Updated: Jan 9, 2021
You’ve read it in the news, and heard it from just about everyone involved in real estate investing. Multifamily properties are hot, and considered a good investment. Prices have risen; sometimes buyers are paying more than the seller’s asking price in order to grab the deal away from other bidders.
More importantly, it currently appears that there is really no end in sight to the rising multifamily market. There are two forces that are fueling this growth: Millennials, who are postponing single-family home purchases due to high prices and limited home availability, along with substantial student loan debt, and baby boomers who are choosing to sell their current home and rent instead of buying another property.
The baby boomers are doing this for basically the same reasons that Millennials are doing it - high single-family home prices, and limited product on the market. In addition, many retiring boomers simply want to downsize and use their home sale funds for other purposes, like travel, family vacations and spending on their grandchildren.
Three Main Risks Involved with Multifamily
I am a huge believer in multifamily and its solid state in the market. As you would imagine, there are risks involved in any type of investment. Despite solid cash flow and potentially significant property appreciation, there are also still risks involved in investing in multifamily properties. Because of what many investors are calling the “multifamily buying frenzy,” many investors are throwing caution to the wind and investing without regard to conservative property buying protocols. The good news is that you can mitigate many of those risks fairly easily.
One risk that comes into play is when some investors hear that a particular market is “hot,” and don’t do the necessary due diligence regarding vetting the market in addition to the actual property. This means their capital is tied to a single market, and if the market tanks, their investment will be going right along with it.
Another risk is the economy. Right now, the economy is sailing along at record levels, as it has for the past 10 years. Should the market become problematic and unemployment levels increase, people may not be able to pay their rents, which would result in higher vacancy rates. That would severely impact cash flow and operating income. Some experts think that Class A properties are being overbuilt in primary markets, which could have negative impacts down the road.
In addition to the economy, the real estate market itself can present risks. Remember the “buying frenzy” term used to describe investors buying multifamily properties above their asking price? Well, if the market slows, investors and sponsors might not be able to earn their projected returns.
Another risk comes up with vacancy rates due to competitors. Everyone is working hard to gain new tenants and keep vacancy rates at optimal levels, and if there’s a competitor near your multifamily property and they’re offering renovated or newer units, you may lose some tenant, which will impact the cash flow and net operating income.
As most properties are bought using debt, lenders look at loan-to-value ratio (LTV) to see how much leverage is used in a deal. If a property is highly leveraged with a high LTV, then there will be a risk that the property’s cash flow might not be able to pay back the debt. That would put the owner in default, and the property would end up in foreclosure. If the market experiences a downturn and the property ends up losing value, then the investor’s equity will be reduced, or even lost completely. One rule of thumb is to avoid anything more than a 79% LTV when looking at a multifamily investment.
Finally, despite the fact that many buyers are bidding up multifamily properties over the asking price just to win the deal, they’re forgetting the risk involved in the property itself. There may be issues with the building’s condition, or code violations, utility problems and other issues that can be ignored or overlooked simply because the buyer wants to purchase that particular property. Just be sure you have proper building inspections performed by qualified personnel before closing, and if something comes up either lower the bid price or walk away.
I believe in the strength of multifamily as an asset class, and implement several strategies to mitigate my risks when I purchase a property. I stick to those strategies and don’t deviate from them. Here are some of the strategies I use.
Reducing Your Risks:
Using Market Analytics to Reduce Risk
One of the best strategies to mitigate your risk when buying a multifamily property is to invest in a strong market. There are a variety of metrics to analyze when looking at a particular market, and they are surprisingly easy to access. If investors avoid performing the necessary market analytics on a regular basis, they might be buying in the wrong market, which will further expose them to a bigger risk.
What should you be looking at? Start with the market’s overall growth, particularly the population increase. When you have a market that has many new people moving there, it indicates a high demand for rental units. If you have a specific market in mind, get on the Internet and check its population. You’ll see a population trend, and pay close attention to the previous 5 years.
While population growth is important, so is job growth. In fact, the two are intertwined, because when you have job growth in a market, population follows to fill the positions that are available. The numbers are impressive: over 2 million jobs were added last year, and the unemployment rate is way down to 3.7%. When companies move to a market, employees follow, and multifamily vacancy rates tend to drop. Increased demand for rental units can also lead to rent increases, which is good news for investors.
Stick to Conservative Underwriting
Another way to mitigate risk in multifamily investing is to underwrite conservatively. We start by looking into the historic rent growth and then the projected rent growth in experts reports. Then, we underwrite lower rent increases than both historic and projected growth. So, if a submarket shows 5% rent increases in the past 24 months, and reports show 4% rent increases in the next 5 years, we will underwrite 2.5%-3% rent increases just to be safe.
In addition, no matter how strong the market is, we always put aside funds for unexpected expenses. Nothing can hurt cash flow like a $50,000 repair bill for a new roof, but having a reserve fund for those types of unexpected emergencies can limit the impact they have on the monthly cash flow.
Another good indicator when looking at a property is the capitalization rate (cap rate). The cap rate is an excellent measure for real estate investments regarding profitability and the return potential. It measures a property’s yield over a one-year time period, so you can compare one property’s cash flow to another, without debt being part of the equation. Investors want o see a high cap rate, which translates to a lower purchase price of a property. Sellers, on the other hand, would prefer a low cap rate because it means that the selling price is high.
From an investor’s point-of-view, a cap rate can help measure the potential of risk in a real estate transaction. Older multifamily properties with a large number of credit-challenged tenants have more risk than a property that is newer with a high number of credit-worthy tenants. Due to that risk, the price should be lower, which would result in a higher cap rate.
Diversification as a Risk Mitigation Tactic
One of the biggest mistakes an investor can make is to invest all of their money in one market. Suppose a market has a low unemployment rate, but suddenly the largest employer announces that their plant will be closing. Many layoffs will ensue, and the unemployment rate will skyrocket. That means less available tenants, and vacancy rates will rise accordingly. If all of your investments are in that single market, you’re going to be in trouble. If you’ve diversified your investments across multiple markets, the healthy markets can help you weather the storm.
It’s healthy to get a new perspective, and that’s what a new syndicator can offer. He or she can also offer access to different deals in other markets, along with access to brokers and lenders you would never encounter if all of your deals were done with a single syndicator. Diversification in terms of markets is simply good business practice for passive investors. After all, you wouldn’t put all of your money in a single stock, would you? Most investors would not. Instead, you would want to spread the risk of investing in the stock market across a variety of stocks in different industries. It’s the same principle with multifamily properties.
Multifamily properties, like all investments, have risks. Without risk, there is no reward. However, the more you can do to minimize the risk, the more you will be able to maximize your investment in a multifamily property. Analyze all of the potential risks, from population and job growth to economic factors and cap rates. Be conservative in your underwriting, and spread out the risk by diversifying your multifamily holdings as much as possible. By limiting your risks you will be able to earn more as an investor.
Are you a real estate investor and interested in learning more about passively investing in multifamily properties? Click here for the “Ultimate Guide for the Passive Investor.”
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