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No more Duplexes, Triplexes, or Quads

Multifamily real estate is one of the best investments that you can make, but you need to know that not all multifamily properties are created equal. Here is the big difference: as soon as you buy a five-unit property or more, the value of the property is dictated by the income that the property produces rather than what a comparable place down the street has sold for. This is because when you have an apartment building with 5 or more units it is considered commercial real estate while 1 to 4 units is considered residential real estate. It’s amazing how one additional unit can make such a huge difference. Now, there are many types of real estate investments in which the value is based on the income the property generates. Examples would be mixed-use (Commercial use and residential), retail, business centers, or self-storage. All of these would be considered commercial real estate. For this article, we are going to focus on multifamily (Commercial Real Estate — 5 units & up). Understanding your options and the differences between 1 to 4 units versus 5 and more is imperative in making the proper decision when investing in real estate. Let’s dive into the five reasons why going bigger is the way to go! (1): How properties are valued 1 to 4 Units: When valuing four-unit properties down to single-family homes, the fair market value is determined based on comparable properties in the area. For example, let’s say we have a single-family home in a specific neighborhood in the Chicago suburbs. It is a two story, 2,500 Sq. Ft. home that has 3 beds & 2 baths and was built in the 1920s. All these factors play into the value of the home. To price this property, we would look at other homes in the area that have similar square footage, number of rooms, features, age, and style. The standard practice is to look at similar homes that have been sold in the past sixty to ninety days. Say we find that homes with this criteria are selling for around $300,000. Well, this is right around the price that this home would be valued at. There are of course details like new appliances, updated interior, or finished basements that drive pricing up or down but to think you can list your home for an additional 100k is simply not feasible. 5 or More Units: Now, let’s look at a 200-unit apartment building. We are trying to determine what the fair market value would be. To determine this number, we look at the Net Operating Income (NOI) that the building is producing. Simply put, this is the income that the property is making before we account for debt. Once we have our NOI, we need one more factor to calculate our fair market value. That factor is the capitalization rate (cap rate). This is the percent return that a property would make if you were to purchase the property with all cash. Now, these cap rates will differ from area to area, but that is where consulting a commercial real estate broker can be super helpful. They will know the exact cap rate that similar buildings are trading at in that area. Now that we have our NOI & cap rate, we can calculate the value. We do this by dividing the NOI by the cap rate. This will generate the fair market value of the property (See example below). Investors prefer this way of valuing a property because it is purely performance based. If you operate the property efficiently with low costs and high income, then you can boost the NOI and therefore increase the value of the property. You can’t do that in the 1 to 4-unit range. NOI: $900,000 Cap Rate: 7.5% Value: ($900,000) / (7.5%) = $12,000,000 (2): Economies of scale Go big! Cost savings is a beautiful benefit that comes along with larger apartment deals. When an apartment is bought, say 80-units or more, we begin to recognize noticeable cost advantages. Expenses like property management, repairs and maintenance, renovations, or additional fees drop dramatically (on a per unit basis) in a large apartment building compared to a duplex for example. Let’s say we need all new paint for the interior. When we hire a contractor, we can likely negotiate a better price (per unit) on the large apartment complex versus the duplex. The real magic with cost savings is that it goes right into increasing the Net Operating Income which in turn increases the property’s value (Since NOI divided by the Cap Rate equals the Fair Market Value). (3): Supply & Demand We are living in a time when both rents and demand for affordable housing are rising. In the 2020 Multifamily Forecast Report by Marcus & Millichap, they mention that we are seeing incredibly low vacancy rates nationally. They mention ten-year low vacancy rates for C-Class apartments of 3.3%, as well as 4% vacancy for B-Class, and 5% for A-Class despite 300,000 new A-Class apartments flooding the market. This is good because the data proves that there is a strong demand for apartments. However, the affordability issue remains. Therefore, the C to B class apartments are an advantageous investment since they offer that pricing relief for tenants. Also, we mainly see A-Class apartments being built rather than the more affordable C to B class complexes. This is causing a supply issue in the market. This is a great business case for investors to go in and purchase these assets. We can then improve those properties which in turn creates a better living experience for the tenants while still providing affordable housing. (4): Performance: Bull & Bear Markets Multifamily real estate seems to be the perfect hedge against the fluctuations in the economy, and here is why. In real estate, there is a grading system. We have D-Class up to A-Class properties, with D-class being the worst and A-class being the best. The sweet spot with high returns for investors lies within the C & B class value-add properties. For that reason, we will focus on those. When the economy is booming, we have low unemployment and there is an increase in spending. During these times, we could see residents upgrade their apartment from D-class to C-class or from C-class to B-class. When the reverse occurs & the economy tightens up, residents would likely downgrade their living. With this shift, the C-class buildings may catch those leaving the B-Class & the B-class could get new residents from the A-Class properties. Either way the market goes, people need a place to live which is why apartments provide a solid hedge against uncertainty in the market. (5): Reduced Risk Owning a duplex, triplex, or quad may be less expensive to acquire, but your risk of not having perpetual positive cash flow increases dramatically. This is due to vacancy. With smaller properties, you may need 90% – 100% occupancy to have meaningful cash flow each month. What happens when you have two tenants move out? Or three? The financials can begin to look quite shaky relatively quick. Now, let’s assume you own a 200-unit building and you experience 10%, 15%, or even 20% vacancy rates…what will happen? Yes, it’s unfortunate that your occupancy isn’t higher, but if you have operating costs in control, then your cash flow will still be strong every month despite the high vacancy. This is why investing in large, multifamily deals are the way to go! Jackson Wietecha

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