Why Invest In Multifamily?

Today there are numerous mechanisms you can use to invest your money. From stocks to start ups, to bonds and real estate, each investment class comes with its own set of pros and cons, as well as risks and potential upsides. In this month’s newsletter, we will explore why at Wren Davis Capital we believe real estate, particularly multifamily real estate, is the best mechanism for building long term, multigenerational wealth.

Stability

One of the biggest benefits multifamily real estate investment provides is stability. Like food, shelter is a basic necessity that cannot be ignored. People need places to live, and in many instances, multifamily properties continue to do well even during periods of economic downturn because people often choose to, or are forced to, downsize or rent. This is one way multifamily properties maintain high demand, even during periods of high foreclosure, such as the 2008 recession. During this period, the multifamily vacancy rate was 7.8% at its highest, just 3% higher than the long-term average of 4.9%.*

Outside of recessionary periods, where multifamily assets often continue to perform, multifamily investments also offer a great hedge against inflationary periods. The short-term nature of leases and subsequent annual turnover allows multifamily investors the opportunity to respond to periods of inflation by quickly adjusting rents, thereby quickly capturing the upside of growth cycles. While multifamily properties occasionally experience short-term drops in valuation, rents and value have continued to show reliable growth rates over time.

*Data curtesy of the National Multifamily Housing Council (www.nmhc.org)

Forced Appreciation

Another benefit of multifamily investments is the ability to force appreciation through value add improvements and efficient management operations. Unlike residential real estate where prices are determined almost solely on comparable sales in the neighborhood of similar kind, multifamily real estate prices are determined by the property’s net operating income (NOI), and the capitalization rate. Improving the property’s NOI by increasing rents (through renovations, for example), will increase the value of the property in the near term. Similarly, decreasing expenses by operating the property more efficiently, will yield similar positive returns to NOI.

Take the example of a 20-unit property that was bought for $1,000,000. At the time of acquisition it had an NOI of $50,000, and therefore a purchase cap rate of 5. (50,000 / 1,000,000=.05%). If the owner invested $40,000 in renovation, and increased rents by $100 a month per unit, it would result in an annual increase in revenue of $24,000 ($2,000 each month).

Without going too deep into the expenses, let us assume these changes resulted in an NOI increase of $21,600 (subtracting 10% of the increased rents for vacancy, property management costs, etc…). The new NOI is therefore $71,600. Using the same purchase cap rate of 5, this property would now be worth $1,432,000 (71,600 /.05). In other words, an additional $40,000 investment caused the property to appreciate $432,000.

While value add improvements take time to enact and stabilize, these returns can be realized in as little as 2-3 years. This forced appreciation is realized during the “exit strategy” of the property, for example during a sale or refinance, and is a return on investment in addition to the monthly cash flow, debt service pay down, and potential market appreciation.

Scalability

Compared to residential real estate investments, multifamily investments offer more rapid scalability in terms of growth and systems. While each multifamily acquisition often involves more work and time compared to a single family purchase, a single multifamily investment can add numerous units or “doors” to your portfolio in one transaction. Therefore, on a per-unit basis, the cost of acquiring a multifamily property is often significantly lower compared to a single family purchase.

Similarly, having numerous units under one property offers economies of scale when dealing with management and maintenance. Professional property management prices are generally a lower percentage than single family home management, in part due to the ease of managing all units in one area. In addition, multifamily properties offer the economies of scale to add onsite management and maintenance staff, ensuring regular and permanent eyes on your investment.

Tax Benefits

A large benefit that draws numerous investors to multifamily investment are the tax benefits. While there are numerous strategies to use in addressing the tax advantages of multifamily investment, this blog post will briefly touch on three; depreciation, cost segregation, and 1031 exchange. The below explanations of the tax benefits associated with multifamily investments are intended for informative purposes only. Wren Davis Capital is not a certified tax expert, and recommends consulting a professional Tax Advisor before exploring any of the below options.

1. Depreciation: The physical structure of a multifamily property has a number of big ticket physical components or systems that deteriorate over time. These items include HVAC, electrical, plumbing, roofs, etc… Depreciation is an accounting concept that allows the property owner to “expense” a portion of the physical structure value each year to account for this deterioration. This, in turn, decreases the property’s NOI, and therefore its tax liability.

2. Cost Segregation: Related to depreciation, cost segregation is a method of using and expensing depreciation. Normally, depreciation is conducted on a straight line, where the property’s systems are depreciated by the same amount each year for 27.5 years. Cost segregation allows an owner to conduct this depreciation over a faster period of time (5-15 years) after an expert or engineer has surveyed the property and has itemized the expenses into different categories. The result of cost segregation is further tax mitigation.

3. 1031 Exchange: Upon the sale of a property, you are often left with a hefty capital gains tax, particularly if you successfully executed a value-add renovation and had a significant increase in NOI. Section 1031 of the Internal Revenue Service code allows an owner who sold their property to defer capital gains taxes at sale by reinvesting the proceeds into another property of “like kind.” This allows an investor to take the money they have made, and reinvest it tax-deferred in another property. In theory, an investor could continue to do this and defer capital gains indefinitely. There are numerous rules and regulations associated with a 1031 exchange, including the timing between sale and acquisition of the link kind asset.

Multiple Investment Mechanisms

Lastly, there are numerous ways to get involved and reap the benefits of multifamily investments. The most evident, perhaps straightforward way is to purchase a multifamily property independently. While there may be significant capital barriers to entry for larger multifamily properties that cost millions of dollars, many of the benefits above can be accomplished from the purchase of smaller, residential multifamily properties (2-4 units).

Investors also have options to invest in larger multifamily assets though partnerships. If an investor desires to maintain a more active role in investing, joint venture (JV) partnerships allow investors to come together to purchase a property and divide oversight and management responsibilities.

Additionally , investors looking to have a more hands-off or passive approach have opportunities to invest in multifamily syndications, where the investment is managed by a general partner, and the investor remains a limited partner in the deal and collect distributions on a scheduled basis.

In conclusion, as described above, there are many benefits to multifamily investments. No matter if you’re a new or experienced investor, making a multifamily investment is a great way to build your portfolio, gain additional income, and even have some fun along the way.