There are literally dozens of way to invest in real estate: fix & flip, single family rentals, multifamily, retail, self-storage and even paper-only approaches like notes and liens. And they all have lengthy pros and cons.
So when BlueSpruce was deciding where to focus we had a lot of options to choose from. After talking it over for several months and meeting with lots of smart advisors on the way, we chose multifamily.
Let’s start with the pros of multifamily.
Pro #1: Multifamily has extremely stable income.
Unlike single family homes, where a vacancy cuts off the entire income stream, investors in multifamily properties are spreading their risk across dozens, sometimes hundreds of tenants. This means the property is almost always at least breaking even, so you don’t have to dig into your couch cushions to keep it afloat.
Additionally, multifamily rent growth has been steady for decades. Even at the height of the financial crisis, rents held their own, as this chart from the St. Louis Fed shows.
Pro #2: Demographics trends favor multifamily.
More US households are renting than at any point in the last 50 years. This is due in large part to the fact that large majority of millennials — the largest generation in American history — prefer renting over buying.
This may seem obvious and impactful on all real estate, but there’s at least one thing millennials are not doing: going to malls and retail stores:
[W]hile Gen X and older purchase in stores 72% of the time, Millennials only walk up to the register 57% of the time.
While that article paints a pretty picture for retailers, I’m long-term bearish on retail. Amazon is eating the world, both online and increasingly offline. In fact, Amazon grosses over $5 billion annually from their physical locations (primarily Whole Foods), but I expect that number to grow tenfold over the next few years as they perfect and scale Amazon Go. And that doesn’t even include their their same-day delivery services and the Amazon Echo (“Alexa, order all the groceries on my shopping list and have them delivered this evening by 5 pm.”)
There are certain sectors of retail that are still attractive, such as medical and urgent care, but I’m not a long term believer in retail.
Pro #3: From a lender’s perspective, multifamily is low risk.
Because of the stable income and high demand, foreclosure is exceedingly rare compared to other asset classes. The charts below illustrate the difference. The chart on the left shows single family foreclosures peaked at 2.23% at the height of the financial crisis, compared to a peak of just 0.8% for multifamily in the chart on the right.
In other words, single family homes foreclosed nearly three times as often during that timespan. In 2017, after a long recovery, single family foreclosures fell to 0.5% and multifamily fell to about 0.1%. In other words, even in good times a single family home is five times more likely to foreclose than a multifamily property.
Lenders like multifamily because the asset is stable and they can deploy more capital quickly. Unfortunately, this doesn’t necessarily translate into lower rates, but it does mean there are plenty of lenders out there. I know because they all seem to call me every day looking for new business!
Pro #4: Multifamily is less emotional than single family.
The number of people who can afford to purchase multifamily is an order of magnitude lower than single family. This makes for a much less crowded market, and that pool of buyers generally is more rational than single family purchasers. That’s because multifamily investors buy based on investment potential as opposed to whether the property is emotionally satisfying. Cap rates sometimes expand and sometimes contract, and sometimes a bidding war erupts, but for the most part competing buyers are using a similar valuation method to yours.
Pro #5: You can force appreciation at scale.
Appreciation refers to an increase in value to the property. In hot markets, appreciation happens all by itself. Just buy the property and wait. But that’s not a winning strategy for the long term, and no serious investor relies only on natural appreciation.
Multifamily properties are valued based on their net operating income (NOI). The heigher the NOI, the more valuable it is. So if you can raise rents, cut costs and/or generate new income through, say, adding coin-operated laundry, you are creating value.
Sometimes the easiest way to add value is just better management. This can range from better tenant screening to proactively invoicing tenants notifying them the rent is due. It also can mean more fee income like charging for designated parking lots.
If you’re really creative, you can do what A-Rod does and give rent discounts to people who provide helpful services, such as a nurse who will take calls from tenants. What you lose in rent for that one person, you make up for in desirability (and thus higher rents).
Rule of thumb: $1 of net income creates $10 of equity value. So if you invest $1,000 in improvements, and income goes up by $5,000, you’ve just raised the value of the property by $50,000! And you earn back the original $1,000 in the process.
This rule of thumb applies in single family rentals as well, but you don’t get the scale of appreciation that comes from raising rents or cutting costs for dozens of units.
Pro #6: Depreciation can shelter your income.
Depreciation is available for all types of real estate, not just multifamily. However, depreciation is not available for paper assets such as stocks, mutual funds and other paper assets like tax liens.
Depreciation is usually done over 27.5 years, but in some cases you can accelerate a substantial amount of depreciation through cost segregation. For example, in our Branson complex, in addition to the buildings themselves we also are acquiring a great deal of personal property (aka “appurtenances”) — things such as furniture, beds, television sets and security cameras. We will be able to write off most of these items in the first year and reduce taxable income for our investors.
The Cons of Multifamily
Multifamily isn’t perfect, of course, so it’s important to look at the downsides as well.
Con #1: Multifamily properties are less liquid because they are held longer.
To be clear, a lot of investors like that they can put their money in an investment and not have to make decisions for five years, but not all investors like that timeline. Unlike house-flipping, where you can be in and out of a deal in months or even weeks in some cases, multifamily operates on a longer time horizon. We tell our investors not to expect to see their principal back for at least five years. This is because it takes time to do the necessary improvements and raise rents. Often the best cash flow returns don’t materialize until years three through five, and more cash flow means a higher sale price. Which leads to…
Con #2: It takes longer to sell a multifamily property.
This directly maps to Pro #4 above. Fewer buyers in the market means it takes longer to sell. You might get a lot of lowball offers, but more likely than not you will need to wait six months to a year to get the full value of the property. Also, many potential buyers who show interest don’t actually have the financial wherewithal to close the purchase. This means you have to pre-screen buyers in order to avoid wasting time and money locked into a contract that will never close.
Con #3: 1031 exchange out of a syndicated multifamily investment is difficult.
1031 exchanges are a powerful method for building wealth by deferring taxes. In a nutshell, a 1031 exchange allows you to sell a property and immediately reinvest the proceeds in a higher-value property without paying taxes on the gain. This greatly improves your overall return and builds your financial firepower over time, allowing you to purchase progressively more expensive properties.
But… 1031 exchanges are difficult for investors in multifamily syndications. This is because an investment in a syndication is technically an investment in a company (usually an LLC but sometimes an LP) rather than a property. The company controls and manages the property and also has its name on the title. 1031 exchanges require that your name be on the title in order to comply with the tax law that makes them possible.
(NB: technically it’s possible for the controlling company to do a 1031 exchange, but in practice that rarely happens because it requires consent of all the members. The majority of controlling companies are dissolved once the property is sold.)
Con #4: Some deal sponsors do not do a good job of reporting.
The great thing about investing in a syndication is its hands-off nature. The downside is that some deal sponsors are not very good at communications and reporting. At BlueSpruce we strive to over-communicate, and we publish all results on our web site. For example, you can see all results and related documents for our Bridgeport deal here.
Why is communication so uneven? I personally believe this is because real estate investing is at least five years behind many other industries when it comes to leveraging technology. I have a lot more to say on this subject in future posts, but in the meantime you can check out my real estate technology presentation. And if you really want to see the cutting edge, check out the video of my presentation Cryptocurrencies and the Future of Capital.
What do you think?
This probably is not the definitive list of pros and cons. This is just what I and our team discovered in our own analyses.
Do you have a list of your own? Or some questions about our list? Let us know in the comments.
DJ has been a serial entrepreneur for over 20 years, founding multiple companies in the software and media industries. He began real estate investing in 2016 and loved it so much that in 2017 he decided to focus on it full time.