Multifamily has long been considered the “darling” of commercial real estate, a fact that became amplified during the COVID-19 pandemic. During the pandemic, multifamily properties generally performed better than other property types: demand remained high, rent collections remained strong, and rent growth skyrocketed once stay-at-home restrictions lifted. Given the national housing shortage, interest in multifamily today remains strong.
Indeed, multifamily provides compelling returns regardless of economic conditions. In a low interest rate environment, owners can utilize leverage to magnify their returns. In a high interest rate environment, owners can push property values by tying lease renewals to inflation.
There are many other reasons to consider investing in multifamily real estate, which we explore in more detail below. Read on to learn the pros and cons of multi-family real estate investing.
Sign up for our educational newsletter and to gain early access to our next investment opportunity.
What is Multi-family Real Estate?
A multifamily investment property is a type of real estate investment that includes a building or structure with more than one residential unit, each capable of housing individual families or tenants.
There are different types of multifamily properties, including duplexes (two units), triplexes (three units), quadplexes (four units), and apartment buildings (five or more units). Individual investors often start their real estate journey by investing in smaller multifamily properties and then work their way up to investing in apartment buildings.
Any building with five or more units is considered “commercial property” and must be financed using a commercial real estate loan instead of a more typical residential loan.
The Upside of Investing in Multi-Family Real Estate
Investing in multifamily properties is a great way to earn passive income (e.g., money they earn regularly with minimal effort or active involvement). Owners benefit from stable, consistent rental payments that can be used to pay down their loans. Here are some of the other benefits associated with investing in multi-family real estate.
Potential Return on Investment
The average rate of return on a multifamily property can vary significantly depending on various factors, such as location, property type, market conditions, and operational efficiencies. However, it’s not uncommon for investors to earn 8-12% or more on their apartment building investments.
Here are some of the ways that multifamily properties earn a return:
- Cash Flow:
Cash flow is the income generated from the rental income minus the building’s operational expenses like the mortgage payment, property taxes, insurance, maintenance costs, and property management fees. The net cash flow is a critical component of the return on investment (ROI) for multifamily properties.
Multifamily properties generally appreciate over time. “Natural” appreciation occurs as a result of market forces like inflation or rising demand. “Forced” appreciation occurs when a property owner makes strategic capital improvements to the property that increase its value.
- Tax Benefits:
Real estate investors can benefit from various tax deductions and benefits, such as depreciation, that can reduce their taxable income and increase their after-tax returns. For example, those who sell property and reinvest the proceeds through a 1031 exchange can defer paying capital gains taxes—sometimes indefinitely.
If an investor uses financing (a mortgage) to acquire the property, the return on investment is magnified due to leveraging the initial capital investment.
We’ll look at each of these in more detail below.
Most investors use some form of leverage (i.e., debt) to acquire commercial real estate. It is generally easier to find and line up financing on a multifamily building than it is on other commercial property. This is because apartment buildings are relatively straight-forward vs. other commercial buildings that have lease complexities and other nuances for lenders to consider.
Apartment buildings are also easier to finance than single-family rental homes. An investor can use one single loan to finance multiple units in an apartment building. Compare this to the process of acquiring single family rental (SFR) homes: each SFR needs to have its own mortgage, its own underwriting process, its own inspections, etc. An owner needs to do this 20 times to acquire 20 SFRs but only once when acquiring a 20-unit apartment building. The financing process is more streamlined when investing in apartment buildings compared to SFRs.
Any property owner faces the risk of vacancy. The nature of multifamily properties – having multiple units and therefore, diverse income streams – helps to mitigate this risk. If one unit becomes vacant, the income from the other occupied units helps to offset the temporary loss from that unit. In contrast, when a single family rental home becomes vacant, the owner loses its entire revenue stream until they re-lease the property.
Calculating the value for multifamily properties is much different than calculating the value for SFRs. Single family homes are valued based on their location, local comps, school districts, and property specifics such as number of bedrooms and square footage. As a result, property values become much more subjective to market conditions than multifamily buildings.
That’s because the value of an apartment building is based on its income. While the factors that impact SFR values also matter to multifamily buildings, they matter less. Even in a down economy, if an owner can find ways to increase their rental income, they can continue to push their property value higher.
Multifamily real estate is a highly tax-advantaged asset class, and one of the reasons why so many investors decide to add it to their portfolios. These tax benefits can help reduce taxable income and increase the owner’s overall after-tax returns. Benefits include:
Depreciation is a non-cash expense that allows investors to deduct the cost of the property (excluding land) over a 27.5-year period – the time frame that the IRS considers the “useful life” of the property.
Rather than taking straight-line depreciation, which is worth 1/27.5 of the depreciation, the owners can use a cost segregation analysis to front-load their depreciation in the early years of ownership. Currently, the IRS allows owners to take “bonus” depreciation which allows them to take the full depreciable amount in the first year after placing the property in service.
Depreciation is arguably the most lucrative tax benefit associated with commercial real estate investments. This deduction lowers the property’s taxable income each year and can significantly reduce investors’ overall tax liability.
- Mortgage Interest Deduction:
Multifamily property owners can deduct the interest paid on their mortgage loans used to finance the acquisition or improvement of the property. This deduction applies to the interest portion of the mortgage, which is usually highest in the early years of property ownership based on standard amortization schedules.
- Property Operating Expenses:
Expenses related to operating and maintaining the apartment building, such as property management fees, repairs and maintenance, utilities, insurance and property taxes, are all tax deductible.
- Section 179 Deduction:
For certain qualified property improvements or equipment purchases, multifamily property owners may be eligible for a Section 179 deduction, which allows for the immediate deduction of the full cost of eligible assets in the year they are placed into service instead of depreciating them over time.
- 1031 Exchanges:
This provision of the Internal Revenue Code allows property owners to sell property and then, if they roll those proceeds into another “like-kind” asset (e.g., a higher-value commercial property), they can defer paying capital gains taxes. Using the 1031 exchange is how many investors grow their real estate portfolios by investing in larger or better-performing properties while preserving their capital gains tax liability.
Investors can utilize 1031 exchanges in perpetuity. If the properties are placed into a trust for their heirs, the heirs will receive these properties at a “stepped up” basis. The IRS effectively resets the value of those properties at that time, thereby eliminating the need to pay capital gains taxes upon receipt from the trust.
It's worth noting that tax laws and regulations are always subject to change. For example, there has been talk in recent years of eliminating the depreciation benefit (for now, it remains available to investors). Tax benefits can also vary based on individual circumstances and the specific investment structure.
Greater Control over Value
Multifamily owners can influence the value of their buildings through various strategies and actions. This is particularly attractive to those who want to be more hand-on investors instead of passive investors. Many investors specifically invest in value-add apartment buildings where they can make strategic investments that increase rents and therefore, property value.
Owners can also make property improvements gradually. Most units tend to turn over every one or two years. When an individual unit turns over, the management team can get into the unit and make improvements without disrupting the rest of the tenant base. They can then re-lease the unit at a higher rate, a process that can usually be completed in 4 to 6 weeks, depending on the nature of the unit improvements.
The Downside of Investing in Multi-Family Real Estate
Of course, there are some challenges associated with investing in multi-family real estate. These are all factors that a prospective investor should consider before buying or investing in an apartment building.
High Entry Point
Unlike single family homes, which often trade for $300,000 or less, apartment buildings can have a high barrier to entry. Most lenders require investors to put at least 25% down on an investment property. For a building that sells for $1 million, this equates to $250,000 in equity needed to acquire the asset. Apartment buildings often trade for tens of millions of dollars, depending on their size, scale and location. Their high entry point often forces investor to partner with other investors to buy the building, something not all owners are interested in doing.
That said, though apartment buildings generally have a higher total cost than individual SFRs, most buildings trade at a lower per unit cost than investors could purchase if buying single family homes one at a time.
As is the case with any commercial property, owners will need to deal with tenant issues from time to time. This could include late rent payment, unruly tenants, or tenants who cause damage to the property. The eviction process can be long, time consuming, and emotionally taxing for property owners. Most tenant issues can be mitigated through careful screening of tenants and use of professional property managers.
One frustration that owners often have is that they have little recourse to respond to unruly tenants (see above). Depending on the municipality, there could be strict rules around making claims against security deposits and/or evicting tenants. Prospective buyers will often look to acquire apartment buildings in landlord-friendly places.
There may be building regulations that owners must adhere to, as well. For instance, some municipalities now require multifamily buildings of a certain size to comply with strict energy codes as a way of mitigating against climate change. More standard requirements generally have to do with placement of units, amount of light in the units (e.g., building code issues), number of parking spaces, bicycle parking requirements, and signage restrictions. Be sure to investigate local, state, and federal regulations that could impact your multifamily apartment building prior to investing (and/or consult with a local attorney to guide you).
Time Commitment for Management
Managing a multifamily apartment building is certainly more time intensive than managing, say, a triple-net leased commercial property where the tenant is responsible for all building operations and maintenance. The larger the apartment building, the more units, and the more tenants you’re dealing with on a daily basis. Whereas an office landlord might hear from their tenant only a few times per year, a residential landlord can expect routine calls throughout the day or night (again, depending on the size of the building and number of units).
Some owners prefer to self-manage their properties. This is generally feasible when an owner has fewer than 20 residential units. Those who own more than 20 units will generally opt to outsource property management to a third-party that has professional expertise. While there are costs associated with property management, it can relieve the owner from the day-to-day tasks needed to effectively maintain and operate an apartment building.
More Tenants Means Frequent Vacancies
Most apartment leases run for a year, and most tenants stay in their apartment for between one and three years. This means that landlords deal with tenant turnover on a rather frequent basis. Whereas more traditional commercial properties (e.g., office, industrial, and retail buildings) tend to have tenants that stay 5+ years, apartment owners must deal with more routine vacancies.
There are certainly ways to mitigate vacancy. The first is by buying an apartment building in a high demand area. This helps to ensure a fast and efficient re-leasing of the property. Most landlords will build language into their leases that require at least 30 to 60 days’ notice prior to ending or re-signing a current lease. This gives the landlord some buffer to begin showing the unit prior to the current tenants moving out.
Another way to mitigate vacancies is by having a streamlined “unit turnover” process. Professional landlords will have cleaning and maintenance crews lined up for when the tenant becomes vacant so it can be re-leased almost immediately. Often, tenant turnover can result in no downtime if managed carefully.
As a precaution, though, experienced multifamily landlords will generally carry a 5% vacancy rate in their pro forma to cover any costs associated with unit downtime.
Competition for multifamily investments tends to be high. First-time and experienced investors alike are drawn to this asset class for its relative ease of management. Most people understand the basics of what it takes to manage an apartment building, and therefore, feel more comfortable investing in multifamily than they do other product types.
The sheer interest in multifamily apartments drives prices up and attracts investors at all skill levels.
Multifamily investments are also considered a relatively “safe” investment when compared to other property types. This makes high-quality, well-located and stabilized apartment buildings (typically, Class A properties) attractive to institutional investors as well. Institutional investors, like endowments and pension funds, will often invest in multifamily as part of a broader portfolio diversification and risk mitigation strategy. Institutional investors are often willing to pay more for Class A properties and accept lower returns for these deals than other investors might, which in turn, edges out other buyers.
Individual investors who are interested in accessing Class A multifamily real estate may want to consider investing in a syndicate or via a real estate crowdfunding platform, as these are two avenues for accessing deals that wouldn’t be available to them otherwise.
Investing in multi-family property is a great way to earn extra income. Investors can opt to be as actively engaged in the investment as they want—including not at all. Those who prefer to take a hands-off approach to management will benefit from utilizing a third-party property management company who can oversee the investment on their behalf. There’s often a happy medium, where property managers handle the routine repairs and maintenance, but the ownership team makes strategic investment decisions that can have dramatic impacts on the property value.
Moreover, the opportunities to invest in multi-family property are vast, regardless of a person’s skill level. People can get started by investing in duplexes. Some may even opt to owner-occupy one of the units while they learn the ins-and-outs of owning real estate and managing tenants. Then, as they become more comfortable, they can grow that experience into larger apartment investments as they scale their portfolios.
Are you interested in learning more about multi-family investing? If so, contact us today and learn why so many successful investors have apartment buildings in their portfolios!