If you’ve been taking the time to research the pros and cons of multi-family real estate, one benefit you’ve likely read about is regular cash flow. Investment assets that generate steady income are desirable to many investors, large and small, particularly those that are easing into retirement. But how exactly does multi-family cash flow real estate work, and is it a safe investment compared to other common assets like stocks, bonds, and other forms of real estate?
What is cash flow investing?
The simplest way to describe cash flow investing is to compare it to the dividends paid by stocks like Johnson and Johnson (JNJ) or Coca-Cola (KO). When you own a share of these companies, and others like them, you are entitled to a quarterly, semi-annual, annual, or irregular (not on a set schedule) dividend payment.
Cash flow real estate investing operates on a similar principle- investors deploy capital in a real estate asset and then receive regular payments from the profit generated by their investment, whether that be ongoing retail leases or cash flow from multi-family apartment building tenants.
How to calculate cash flow
Calculating cash flow is a relatively straightforward process. For instance, imagine a multi-family apartment building with 100 units, with each unit renting for $2,000 per month. That gives us a gross rent income of $200,000. You now have to deduct expenses. Let’s assume you have 2 vacant units, which reduces your total income by $4,000. You will also be liable for taxes and insurance, and potentially a mortgage payment, let’s say $40,000 per month. Finally, you will have ongoing expenses like repairs and management fees. We can put that number at around $6,000 a month.
Keep in mind that these are illustrative numbers, and every situation is different, but the calculation will look something like this:
$200,000 gross rent income – $4,000 – $40,000 – $6,000 = distributable cash flow of $150,000.
Why multi-family properties?
There are many good reasons why investors choose to deploy capital in multi-family real estate.
Large Tenant Pool
According to the Pew Research Center, more people are renting now than at any time in the last 50 years. This fact should come as no surprise to anyone who has followed the rocketship trajectory of the housing market in the past decade or so. We find ourselves in a situation where, unfortunately, homeownership is out of reach for more and more Americans.
This is not an ideal situation for several reasons, but it does provide investors with a phenomenal opportunity to benefit from these macro trends. As homeownership trends downward, people still need a place to live- and they are increasingly choosing to live in multi-family apartment buildings.
Multiple Sources of Income
You can generate cash flow from multi-family buildings from more than just tenant rents. The availability of ancillary income sources can dramatically and directly impact the value of a property, which will be reflected in its cap rate. Additional sources of income include exclusivity deals with cable and phone providers, who then provide compensation to owners. Laundry rooms, moving supply sales, cell phone tower rentals, and ATM are other common examples of ways that landlords monetize their properties aside from rent- although there are many other potential opportunities.
Management for a multi-family property is substantially easier than managing similarly-sized/cash-flow generating single-family home investments. Centralization makes management, repair, and upkeep duties much simpler and efficient. Think about it- let’s say you have 50 single-family homes within the Kansas City Metropolitan Statistical Area. In order to facilitate repairs and deal with tenant issues you, or your management team, will have to travel to each individual unit.
With a multi-family property, everything is in one place. Additionally, unless you are buying a bulk portfolio, you will have to engage in multiple deals and negotiations to acquire those single-family properties- with a multi-family building, it is one and done.
More Appreciation Opportunities
In comparison to other investment avenues, like stocks and bonds, multi-family real estate gives owners the ability to “steer their own ship” and create what is known as forced appreciation to increase the value of their asset. This ability to influence the direction of your investment is essentially unattainable in the equities markets unless you are a market maker or institutional investor.
However, even the smallest multi-family property owner can make changes to increase the yield from their building(s). There are many ways to raise the value or rents collected from a property, including unit upgrades, beautifying the building and surroundings to increase curb appeal, or changing directions in terms of how you market the building and seek out tenants.
Want to know more about the power of renovation for appreciation? Read our Willow Glenn Case Study.
Real estate is arguably the most tax-advantaged investment class, and multi-family buildings are among the most tax-advantaged options within the real estate sphere.
One major tax benefit offered by multi-family properties is the ability to deduct property depreciation from your taxable income. Typically, the amount you can deduct is calculated using the federal depreciation table and the Modified Accelerated Cost Recovery System (MACRS), which is the current depreciation system in the US, where capitalized cost or basis of tangible property is recovered over a specified life by using annual deductions for depreciation. Multi-family properties that fall under the residential real estate classification can be depreciated over a 27.5 year period. This depreciation usually includes the cost of the building and improvements minus the amount allocated to land.
Multi-family properties also allow investors to deduct the cost of any interest payments made on the loan during renovation and throughout ownership of the property. Deducting interest from income before calculated how much tax is owed on that income allows investors to improve their cash flow by reducing their tax burden.
What makes a good multi-family investment?
There are a few characteristics you should look out for when trying to identify what a “good” multi-family investment is. Keep in mind that what is “good” may often be determined by an individual investor’s portfolio, but there are things you can look out for to separate the wheat from the chaff.
If you’re even casually familiar with real estate, you know that location is everything. It doesn’t take a rocket surgeon to deduce that a property with a view of the Golden Gate Bridge or Central Park is going to be more valuable than one that sits next to a sewage plant or chemical production facility. With multi-family, you want to find properties that follow the same underlying trends as other residential spaces.
You want to buy in locations with
- Good employment trends
- Population growth
- Low crime
- Excellent schools
Of course, there are plenty of opportunities where you can make money while lacking one, many, or even all of the positives mentioned above, but as a general rule, those are things you want to look out for.
Healthy competition is good for tenants, but not ideal for investors and landlords. Like any business, from restaurants to nightclubs to delivery services, competition often brings increased costs, like from marketing efforts, as well as may drive down the price of goods or services due to efforts to take or protect market share from competitors. Unfortunately, like many of the businesses mentioned above, competition is going to happen in the multi-family space but there are only so many desirable areas in which to develop, rent and manage multi-family properties.
There are various ways to assess competition for multifamily buildings in a given area. The first is to look at vacancy rates and ensure that they are generally low. This suggests that supply is short. Second, take a look at the pipeline for new construction. This will involve a visit to the local government planning office to see what projects are being planned. Owners of land wanting to build new projects will have to apply for permission with the local municipality and generally that information is openly available to the public. A third way to track the competition requires a little more sophistication and research – take a look at how rapidly rents have been rising in the area.
This may require use of proprietary databases, but if you notice that rents have been flat for an extended time this could suggest two things; one, that there is equilibrium between supply and demand, or two, that local owners are not in tune with the levels of rents that they could be getting. This brings us to the fourth indicator of competition; age of existing stock. If an area is predominately older stock i.e. 20-30 years old or more, and rents have been rising for an extended period of time, this could speak to opportunity to acquire, renovate and reposition older buildings into newer, more highly desirable properties that can command higher rents than the surrounding competition.
Read more about knowing your geographical market to stay competitive in our Eleanor Apartments Case Study.
Appreciation is the second essential ingredient you need to add when cooking up a successful multi-family investment. While you do not necessarily need substantial appreciation to benefit from multi-family investments especially if your strategy is to invest strictly for cash flow, it will benefit you anyway as you may be able to refinance the property, returning your equity while continuing to generate income from rents.
As mentioned earlier, you can force appreciation through well thought-out upgrades, repairs, and business plans. You should also take macro trends into account. You cannot always predict the future, but looking at metrics like employment, educational levels, economic stability, and others will give you some idea as to the potential future growth in both demand and rental rates for your properties.
Be sure to focus on maximizing the value you get from renovations- they must have a clearly defined benefit in terms of increasing rents, cash flow, etc. There is little point attempting to turn a Class-C property into a Class-A property in a Class-C location. Renovations have to be aligned with local competition and area socioeconomic characteristics. Conducting renovations in order to add value is by far one of the best ways to build wealth by driving rents upward and increasing occupancy levels.
However, acquiring a property with substantial renovation requirements, or particularly environmental issues, without being highly focused on exactly what you planning to do can be a death knell for a project. Proper planning and pre-purchase due diligence including an accurate assessment of the local area and what is an appropriate level of build-out that is essential to a successful project.
Maintenance and amenities expenses are similar to renovation expenses in that issues come into play when developers and investors overspend due to inexperience, or because they have a fundamental misunderstanding of the realities on the ground. To avoid problems related to these issues, double down on your due diligence so that you don’t miss anything and end up with costly repairs you had not budgeted for.
The biggest items to watch for include checking that the roof is in good repair, and that all the mechanical systems – heating, ventilation, and air-conditioning, electrical and plumbing – have been well maintained and are in good condition. If they are not, then costs to bring them up to a high standard able to withstand years of low-cost operations will need to be built into capital budgeting.
Valuing a Property
Coming to an accurate valuation before acquiring or selling a multi-family property is fundamental to success in the property markets. Investments in this space can be incredibly lucrative if managed correctly, but they can also be very risky if investors are unable to come up with accurate valuations. We have written about how to properly value a multi-family asset elsewhere, so will stick with a couple of quick points here for brevity’s sake.
Determine the NOI
The NOI, or Net Operating Income is used to assess the value of the property and figure out how the building generates income by examining current cash flow. You determine the NOI by subtracting property expenses from the total revenue generated by the property annually. This includes tenant rents and the ancillary forms of income we mentioned earlier. Costs include things like building maintenance, property management fees, utility bills, property taxes and insurance, and building repairs.
Examine Cap Rates
The cap rate, or capitalization rate of a property is another excellent way to determine the value of a given property. You find the cap rate by dividing the property’s estimated NOI by its current market value, which can be found by looking at recent sales of comparable properties. Cap rates are expressed as a percentage, the formula of which is as follows:
Cap rate= Net Operating Income
For instance, if your expected annual net operating income is $100,000 dollars on a $2 million building, your cap rate is 5%. Cap rates are used throughout the real estate industry because it is relatively easy to calculate and indicates the kinds of returns an investment may deliver. The higher the cap rate, the lower the purchase price, and the higher the net income relative to invested equity the property will have.
However, as you might expect, higher cap rates properties can come with different characteristics than lower cap rate properties. A higher cap rate building, i.e. a lower priced deal, is more likely found in neighborhoods that are not so great, or the property itself needs substantial repair and remodeling. Lower cap rates are typically in more high-demand areas with greater population density, higher employment levels, and broader socioeconomic diversity. Striking a balance between investing in higher and lower cap rate markets is how the seasoned sponsor identifies value investing opportunities for themselves and their investors.
These are just two of the ways to evaluate multi-family real estate. Before you pull the trigger on a purchase you should also check out other methods such as comparable property searches, deep due diligence, location and market study, and in-person inspections. It can never hurt to be prepared, especially when it comes to hundreds of thousands or even millions of dollars of hard-earned investment capital.
Few investment avenues offer the stability, appreciation, and regular cash flow benefits possessed by multi-family buildings. While past performance is not an indicator of future returns, many trends, like the number of renters compared to homeowners, available housing stock, or growth in urbanization and the movement of people to cities, portends a bright future for multi-family assets, and the investors who own them.