Multifamily housing has consistently been one of the more popular property classes in commercial real estate. Other sub-classes that have faired well, particularly during the corona virus pandemic, have been industrial and warehouse space, as well as self-storage. Some investors continue to find value in triple net (NNN) investment deals but this is more risky area as many such properties are tied to retail and restaurants. Industrial and warehouse space has done well due to the continued need for manufacturing and increased need for shipping and warehouse space. Multifamily is obviously a draw as people continue to need a place to live and now increasingly, work from. The main draw of this property type is high rate of collections and positive cash flow. However, the profitability of a multifamily investment is not guaranteed. Several factors influence this asset type’s profitability, and it is a requirement to know these factors before investing.
This article provides a high level overview of the factors to consider before purchasing a multifamily property.
Before we begin, you should note that any investment property’s value is determined by the cash flow it creates. Investors are prepared to pay high prices (increasingly lower capitalization rates or “cap rates”) if they expect substantial ongoing increases in a property’s cash flow. Also, if the land offers significant value (think East Coast and West Coast), investors are willing to pay more.
Cashflow typically grows as time passes, but this does not happen automatically. A lot of care, thought, insight, execution and often creativity are required to ensure success. Issues such as physical and functional obsolescence, the slow but steady decline of a neighborhood, the departure of an influential local employer and local rent controls can stunt cashflow growth and sometimes result in a decline. A trusted property manager and an attentive asset manager are key to ensuring that your investment continues to perform at its full potential.
FACTORS TO CONSIDER BEFORE PURCHASING A MULTIFAMILY PROPERTY
If you have experience renting a home then you understand that location determines rent. For example, the average apartment rent in New York City is going to be higher than the average rent for a similar apartment in Chicago which in turn will be higher than the average rent for a similar apartment in Detroit.
So it follows that the location of a multifamily property you want to acquire will influence the potential cash flow. Other factors, such as job availability, employment levels and regional economic drivers, have to be considered too. Within a city, a detailed study of neighborhoods is crucial to understanding where to buy and what to expect. The Upper East side of Manhattan is very different from Spanish Harlem; Lincoln Park in Chicago has a different tenant base from Ukrainian Village; living in the Central Business District in Detroit tends to be more expensive than say Corktown, and so on.
Your study should answer fundamental questions such as:
- Is the location popular, or is it rising in popularity?
- What are the demographics of the people living in the area?
- Does the area have a primarily blue-collar, white-collar, or no collar workers?
- What kind of big businesses are moving to the area? Is there a job growth, stagnation or decline?
- Is the area accessible or closed off from amenities and transportation?
The above questions are not comprehensive but will start helping you paint a picture of the neighborhood and what you may reasonably expect of a property that you purchase there.
2. PHYSICAL CONDITION
This factor cannot be overemphasized. In multifamily asset investments properties are classified from A to D based on their age, condition, location, and amenities.
Class A properties are less than 10 years old, located in prime areas, and in great physical condition.
The next class is Class B assets. These assets are over 10 years, but less than 25 years old. They may be located on the outskirts of primary markets and have fewer facilities than Class A properties. Alternatively they may be older properties but recently renovated and in extremely good condition.
Class C properties are built between 20 to 50 years ago. They are located in not so desirable neighborhoods and require significant repair to function at their potential.
Lastly, Class D properties are over 30 years, situated in undesirable areas, and need a considerable capital investment or makeover.
This classification system provides a roadmap for property investment evaluation. Before making a bid, it is recommended to assess the property’s foundation, status of roofs, HVAC systems, plumbing, electrical systems, elevators, landscaping and other buildings aesthetics. At Cape Sierra Capital, before we buy anything we make it a point to walk through every unit in the complex to eliminate surprises.
3. COMPETING SUPPLY
Although there is hardly a glut in the supply of multifamily units, it is shrewd and good practice to know the area surrounding your potential property to understand what competing supply exists on the market and what condition those units are in. In business, new competition presents a threat to profitability. The same goes for real estate.
Consequently, it is best practice to research the new construction permits and housing statistics to know whether the property market is saturated or stable. Having new properties built around you is not necessarily a bad thing but investors should understand how new projects may affect their investment. It is also useful to understand the local building laws such as zoning, building codes, and ecological impact studies and fees. Over the long haul, such regulations could cause local price appreciation to become higher than in the other areas as they serve as barriers to entry for new developers.
4. PROPERTY MANAGEMENT
Tenant turnover is the enemy of cash flow. The more you have to deal with tenants moving in and out of your property the more headaches and cash outflows you will experience. It can be a real joy to manage an apartment community of 20 to 200 tenants yourself. Oh, the stories you would tell and the surprises you would come across! Most investors do not invest in real estate for this very reason–“I don’t want to answer tenant calls about plugged toilets!” The answer to this is professional property management.
Your property manager is your best friend and good property managers are worth their weight in gold. Your property manager can make your investment a success or they can run it into the ground. They can make your property stay close to 100% occupied or create a death spiral of revolving tenants which leads to reserves continually spent on replacing carpets, repairing plumbing and painting walls.
At Cape Sierra Capital we have walked away from properties that on paper could be good investments because we could not find good and trustworthy property managers in the area. It is important to not just pick anyone to manage your investment. Too many times realtors think that they can manage a property “on the side” and handymen think they would make a go of it and start their own property management company. These are a recipe for disaster. There are many resources about how to select a property manager on the web. Use them. Ask good questions. Pick a firm, not an individual, that has good processes in place for rent collections, evictions, making a unit rent ready and leasing. They need to know the area and the local neighborhood, must have experience with contractors, must understand how to communicate effectively with tenants and should be well versed in the local laws.
5. OPPORTUNITIES TO ADD VALUE
An attractive benefit of a multifamily property is that the owners are much more in control of the value of the investment and can drive this value upwards by investing in the right initiatives. Improving the landscaping, remodeling common areas, creating useful amenities for tenants can help generate higher rents. Relatively simple changes such as redesigning the façade or remodeling kitchens, bathrooms and floors can justify higher rents and improve cash flow.
Multifamily units tend to generate ancillary sources of income. For example, amenities such as a dog washing station, coin-operated laundry and vending machines can further improve revenue.
When done correctly, a multifamily investment can generate a healthy and passive stream of income for generations. However, individual investors often shy away from this asset class for a number of reasons. Multifamily investments tend to have a relatively high barrier to entry due to the amount of capital required. The investment often depends on specialized knowledge; individuals tend to lack the time necessary to research neighborhoods, and put together the teams needed to manage investments of this type.
Most individual investors with multifamily assets in their portfolio do so through partnerships with firms such as ours. Cape Sierra Capital offers investors access to invest in multifamily properties in select markets. We handle every detail, from sourcing to purchase and management. To learn more about how multifamily investing can help you to grow your wealth over time download our ebook, The Personal Cash Flow Formula.