Why investing in multifamily?

While there are a number of different real estate asset classes to invest in (e.g., single-family, industrial, office, hospitality and retail), the multifamily asset class is considered one of the safest real estate investment options today. We at Now West Capital target specifically large operating multifamily assets in order to provide our investors with low-risk and attractive-return investment opportunities. Here are the four main reasons we like this asset class.

1. Stable Cash flow

The main advantage of investing in a multifamily building is the actual cash flow it generates from rental income. We target properties that provide cash flow on Day #1 of the investment. Although by comparison a new development can provide the potential for higher returns, it comes with more risk and uncertainty as to the profit potential and timing. Costs can overrun and construction projects can be delayed—greatly eroding the return profile promised to investors. By contrast, through acquiring an apartment complex that is operating and generating positive cash flow, we can provide our investors with regular (quarterly or monthly) distributions shortly after the investment (Usually, distributions start a few months after the investment and continue to the time of sale).

This cash flow is also more stable compared to single-family homes, as there is low turnover risk as any vacancies are spread-out over a larger base of revenue-generating units. For example, if we own a large multifamily property with over 100 units, losing one tenant means a setback of only 1% or so of our expected monthly rental income. During the underwriting process, we assume a conservative economic vacancy rate even if our target property’s actual occupancy rate is better. In this way, the property is more likely to perform as projected or better.

Moreover, the multifamily asset class is considered recession resistant. Even during a recession, demand for rental apartments continues existing as people need a place to live, and renting is deemed more affordable than buying and living in a single-family home. Furthermore, we pick markets with strong fundamentals (e.g., job growth, population growth, income growth), which helps ensure rental income is stable even during economic downturns.

2. Forced-appreciation through value-add improvements

In addition to cash flow income, multifamily investors can enjoy additional gains through appreciation which are realized at the time of sale. Some people say appreciation is not guaranteed because the market (buyers) determine the property value and thus price. However, appreciation can be broken down into two parts: natural appreciation and forced appreciation. While the first one (i.e., natural appreciation), appreciation of a neighborhood or city, is subject to market conditions, the latter (i.e., forced appreciation) can be achieved through a value-add strategy, such as improvements made to the property.

Such forced appreciation is possible for a multifamily property because unlike single-family homes, which is determined by a buyers’ willingness to pay, the value of a commercial property is determined by its capitalization rate (cap rate) and net operating income (NOI).

A property’s NOI is calculated by subtracting all the operating expenses (e.g., property management costs, maintenance costs, utility costs, insurance cost and taxes) from sum of its rental income plus any other income (e.g., application fees, pet fees, utility reimbursement, etc.). Therefore, by increasing rents or reducing its operating costs, we can improve the NOI, resulting in a higher property value. We target properties that have the room for operational improvements, such as below market rents or inefficient operating expenses. As part of our business plan, we then upgrade the property through renovations and/or optimization of the property’s operations and expenses in order to maximize the property value. This strategy is called a value-add strategy and it is a proven way to “force” a property to appreciate.

On the other hand, a building’s cap rate is a factor that reflects the market’s sentiment and represents natural appreciation (or depreciation). If there is higher demand in the market, the cap rate gets compressed, increasing the property value. A cap rate is a useful indicator to confirm how much more or less you’re paying for the property compared to other comparable transactions, and more importantly, is used to project the property sale price at the time of exit. As it is hard to correctly forecast an economy, it is nearly impossible to correctly project an exit cap rate (i.e., a cap rate 5-10 years from now depending on the holding period). To mitigate this uncertainty, we use a conservative estimate for the exit cap rate (i.e., higher cap rate than today’s market cap rate) assuming that the market condition would deteriorate regardless of the market’s strong fundamentals.

By maximizing a property’s value through forced appreciation and using a conservative exit cap rate in the projection, the expected return from multifamily investing can be much more predictable than other investment alternatives.

3. Economies of scale

In addition to the rent diversification benefits mentioned above (i.e., limited impact from losing one tenant), a large multifamily asset can realize economies of scale that allow us to spread out fixed costs more effectively. For example, with scale, we can hire high-quality on-site property managers that allow us to maintain our properties more efficiently and effectively. High-quality property managers also provide tenants with better service and experience, which creates a virtuous cycle that brings in more high-quality tenants who love where they live. This is another key factor in unlocking higher NOI and consequently increasing the value of the property.

4. Tax savings

Lastly, large multifamily properties can generate significant tax savings through maximizing depreciation. By conducting a cost segregation study (*), we can recognize a significant part of the depreciation upfront, leading to a paper loss on the investment but actual cash generation that is not subject to taxation. At the time of sale, profits are subject to capital gains tax. However, the capital gains tax rate is lower than the income tax rate, and the money generated by tax savings is more valuable than the amount taxed at the point of sale due to the time value of money. Moreover, investors can pursue tax strategies to defer the liability further through opportunities like the 1031 exchange rule(**), which allows them to reinvest the proceeds in a new investment tax-free. It is important to consult your CPA as each situation is different. However, multifamily investing can be a great investment option to enjoy both good returns and tax savings.

You may be wondering how to invest in a multifamily property with the above advantages when properties can cost upwards of a few million dollars. First, read our article on passive investing. Secondly, we at Now West Capital provide our investors with passive investment opportunities that allow investment in multifamily properties with as low as $50,000. If you’re interested in knowing more about what passive investment opportunities Now West Capital offers, please contact us at info@nowwestcapital.com.

(*) A cost segregation study is used as a tax deferral strategy that front-loads depreciation deductions for real estate assets into early years of ownership. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) vs. the standard straight-line depreciation (27.5 years for residential property and 39 years for non-residential property).

(**) A 1031 exchange is a type of real estate purchase allowed under Section 1031 of the US Internal Revenue Code. It allows an investor to defer capital gains taxes when selling a property, as long as the proceeds are used toward a similar investment within a certain time frame. (Source: https://www.businessinsider.com/1031-exchange).