Updated: Jan 9, 2021
For many passive investors, multifamily properties are where the action is. Multifamily investing has skyrocketed over the past several years and shows no signs of a letup in the incredible growth of this sector. The fervor that fueled the single family home market’s “buy, fix and flip” approach has given way to investors making solid investments in multifamily housing.
It’s all happening for very good reasons, and everyone wants to participate. Unfortunately, this insatiable interest is driving up the prices of multifamily properties to levels that have never been seen before. Despite the huge price increases, the demand for multifamily properties hasn’t lessened at all, which is further compounding the problem. So how did this all happen, and how did multifamily properties become the darling child of investors?
It Starts with the unique Benefits of Multifamily Investing.
One of the biggest benefits of investing in a multifamily property is the leverage it provides the investors. A passive investor can put up an amount as little as $50,000 or $100,000 and be involved in a property worth over $1,000,000. In addition, the investor can benefit from ongoing cash flow, potential asset appreciation and can also participate in exceptional tax benefits. Because of these factors, lenders are willing to lend money for the purchase of multifamily properties, as their risk is minimized.
Perhaps the biggest benefit of all for multifamily investors is the tax benefits bestowed by the IRS. And it all begins with depreciation.
Over the years, multifamily properties tend to increase in value, and thanks to vigilant upkeep and maintenance their useful life goes on for a long, long time. To make sure that enough capital expenditures are made by property owners to do the necessary maintenance, the government allows multifamily owners the ability to take depreciation deductions against current income each year. The amount allowed is equal to 38% of the property’s value when it was purchased.
Why 38%? It’s the equivalent of 1/27.5, a number that is based on the 27.5-year lifespan the government places on a multifamily property. Here’s something else: every time the property is sold, the 27.5 years starts over again. With most properties, the depreciation deduction helps eliminate almost all of the current income, so investors often gets a cash distribution while showing on loss on his or her tax return.
As if that wasn’t enough, you can even do a cost segregation study that can speed up the depreciation of various assets within the property, such as doors, window, appliances and more. Not every single item in a multifamily property has a 27.5 lifespan. But cost segregation studies can be expansive, over $10,000 and more. So it depends on the property whether or not the cost justifies doing the study.
Investors get to enjoy another benefit from multifamily real estate - passive income tax status. Just as long as you’re an investor and not the syndicator of the deal, income from a multifamily property is taxed at lower passive income rates. This income is exempt from employment tax and their rates are lower than current income tax rates. So if there is any taxable income to be distributed after the depreciation is taken, it will be taxed at the lower passive income rate. Here’s something else: appreciation is taxed at capital gains rates, which are of course lower than income tax rates.
As you can see from the tax benefits alone, multifamily properties are a very attractive investment for passive investors. But there are many other benefits to consider as well.
A well-managed multifamily property is going to provide steady monthly income from the tenants’ rents, which are secured by a legal lease, which is governed by federal and state laws and regulations. Plus, building owners can feel secure in that their properties will continue to generate rental income at set occupancy levels thanks to a tenant’s limited ability to break a lease.
Cash flow from apartment rent is only one part of the income generated by a multifamily property. Smart owners are putting in other revenue-generating options like vending machines, health clubs that charge a monthly fee, laundry rooms, premium parking fees and additional forms of revenue. It adds up to extra monthly cash flow that adds to the net operating income. Plus, if expenses can also be reduced alongside additional revenue, there will be more net operating income as well.
The fact that multifamily properties hold their value is one of the key benefits to investors. Because that appreciation is on top of the monthly cash flow that the property generates. In addition, the demand for rental units isn’t expected to drop anytime soon. In fact, vacancy rates have ranged from 7% to 12% over the past 40 years, and as long as the rents are reasonable and provide a good alternative to home ownership, the vacancy rates will continue to be stable.
Most rental units are kept in fairly good condition by the tenants, which are kept in place thanks to the security deposit that they place when a lease is signed. In addition to the security deposit funds, owners can bring legal action to a renter if they cause extensive damage to their apartments. That’s part of the reason that multifamily properties maintain their stable value.
On top of stable value, multifamily properties offer owners and investors the opportunity to significantly increase the property’s value. This is based on the type of multifamily property that the investor participates in. There are basically 3 types of multifamily properties: core, value-add and opportunistic.
Core properties are often in pristine condition, most fully leased and requiring little if any improvements. They are the luxury apartment buildings. They are found in the best locations and have no trouble leasing their units. Because of their excellent condition, they often do not generate significant appreciation in value.
Value-add properties have excellent cash flow, but they also present an opportunity to increase that cash flow and their value by making repairs and repositioning the property. This involves refurbishing exteriors and interiors, including new appliances, flooring, painting and other improvements that can command higher rents. Once all repositioning is completed, the owners have an opportunity to sell the property or refinance and take cash out.
The final type of property is called “opportunistic,” and while they can appreciate like a value-add property, they often pose a much higher risk do to the extent of repairs required or the location that the property is in. Financing these properties also costs more than value-add or core properties, but if successfully completed they offer the highest returns.
Favorable Market Trends
Here’s where you can find many of the reasons as to why multifamily properties have become the darling child of investors. For the foreseeable future, the market is favoring multifamily properties. Since home ownership rates started declining after the “great recession” of 2008, the desire to rent has increased. Most importantly, it has increased in two particular groups: Millennials and Baby Boomers, and both groups make excellent tenants.
Millennials are simply choosing to start families at a later age, and often come into the workforce with a high level of student debt. This group also enjoys living in core urban areas, where single-family homes are extremely expensive to own.
Renting is what comprises the bulk of housing for the Millennials, which happens to be the largest generation in history. Compared to the general population where home ownership sits at 64%, Millennials come in at 31% for those aged 25-29, and 45% for those who are 30 -34.
Another factor affecting Millennials are the constantly rising median home prices that are putting ownership out of reach. This group also enjoys the freedom and flexibility that renting offers.
Baby Boomers are either downsizing or giving up the suburban lifestyle to liv in urban areas that feature more social and cultural opportunities. Others are selling their homes, most of which are mortgage-free, and electing to travel or spend time with their children and grandchildren. Renting offers an opportunity to do all of these things without the obligations that often come with home ownership. Baby Boomers also appreciate the luxurious amenities available in many multifamily properties, luxuries that they couldn’t afford if they were purchasing a single-family home.
From the multiple benefits of investing in multifamily properties like the tax advantages, depreciation, cash flow and a stable investment to the many positive market trends that indicate renting will continue to rise, multifamily investments have become the darling child of investors. There are other benefits as well, including preferential financing rates from lenders and the ability for an investor to build a portfolio of properties faster than with other real estate investments. They all point to multifamily properties as an excellent investment for passive investors. Just be sure to do your due diligence before investing in any property.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specializes is multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of Unbelievable Real Estate Stories, a podcast that shares true stories from within the industry, and the critical lessons learned, from the most successful real estate investors, innovators, developers, and more from around the globe!
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.