Why We Love Investing in Multifamily Assets

As a capital raiser for a large multifamily syndicator, I often encounter potential investors who express interest in apartment investing. However, they tend to believe that such investments are only accessible to institutional or wealthy individual investors, as they are not familiar with the private equity syndication model.

The advertising restrictions imposed by SEC regulations further contribute to the mystique surrounding these investments, and only accredited investors are legally allowed to invest in them.

While many real estate investors start small by investing in duplexes, four-plexes, or small apartment buildings, such investments require active management, which can be challenging for high-income earners with limited time.

Overall, the private equity syndication model offers a unique opportunity for accredited investors to invest in larger multifamily assets, but it may not be as well-known or accessible to the general public as other types of real estate investments.

In my work with high-income earners, I have found that they prefer to be passive investors in attractive asset classes due to their busy schedules. Instead of trying to handle everything themselves, they focus on their area of expertise, such as medicine, law, accounting, or business, while making their capital work for them through investments in assets like multifamily properties.

This is where syndicate groups come in, as they offer the exact service that these investors are seeking. Syndicates pool capital from passive investors for acquisitions and provide attractive income and capital returns. In the multifamily niche, value-add syndicators typically target older apartments, such as Class B or C buildings from the 1980s, due to the value-add component of renovations, modernizing systems, and professional property management.

Based on my experience, value-add syndicators aim for preferred returns of 8-10%, cash on cash returns of 10%, and an internal rate of return (IRR) of 20% over a 5-year period.

Due to a volatile equities market, uncertainty surrounding public markets, and lingering memories of the 2008 recession, commercial multifamily apartments have emerged as a highly desirable investment niche and have established themselves as one of the most effective ways to generate wealth. This is particularly evident when one takes into account the four key factors that have contributed to this shift.

1. Largest Rental Group – Millennials

2. Second Largest Rental Group – Baby Boomers

3. US Home Ownership Ratio

4. Economies of Scale

Largest Rental Group – Millennials

A major factor contributing to the rising rental rates in the multifamily apartment market is the significant number of new households aged 18-30, which totals around 76 million. This demographic has been disillusioned by the concept of home ownership due to the 2008 recession, and as a result, roughly 75% of them are more inclined to rent than to purchase a home.

Second Largest Rental Group – Baby Boomers

It is expected that the Baby Boomer generation, which represents the largest demographic group in the US with 78 million people, will increasingly shift from home ownership to renting, and may not return to owning a home. As this generation continues to live longer, there may be a growing demand for rental properties throughout their lifetime.

US Home Ownership Ratio

The rate of home ownership in the US has decreased from 69.2% in 2004 to an average of 64% today. This decline has led and will likely continue to lead to more households moving away from owning residential properties and towards renting apartments instead.

Economies of Scale

Go Big or Go Home: To achieve cost efficiencies, larger properties can benefit from economies of scale at a high level, meaning that they can save money by operating on a larger scale than smaller properties.

Go Pro: Professional property management services are available to larger multifamily apartments on a scale that is not feasible for smaller properties.

The US population growth is now largely driven by immigrants, who tend to rent apartments when they first arrive and stay in them for longer than native-born Americans. Due to this trend and other factors, the National Multifamily Housing Council has determined that the US will require approximately 4.6 million new apartment units by 2030 to meet the growing demand.

Value-Add Properties

In contrast to non-commercial residential properties with fewer than four units that are valued based on comparable sales, the value of large multifamily apartments is determined using the income method. This method uses a formula that divides the net operating income (NOI) of the property by the expected rate of return on investment (cap rate) to determine its market value. The cap rate is the rate an investor would expect to earn if they paid 100% cash.

By using the income method to determine market value, property owners and investors can increase the value and equity of a property by increasing the net operating income (NOI) through value-add strategies. This method can lead to significant increases in market value, even in stagnant market conditions. For example, if a property owner identifies a value-add property and increases the NOI, the market value and equity of the property can increase substantially, despite any unfavorable market conditions.

To illustrate the power of the income method, consider a multifamily property valued at $1 million with a cap rate of 7%, which would result in an annual return of $70,000. If the cap rate remains constant but the net operating income (NOI) is increased, even by a modest amount, the market value of the property can increase significantly. For example, if the NOI is increased by just $15,000, the market value of the property would increase by approximately $214,000. This concept is known as forced appreciation, and it is a key factor that makes apartment investing and commercial real estate so potent, yet often misunderstood by the average investor.

It is important to note that our strategy for increasing the property’s value does not heavily depend on the prices of other similar properties, but rather focuses on identifying opportunities for adding value that our tenants are willing to pay for. By doing so, we can utilize the valuation model to drive appreciation, giving us greater control over the process rather than relying solely on external factors.

Another factor working in our favor is leverage, which is particularly advantageous in the context of multifamily apartments due to their scale. This concept can be best illustrated through an example: suppose we purchased an apartment building for $1M in cash, and the building generated a net operating income (NOI) of $100K per year. In this case, our return on investment (ROI) would be 10%.

Let’s consider an example to understand how leverage can be advantageous. Suppose we purchase a $1M apartment building by paying the full amount in cash and the building generates a Net Operating Income (NOI) of $100K per year, which gives us a return on investment (ROI) of 10%.

Now, instead of buying the property in cash, let’s say we make a standard 20% down payment of $200K and then invest in value-add improvements to increase the NOI by 50%. Our new NOI would be $150K per year, out of which we will pay $50K towards debt payments. This still results in a NOI of $100K per year, which is the same as the all-cash deal. However, the ROI now becomes 50%, which is five times more than the all-cash deal. This is the power of leverage.

In addition to forced appreciation and leverage, the tax benefits of commercial real estate are another significant and appealing feature. As previously mentioned, syndicators aim for preferred returns of 8-10%, and these can be offset as a paper tax loss on your annual K-1 partner distribution tax statement. This is due to the fact that depreciation, property taxes, and loan interest are substantial deductions that can offset gains.

One of the major benefits of investing in commercial real estate is the tax advantages that come along with it. Syndicators aim for preferred returns of 8-10%, which can be offset as a paper tax loss on the annual K-1 partner distribution tax statement due to significant deductions like depreciation, property taxes, and loan interest. This tax advantage is even more significant during the average 5-year holding period, where syndicators can ensure positive cash flows offset by tax losses. Moreover, syndicators frequently do a cash-out refinance after renovations, which the IRS considers a return of capital and hence not a taxable event. While there is some depreciation recapture at the time of sale, the expected gain is taxed at the long-term capital gains rate, currently 15%.

When it comes to operational management, having more units provides the opportunity to achieve economies of scale, resulting in lower maintenance costs per unit. However, there are certain thresholds where having onsite property management and maintenance makes more sense. For instance, the cost of an onsite manager for a 100-unit or 20-unit apartment building is nearly the same, but the cost per unit drops significantly as we move up in scale.

David Thompson, my mentor, has shared his experiences regarding how multifamily apartments retain their value from a risk management perspective.

David Thompson, my mentor, has shared his experiences in risk management and provided case studies to illustrate how multifamily apartments retain their value. According to him, during the oil downturn in Houston, his operating partners presented data that demonstrated how value-add Class B/C properties held their value compared to Class A properties. During that time, Class A properties experienced a significant drop in occupancy of 15-20%. This is because people tend to move down the rental market gradually and incrementally, from A to B, rather than making a drastic shift from A to C. Thus, Class B/C properties are better equipped to withstand higher levels of stress, such as downturns and recessions, than more expensive properties.

According to Paul Moore’s findings in his book “The Perfect Investment”, during the 2008 recession, while delinquency on residential mortgages reached as high as 4-5% nationwide, multifamily loan delinquencies were only at 1%. Moreover, when excluding over-exuberant markets such as Las Vegas, Phoenix, and Miami, multifamily loan delinquencies were almost non-existent, indicating that experienced operators can successfully manage risk in multifamily investments.

In summary,

To sum up, investing in large multifamily apartments offers various advantages. The most promising opportunities for attractive, risk-adjusted returns are value-add Class B/C properties. Although these deals require accredited status, they provide an attractive niche in an already promising asset class.