any control over the market, the fluctuations or any influence in that business.

For example, when someone buys a share in Apple, they are investing in paper to buy a piece of the company with the hopes to benefit from the company’s success. The unfortunate part is that a paper asset like a stock’s value isn’t tied only to the success of that business. Apple could be thriving in this example, with it’s stock dropping because of market sentiment or external crisis. The economy, the media and the CEO of Apple all influence the stock price and value of this paper asset. 

Conversely, when a multifamily operator purchases a property they are buying it with leverage. The bank puts up 80% and the investment team puts up 20%. The management team is in control of this asset making decisions day-to-day that influence and ultimately impact the final returns. The passive investor partners on the team have delegated control to the management based on their expertise in the space. Together they are positioned to succeed. As a result, the returns increase dramatically because of the leverage, while the team benefits from the business growth. 

These and many other benefits that should lead investors to consider multifamily real estate as a part of their portfolio. The multifamily real estate market will continue to be a strong option for investors as demand continues to increase while more and more people need an affordable place to call home. Both the number of Millennials and Boomers renting are expected to continue to rise. With the tax benefits multifamily investors enjoy, when paired with the smart use of leverage, make this a solid option to consider. If you aren’t already investing in multifamily, now is the time to think about adding this to your growing portfolio.

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