Multifamily properties have long been the bread and butter of real estate investors, and for good reasons: consistent income and appreciation make apartments very appealing. However, a closer look at the question, are apartments a good investment, reveals even more reasons to add multifamily housing to your portfolio.
Why Invest in Apartment Buildings
At this point, multifamily housing is much more than a trend. Through investing, it is a way to change your financial circumstances radically. Apartment buildings, which are buildings with five or more units under one roof, are one portion of the multifamily industry. Let’s take a look at the characteristics of apartment buildings that give them so much potential.
MORE CASH FLOW FASTER
Apartments are excellent for generating passive income quickly. One of the greatest appeals of becoming a multifamily owner is knowing that rental income flows to you upon closing the purchase
During the purchase process, a buyer should receive rent rolls from the property. The rent roll reports the details on every active lease for the property, giving the buyer a clear picture of how much income they can expect to have coming in on day one.
Apartments also have the benefit of annual lease terms which give operators the opportunity to increase rents more frequently than on commercial leases, which are commonly multi-year leases. Besides allowing apartment rents to keep up with inflation and changing expenses, it also allows operators to quickly capitalize on renovations.
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INCOME STABILITY THROUGH MULTIPLE INCOME STREAMS
It is no secret that apartment buildings are favored for their income potential, but it is not just about the quantity. As unit numbers increase, so too does the consistency of the income for the property owner.
Rental properties face gaps in income production when one lease ends and a new one begins. Even when the logistics align perfectly and the outgoing tenant is replaced quickly, it still takes time to clean and make any needed repairs. More commonly, the timing of the new tenant doesn’t work out perfectly, and the unit sits empty for a couple of weeks.
In the worst-case scenario, no new tenant is on the horizon when the old one moves out.
When the rental is a single-family home, that income interruption, no matter how small, will be very noticeable to the bottom line. However, apartment building owners get to rely on the income from other units during this time for consistent cash flow.
Ideally, the property manager structures and times leases so that they do not all end simultaneously. When the units are on a cyclical schedule, the bottom line should be consistent each month, even as a portion of the units turn over.
ECONOMIES OF SCALE
The nature of multiple units provides another benefit: lower cost-per-unit to manage and run. As units increase, so too does the efficiency of operating them.
For owners and investors, that translates to both financial efficiency and optimal time management. When considering time, it is only common sense that an apartment building with six units will be easier to maintain and provide service to tenants than six freestanding houses around town.
From a financial perspective, many of the costs of running an apartment building are somewhat set, so the more units in that building, the lower the price is per unit. For example, consider the calculation of property insurance for an apartment building.
The insurance premium will be based on the cost to rebuild the property if a disaster happens and will take into account the risk factors of the area. The premium price increases with size because the replacement cost increases, but not at the same rate as if each unit were freestanding like a house. Essentially, this is like buying in bulk.
The U.S. Tax Code has a generous web of deductions and options for lower tax rates, making real estate a wise investment in general due to tax benefits. To better understand why this matters, try reframing your view of tax liability from an unavoidable slice of the pie you have to give Uncle Sam to a business expense that you want to reduce. Reducing costs leads to more profit.
The depreciation deduction is often the most lucrative deduction for multifamily investors. Depreciation is the premise that all buildings and structures have a finite usable life. Each year, that incremental deterioration becomes an “expense” that owners can deduct from their taxable income, thereby reducing their tax liability.
For apartments, this means that the value of the building, which is usually the purchase price minus the value of the land, can be deducted from your taxes over 27.5 years. In addition, with cost segregation, the value of improvements and personal property in and around the building can be depreciated on an accelerated timeline, bringing even more savings at tax time.
Owners can then reduce their overall tax rate on income earned from the property via the qualified business income (QBI) deduction. In practice, this means that the IRS allows taxpayers to deduct as much as 20 percent of the pass-through income from entities like LLCs and S-Corporations.
The investment world is prone to its share of fads and trends, but simple demand keeps apartments in the portfolios and strategies of savvy investors.
The ongoing demand stems from the long-term housing shortage in the United States. For over a decade, new construction has not kept up with population growth, leaving the country with an inventory shortage of millions of units.
The lack of housing is predominantly concentrated in the entry-level home market, so it most impacts those with tighter budgets. For many, this predicates apartment living.
Of course, people don’t turn to apartments just out of necessity; it is increasingly a lifestyle preference. Apartments facilitate travel and busy lifestyles because residents can hand off maintenance, repairs, and lawn care to the owner.
Apartments have long been the purview of the young and nomadic. However, they are increasingly a transitional home for the elderly who can still live independently if they eliminate the burden of a house with its stairs and never-ending repairs.
APPRECIATION OF ASSET VALUE
All of these factors contribute to perhaps the best reason to invest in multifamily housing: the property is very likely to increase in value. Hence, it provides both steady income and significant capital gains.
Strategically chosen apartments are more likely to increase in value over the holding period, both because of the generally rising real estate market and the steady demand for the product. However, owners can exponentially grow the value of their investment by working with value-added properties.
To maintain value, ensure that the property remains in good repair and is in an area likely to see continued demand. To increase value, though, look for a property with room for improvement and then make those changes.
Investors frequently pursue Class B or C properties, which are neither the best nor the worst around. Instead, they are properties that can increase their rental rates and occupancy with some renovations, better management, and improved marketing.
The most ambitious among us may want to pursue direct ownership for the most potential reward, and it is a surprisingly feasible option.
Remember, apartment buildings can be as small as five units under the same roof, and a building of that size will be much more affordable for a single buyer than a high-rise building with hundreds of units.
Also, keep in mind that there is no need to have the total purchase price in your pocket. Most buyers only put down 25 percent of the purchase price, at most. This ability to leverage a relatively small initial investment for something much more valuable is one of the reasons that real estate is such an excellent investment.
REAL ESTATE SYNDICATIONS
Real estate syndications often select apartment buildings for their subject properties, so they are a fantastic option for investors who want to avoid the hassle of running an apartment building but see the financial value of direct ownership
Syndications, which are companies that buy and operate real estate, raise capital through a pool of investors called limited partners. The investors’ share in the monthly profits of the property and in the appreciation realized at a sale or refinance.
Syndications are a particularly good fit for those who want to invest in the $50,000+ range.
Finally, for those who don’t have enough to meet the minimum investment amount for a direct investment into a syndication, consider a real estate investment trust (REIT) specializing in apartment buildings. To invest in a REIT, simply buy shares through a national exchange.
REITs are an easy way to get started because you can do it for the cost of a single share, but it offers lower potential returns than direct ownership or syndications. Still, it can be an option for getting started and growing your investment funds for future syndication investment or the purchase of an apartment building.
Apartment buildings are sometimes a good investment, and offer tremendous potential, but investors should remember that no property or investment is guaranteed. While the future is bright for the sector, some markets will see less demand as their population declines.
Of course, we cannot underestimate the human element involved. Finding, renovating, and running an apartment building are all skills honed over time. They require knowledge and familiarity of apartments in general and of the demands of the local population. Investors who work with me can benefit from my expertise as they springboard into their own real estate careers.