Real estate, once considered a niche industry, has become a darling among investors of all kinds. One of the reasons people are drawn to real estate investing is because of the asset class’s diversity: you can invest in office buildings, retail centers, hotels, industrial properties, residential homes, and more.
The first-time investor is particularly drawn to multifamily investing. This is because residential real estate is relatively easy to grasp. You buy a home, typically with a mortgage, and rent the units at a rate high enough to cover your expenses (hopefully, and then some!). These expenses include your mortgage, interest, taxes, insurance and routine property maintenance. Most investors own a home for themselves, and if not, live in a rental apartment – so again, it’s a familiar concept.
Beyond the relative simplicity of multifamily investing, there are other reasons to consider investing in multi-unit properties, which we’ll cover in this article. Anyone who has ever thought of investing in multifamily real estate will want to read on. At Trion, we value multifamily properties, modernize old apartments and sell them for a return.
Tap in to our expertise with this ultimate guide to multifamily home real estate investing.
What is a multifamily home?
A multifamily home, or multi-unit home, is simply any residential property that contains more than one dwelling unit. A multifamily home can consist of just two units, which is often referred to as a duplex or two-family home. A multifamily home can also be just three units, which is often called a triplex, three-family, or triple-decker (the latter example is often used to describe units that are stacked one on top of the other).
Yet multifamily homes can be much larger, as well. Think of a large apartment building. These can have anywhere from 10+ units to upwards of 400 or more units. In either case, the properties are considered multifamily properties.
What is the difference between multi-family homes and single-family homes?
The primary difference between a single-family home and multifamily home is how many dwelling units are in the property. A single-family home contains just one dwelling unit, whereas a multifamily home has two or more units.
There are several practical considerations to investing in a multifamily home versus a single-family home, including:
- Single-family homes are more expensive to maintain. Each property, whether a single-family or multifamily property, has a set of “systems” that need to be maintained. These “systems” include the HVAC unit(s), electrical system, roofing, grounds and more. A single-family home has all of these systems but benefits from only one rental payment coming in for that property. Compare this to a multifamily property where multiple units share the same systems and so the cost to maintain each system is lower on a cost-per-unit basis. For example, when you need to repair the roof on a 6-unit apartment building, it’s still only one roof that needs to be repaired. This is less expensive than trying to maintain six roofs from a rental portfolio of six single-family rental homes.
- It is harder to aggregate a portfolio of single-family rental properties. Whether you’re in a competitive market or not, it can be hard to accumulate a portfolio of single-family rental properties. Each time a property comes to market, you need to bid on the asset, secure financing, fund a down payment, conduct an inspection, hire an attorney, etc. This can be a lengthy and time-consuming process compared to buying a multi unit property, wherein you’re growing your real estate portfolio by multiple units in one fell swoop. Both the purchasing process and later, the property management process, become more efficient when buying multi unit properties compared to investing in single-family homes, where parties are forced to travel from site to site, losing valuable time in the process.
- Single-family rental properties are more management intensive. One of the reasons why so few investors buy single-family homes as rental properties is because the management of individual properties is incredibly time intensive. A property manager has to travel to and from each individual site for repair, maintenance, to collect rent checks, etc. There are no economies of scale, compared to multifamily investing. The more units within a property, the more cost effective the property is to manage on a cost-per-unit basis. Often, multifamily properties of a certain size will even warrant having an on-site property manager, which makes it easy to respond to issues quickly and efficiently.
Other economies of scale include the ability to use one leasing broker for all multifamily properties, a single on-site maintenance staff, and the ability to store tools and materials on-site versus in a warehouse or van, which is often the case when managing individual properties in scattered locations.
How to find multifamily homes
There are many ways to find multifamily homes for sale. The most common way is to hire a real estate broker to search for properties on your behalf. This is no different than the process you’d follow when hiring a broker to find you a single-family principle residence. In almost all cases, a buyer’s broker collects their commission from the seller, so there is no direct out-of-pocket cost to the person buying the multifamily property.
More experienced investors will often utilize a multi-pronged approach to finding multifamily properties for sale. This could include working with a broker in addition to sourcing their own deals.
There are several ways to find multifamily homes for sale on your own, including:
- Searching MLS. There are generally two ways properties are sold: on-market or off-market. Multi-unit properties listed for sale on-market will be entered into what’s known as MLS, or the “multiple listing service”. The owner (or broker) will list the property on MLS for a fee, and in exchange, the listing is syndicated to hundreds of online real estate platforms (like Zillow, Trulia, and LoopNet). This is how listings gain the most exposure. Anyone can search these online portals, but the property information included is often limited. In order to gain access to all pertinent property details, including all disclosures and financial information, you’ll need to have access to an MLS account which requires a monthly subscription. (Brokers all have MLS accounts, which is why people often work with a broker when buying multifamily homes.)
- Finding Off-Market Deals. Some of the best deals to be had in multifamily investing are those that are found off-market, since there is inherently less competition than deals made available to the general marketplace. There are a few ways to find off-market deals. One way is to look on a website like Craigslist, where sellers are often testing the waters prior to listing the property on MLS. Other websites, such as FSBO.com, also feature properties for sale by owner. Some owners, particularly those who are highly levered, try to sell their property off-market to avoid paying a broker’s commission.
- Direct Solicitation. Another way to find multifamily homes for sale is direct solicitation. This can take many forms. The most common form of direct solicitation is to send property owners a letter or postcard offering to purchase their property directly. The most successful mailings are those that are highly targeted; in other words, there should be some rationale for who you send a mailer to – maybe they’ve owned the property for 20+ years, maybe the property has depreciated in value in recent years, or maybe the owner has moved out of state. There are various tools to help you identify this information, such as Reonomy, a software program that provides property, building and owner information for real estate investors looking to purchase multifamily homes for sale. As a follow-up to these letters, an investor may consider calling the owners to once again offer to purchase the property.
Direct solicitation strategies for multifamily investing can prove fruitful, but it often takes a long time for deals to materialize. An owner might not be ready to sell today, but they might tuck away that postcard and give you a call six months or a year later when the time is right.
Multifamily home as an investment
There are many strategies to employ when buying a multifamily home as an investment. Generally speaking, there are three types of investment strategies:
- Buy and hold. The “buy and hold” investment approach for multifamily investing refers to investors that purchase a property with the intention of holding it in their portfolio for the foreseeable future, if not indefinitely. Buy and hold investors typically look for properties with (a) strong existing or potential cash flow; (b) strong long-term appreciation potential; or (c) both cash flow and appreciation potential.
For example, a buy and hold investor might overpay for a four-unit multifamily property because the existing cash flow is still strong enough to cover their expenses while still generating strong monthly returns. This investor might not care if the property depreciates in value in the short term if he plans to hold it for the long-term, given their confidence in the cash flow potential remaining strong.
Alternatively, an investor might purchase a property with little free cash flow but with the confidence that the property is located in an area that will come up in value over time (with cash flow following suit).
- Value-add. Value-add refers to the process of an investor purchasing a property and then, as the name implies, adding some value to it. Value-add strategies for multifamily property investing can take multiple forms, where there is a substantial renovation or the new owner increases rents to market for unrenovated product where there is little to no renovation. The two strategies are known as heavy value-add and light value-add, respectively.
For example, an investor might purchase a multifamily property at a discount because the property’s rents are 30% below market rate (values are often based on income, and in this case, with low rents, the value would be artificially depressed). Upon purchase, the new owner then implements a renovation program to modernize the asset and better marketing practices to optimize the net operating income, thereby increasing the value. At a higher value, the owner is then able to refinance the property, take some cash out, and use that cash to invest in other properties, or sell and move on to the next project.
- Ground-up development. Another multifamily investment strategy is to purchase a parcel, either vacant or with an existing structure, and clear the lot to allow for more significant ground-up development. Zoning dictates what can be built on the site, including how many units of multifamily housing. Any deviation from the zoning code will require rezoning, a special permit, a variance, or some combination of the three. Many investors will make an offer to purchase contingent upon getting the entitlements for the property, as what can ultimately be built on the site will affect the property’s value.
How much does it cost to maintain a multifamily home?
How much it costs to maintain a multifamily home can really vary depending on the size, location, and age of the apartment building in question. Understandably, it costs less to maintain a newer multifamily property than an older one. It also depends on the amenities offered on-site. It costs more to maintain a property with a large backyard, swimming pool, and on-site gym than it does a simple two-unit property with none of the above.
As a general rule of thumb, investors should budget between 10% and 15% of net operating income (NOI) as the cost of maintaining a smaller multifamily building (4-50 units), and 5%-10% of the NOI as the cost of maintaining a larger multifamily building (50+ units).
How to finance a multifamily home?
Most investors will finance the purchase of a multifamily home using a mortgage. Most banks will want borrowers to put down at least 25% to 30% when purchasing the home, resulting in a 70-75% loan-to-value ratio. By way of example, if you were going to purchase a four-unit apartment building for $1 million, this means you’d have to put down at least $250,000.
Many first-time investors have a hard time coming up with this steep of a down payment, and understandably so. One way around this requirement is to owner-occupy the property. Those who plan to owner-occupy a multifamily property are able to secure better terms, sometimes with as little as 3.5% down and mortgages at lower interest rates.
In general, investors who do not plan to owner-occupy a property should expect interest rates to hover about 50 to 75 basis points higher than the going rate for an owner-occupied property.
As a final note on financing: multifamily properties with more than five units are generally considered “commercial” loans and will have different terms than those for strictly residential loans, including higher interest rates and more stringent debt-to-income ratios. For larger properties, lenders will want to see that the owner has a substantial track record of owning and operating multifamily buildings, stronger financials and larger down payments.
Should you hire a property manager for your multifamily home?
Managing a multifamily home is not for the faint of heart, particularly as your portfolio of units grows. Managing a duplex or triplex in your area is certainly do-able, but with more units come more responsibility, and managing a multifamily property becomes more challenging for those who have other full-time responsibilities.
When deciding whether you should hire a property manager for your multi unit property, ask yourself the following questions:
- How much time do I have? Those who have little free time will often find it easier to outsource day-to-day duties to a property manager.
- How many units do I need to manage? The more units in your multi unit property, the more calls you have to take about leaks, late rent payments, etc. As your portfolio grows, there can be some efficiencies in hiring a property manager to deal with all units.
- How much free cash flow does the property generate? If the monthly returns for your multifamily investment are already relatively low, it might make sense to self-manage until rents rise. For instance, if a property only generates $500 in free cash flow each month, but it costs you $300 to hire a property manager, your actual returns will be slashed by more than half.
- How robust is my network of contractors? Property managers of a multifamily home often have a deep rolodex of contractors whom they rely on for plumbing, electrical, landscaping and other services. Those who self-manage will need to have their own reliable contractors available at their beck and call.
- Where is the property located? If the multifamily property in question is located more than 30 minutes away from where you live, it’s often best to hire a property manager. It becomes exponentially harder to manage a property from a distance for the aforementioned reasons (lack of contractor relationships, limited time, etc.).
5 Reasons you should invest in multifamily homes
There are many reasons to consider investing in multifamily homes, some of which we’ve already discussed above, but one of the primary reason people choose multifamily investment is to diversify their investment portfolios to non-correlated assets. The average person tends to invest in their 401k or IRA as their primary investment vehicle. Doing so puts you at the mercy of the stock market, which can experience dramatic swings, even on a day-over-day basis. Investing in real estate is a good way to diversify your holdings and hedge against stock market fluctuations.
This isn’t to say that multifamily home values don’t also fluctuate in value. The housing market bottomed out in 2008 and in the process, many real estate investors were crippled. That said, real estate cycles generally last about 10 years, so anyone who sat tight during the market downturn is likely to have seen their properties recover in value – and as an added benefit, many were collecting substantial cash flow during the down turn, as well.
Here are five other reasons to invest in multifamily homes.
Reason 1 – Leverage.
One of the main benefits to investing in real estate is the ability to leverage the asset. In real estate, the term leverage refers to the ability to move more money with less effort. Think about how this works in practice: in order to purchase $1 million worth of stocks, you’d need to have $1 million in cash on hand. In order to buy a $1 million rental property, you only need $250,000 – you’d get a mortgage for the remaining $750,000. By using leverage to help finance your multifamily investments, you are increasing your average rate of return. (Note: this also increases your risk, as you are borrowing against the asset and paying interest on the loan). Many investors believe leverage is the gateway to building a greater net worth.
Reason 2 – Scalability.
Unlike investing in one-off single-family rental properties, investing in multifamily properties allows you to grow your real estate portfolio quickly. Your ability to scale is also a result of the leverage concept discussed above. If you had $1 million in cash on hand, rather than investing in $1 million worth of stocks, you could invest $250,000 in four $1 million properties. The cash flow from the rentals would go toward paying down the loans, and over time, you would have accumulated a portfolio worth $4 million by only putting down $1 million. Many investors use leverage to scale their portfolios in this way.
Reason 3 – Tax Benefits.
Real estate is one of the most tax advantaged asset classes. The two biggest benefits are the mortgage interest deduction and depreciation. Because larger investment properties typically require large mortgages at 5%+ interest rates, this can result in a high annual deduction for multifamily investors.
Meanwhile, depreciation is one of the biggest real estate tax shelters for rental property owners. Depreciation works on the premise that properties depreciate over time, even if they’re technically appreciating in value. Depreciation is intended to cover the property’s exhaustion or “wear and tear” over time. Residential properties are depreciated over a 27.5-year period (the property’s “useful life”) whereas commercial properties are depreciated over a 39-year period—or sooner, depending on whether the owner utilizes a cost segregation study.
Reason 4 – Appreciation.
In addition to investing in a multifamily home for its cash flow potential, many investors buy multifamily properties given their appreciation potential. While properties may not experience major upticks in value, those who hold for long periods of time will generally eventually benefit from some degree of appreciation given routine inflation. That said, those who add value to multifamily properties through upgrading systems and generally improving the properties can reap outsized returns selling to investors who are looking for yield.
Appreciation can also help you grow your investment portfolio. Consider the investor who owner-occupied a two-family property that she purchased for $400,000 five years ago. Because she owner-occupied the property, she was able to get a mortgage that required her to only put 3% down, or $12,000. This property is located in an area that has substantially increased in value, and now the property is worth $850,000. Over the past five years, she has paid down her loan and now only owes $300,000 on the mortgage. She now has $550,000 in equity in the property, a dramatic increase from the initial $12,000 she put down as a down payment. Now she’s able to tap that equity, or leverage that equity, to invest in other properties. Some would like to say she’s playing with the house’s money at this point. Savvy investors will repeat this cycle to grow their real estate portfolios over time.
Reason 5 – Passive Income.
A final reason people like to invest in multifamily rental properties is that it allows investors to generate passive income. In other words, once the property is rented and generating cash flow, an investor can sit back and collect the rent payments without having to lift a finger (this is particularly true when hiring a property manager to oversee the day-to-day operations and maintenance of a property).
No matter how wealthy an individual, the same holds true: we all only have 24 hours in each day. One can only work so hard during a 9-to-5 job in order to become wealthy. Finding opportunities to generate passive income is a great way to build wealth, which is why multifamily investing has become so attractive to investors of all kinds.
How do rising interest rates affect multifamily homes?
There are a few ways that rising interest rates affect multifamily homes.
The first is related to cash-on-cash returns. In real estate, a cash-on-cash return is a rate of return that calculates the cash income earned on the cash invested in a multifamily property. Simply put, cash-on-cash return measures the annual return the investor made on the property in relation to the amount paid for the mortgage during that same period.
Therefore, as interest rates go up, this has a negative impact on cash-on-cash returns as an investor now pays more for their mortgage each year. Properties are often valued based upon their income-earning potential, and cash-on-cash return is one metric to evaluate income. So as interest rates rise, and cash-on-cash returns go down, a property’s value can also go down. Conversely, if interest rates go down, cash-on-cash returns improve and as a result, multifamily property values improve. The wider the swings in interest rates, the more impact this will have on cash-on-cash returns and property values.
One of the ways investors try to lower their monthly mortgage payments is by using an adjustable-rate-mortgage (ARM), which typically carries a lower interest rate but is only fixed for a finite period of time (5, 7, 10, and 15-year ARMs are most common). After the fixed period, the interest rate can float – upward or downward – based on the interest rates at that time. Investors who use ARMs must watch interest rates closely, particularly if they are nearing the end of their fixed-rate period, because if the interest rates jump, it will eat into the monthly cash flow, thereby affecting the cash-on-cash returns. If interest rates go down, your mortgage payments go down and cash-on-cash returns go up.
Investors concerned about major fluctuations in interest rates may opt to buy what’s known as a “Libor cap” or “interest rate swap”. What this will do is either a) fix your floating rate loan, or b) cap interest rate increase at a certain level.
Of course, the best way for multifamily investors to hedge against interest rate risk is to prevent their debt load from getting too high (relative to both value and net operating income). In commercial real estate, this is referred to as the debt service coverage ratio (DSCR). The DSCR is the relationship of a property’s annual NOI to its annual mortgage debt service (principal + interest payments). For example, if a property has $250,000 in NOI and $200,000 in annual mortgage debt service, the DSCR is 1.25. Most investors strive to keep the DSCR at 1.25 or above. As interest rates rise, the NOI can only support a certain amount of debt, thereby capping the loan amount a borrower is able to secure for that property. The lower the interest rate, the larger the loan an investor can borrow based on DSCR.
Multifamily home investors also monitor the interest rate environment because it has an impact on those who want to refinance. Let’s use the example of an investor who purchased a 20-unit property for $1.5 million. They then put $300,000 into property renovations. Now, the property is worth an estimated $3 million given the increased cash flow. Most banks will allow investors to borrow up to 75% of the property’s value (the loan-to-value ratio). At a valuation of $3 million, this translates into a $2.25 million loan. The investor can use this loan to pay off the original $1.5 million loan, plus the $300,000 needed for property improvements, and still has $450,000 left over. However, banks will look at more than just the LTV ratio. They’ll also consider the DSCR. As interest rates go up, the mortgage amount could go down based on the DSCR. Therefore, even if an investor would otherwise be able to refi based on a 75% LTV ratio, if the DSCR doesn’t support that loan amount, the investor will have to leave some of their equity untapped (i.e., less cash out with the refi) until either interest rates go down or NOI goes up.
Finally, when it comes time to sell the multifamily property, the interest rate environment can have either a positive or negative impact on the sale. The higher the interest rates, the less someone will be able to borrow (and therefore, afford) to purchase the property which can push prices downward. The lower the interest rates, the more a borrower can afford, in which case they may be willing to pay more for the property. The lower the interest rate, the higher the NOI, which can improve the property’s cap rate and draw a larger pool of investors.
Ultimately, the decision to invest in multifamily property is a personal one – and a decision that someone should make in the context of their overarching investment goals. That said, multifamily investing is a great, proven way to diversify one’s investment portfolio, generating immediate cash flow and significant appreciation potential.
The tax benefits of investing in multifamily real estate cannot be emphasized enough. There are other tax provisions that can be leveraged to offset the costs of buying and selling multifamily real estate as well, such as using what’s known as a “1031 exchange” to defer paying capital gains tax on the sale of a multifamily home, so long as those proceeds are then reinvesting in another property (a great way to trade up into higher-value assets)
Yet multifamily investing isn’t for everyone. Own a property for long enough and something is bound to go wrong. A tenant fails to pay rent, a basement floods, a unit goes unleased for too long. But these trials and tribulations can be overcome with thoughtful planning and strong property management, making the prospect of investing in multifamily still a strong one.