Investing in multifamily real estate has been a popular way to create passive income, tax write-offs and equity value over the past several decades. However, without the tailwind of 40 years of declining interest rates, does it make sense to devote time, energy and capital to multi-family property?
Even if you hire a property management company to do everything for you, does the idiosyncratic stress associated with owning rental property, inflation and higher rates justify the valuations in the sector? We discuss all of this and more in the following article.
What is a multi-family home?
A multi-family home, also known as a multi-unit property, is a type of residential real estate that is designed to accommodate more than one family or household. It legally has more than a single-unit, thus differentiating it from a single-family unit or house.
A multi-family property generally refers to a building or a complex that contains multiple separate residential units, each with its own living spaces, such as apartments, condos, townhouses, or duplexes, that are intended for individual families or tenants.
Multi-family properties can vary in size and configuration, ranging from small townhouses with just a few units to large apartment buildings with hundreds of units.
They can be owned and operated by individual investors, real estate developers, or investment companies, and can be used for various purposes such as rental properties, investment properties, or as a primary residence for one of the units while renting out the others.
Investing in multi-family properties can be attractive to real estate investors due to the potential for generating rental income from multiple units, which can provide a steady cash flow and potentially higher returns compared to single-family properties. However, multi-family properties also require management and maintenance of multiple units and tenants, and may have additional regulations and considerations compared to single-family properties, such as zoning and building code requirements.
Pros of investing in multi-family property
Investing in multi-family properties can offer many advantages for real estate investors, such as greater and diversified cash flow, scale and tax benefits.
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Cash Flow: One of the primary benefits of multi-family investing is the potential for generating rental income from multiple units. With multiple tenants paying rent, the cash flow from a multi-family property can be more stable and consistent compared to a single-family property. This can provide a reliable source of income, which can help cover expenses such as mortgage payments, property taxes, insurance, and maintenance costs, while also potentially generating a profit. Additionally, having multiple tenants typically means the ability to generate more cash flow vs a comparable single-family rental property.
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Economies of Scale: Another advantage of multi-family properties is the potential for economies of scale. Managing multiple units in a single property allows for more efficient management and maintenance compared to owning multiple single-family properties scattered in different locations. This can result in cost savings in terms of property management fees, maintenance and repairs, and other operational expenses, which can enhance overall profitability. Furthermore, the different units will often share the same structure or amenities (if any), thus saving you money when it comes to structural maintenance & repairs.
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Appreciation and Equity Building: Multi-family properties, like other types of real estate, can appreciate in value over time, potentially allowing investors to build equity. As property values increase, the equity in the property can grow, providing the opportunity for investors to leverage that equity for further investments or to sell the property for a higher price. This has worked out incredibly well over the past 40 years as mortgage rates decreased approximately 20% from the high to its recent all-time lows. It’s hard to overstate how much of a tail-wind declining interest rates have been on this asset class.
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Diversification: Multi-family properties can provide diversification to an investor’s real estate portfolio. Owning multiple units in a single property can spread the risk across multiple tenants, reducing the impact of a vacancy or loss of rental income from one unit. This diversification can help mitigate risks and provide a more stable investment compared to relying solely on a single-family property.
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Tax Benefits: Multi-family properties can offer several tax benefits to real estate investors. For example, investors may be able to deduct expenses such as mortgage interest, property taxes, insurance, and depreciation, which can reduce taxable income and lower overall tax liability. Additionally, multi-family properties may offer opportunities for cost segregation, which allows for accelerated depreciation deductions and further tax benefits.
Even though many banks classify multi-family properties as commercial (i.e. often if 4 or more units), it may be easier to obtain a mortgage on a multi-family rental family due to the diversification in rental income.
What is cost segregation?
Cost segregation is a tax planning strategy that can be applicable to multi-family properties and can provide additional tax benefits for real estate investors. It involves the process of identifying and reclassifying components of a property, such as building improvements, into shorter depreciation periods for tax purposes, which allows for accelerated depreciation deductions.
Under the U.S. tax code, buildings are typically depreciated over a long period of time, typically 27.5 years for residential properties and 39 years for commercial properties. However, many components within a multi-family property, such as appliances, carpets, lighting fixtures, and landscaping, may have shorter useful lives and can be depreciated over a shorter period of time. By utilizing cost segregation, investors can accelerate the depreciation deductions for these components, which can result in higher depreciation deductions in the early years of ownership, and therefore lower taxable income and potentially reduce overall tax liability.
Cost segregation studies are typically conducted by qualified professionals, such as engineers or tax experts, who evaluate the property and determine which components can be reclassified for accelerated depreciation. The results of a cost segregation study can vary depending on the specific property, its components, and the tax laws and regulations in the jurisdiction, but it can potentially result in significant tax savings for multi-family property owners.
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Cons of investing in multi-family property
Investing in multi-family properties, like any investment, also comes with potential risks and drawbacks that investors should be aware of. Don’t be attracted purely by the perceived stability of cash flows, the static nature of cap rates and tax benefits like depreciation.
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Management Challenges: Managing multi-family properties can be more complex and time-consuming compared to single-family properties. Dealing with multiple tenants, maintenance requests, rent collection, and property management can require significant effort and resources. Hiring a property management company can alleviate some of the burden, but it also adds to the operating expenses, potentially impacting the overall profitability of the investment. Additionally, tenant turnover, vacancies, and dealing with difficult tenants can also pose challenges, which may require additional time and effort to address.
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Market Volatility and Risk: Real estate markets, including multi-family properties, can be subject to fluctuations and risks. Changes in local market conditions, such as shifts in supply and demand, economic conditions, and regulatory changes, can impact rental rates, property values, and overall investment performance. Market risks, such as changes in interest rates or changes in demand for rental properties, can affect cash flow and property valuations, which may impact the return on investment. Real estate investments also come with risks such as property damage, natural disasters, and liability issues, which can potentially result in financial losses or legal liabilities.
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Capital Requirements and Financing Challenges: Acquiring multi-family properties may require substantial capital, including down payments, closing costs, and ongoing operating expenses. Financing multi-family properties can also present challenges, such as stricter lending requirements, higher interest rates, and larger down payment requirements compared to single-family properties. Obtaining financing for larger multi-family properties may also be more complex and time-consuming, which can impact the timing and feasibility of the investment.
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Market Competition: Multi-family properties are a popular investment choice, and competition can be intense in certain markets. This can drive up property prices and lower potential returns, making it challenging to find properties with attractive valuations or favorable cash flow. Additionally, competition among landlords for tenants can impact rental rates and occupancy rates, which may affect the potential rental income and overall profitability of the investment.
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Regulatory and Legal Considerations: Multi-family properties are subject to various regulations and laws, such as building codes, zoning ordinances, landlord-tenant laws, and other local, state, and federal regulations. Compliance with these regulations can require additional effort, time, and costs, and failure to comply can result in penalties or legal liabilities. Legal issues, such as disputes with tenants, eviction proceedings, or property-related lawsuits, can also arise and pose risks to the investment.
Investing in multi-family real estate is bound to be messy because it involves real world problems, and dealing with people in the real world.
Plus, you have state and local regulatory risk as many jurisdictions become more tenant-friendly. For example, it took close to a year on average in NYC to evict a tenant pre-pandemic. And during the pandemic, it became even harder and outright impossible in jurisdictions like LA and NYC that kept eviction moratoriums in place for years.
Lastly, don’t forget the headache and heartache that comes with being a landlord. You won’t be compensated for all the stress that comes from finding out you have a serious leak or issue at your property in the middle of the night. And if you have a property manager handling everything for you, then expect to see your returns decreased by hefty management fees. There is no free lunch!
Investing in a multi-family property can be a great way to generate passive income and build long-term wealth. However, like any investment, it requires careful planning, research, and execution to be successful. Here are some tips to consider when investing in a multi-family property:
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Location: Location is one of the most critical factors when it comes to investing in a multi-family property. Look for properties in desirable neighborhoods with high demand for rental properties. Consider factors such as proximity to schools, public transportation, shopping centers, and employment centers. Also, research the local rental market to determine rental rates and vacancy rates.
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Financing: Financing a multi-family property can be more complicated than financing a single-family home. You will likely need to secure a commercial loan, which may require a larger down payment, higher interest rates, and more stringent lending requirements. Work with a reliable lender who has experience in financing multi-family properties and can guide you through the process.
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Cash Flow: Before making an offer on a multi-family property, analyze the cash flow potential. Calculate the property’s net operating income (NOI) by subtracting operating expenses from the property’s gross rental income. This will give you an idea of how much cash flow the property will generate each month. Make sure the cash flow is sufficient to cover the mortgage payment, property taxes, insurance, maintenance, and other expenses.
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Property Management: Managing a multi-family property can be a significant undertaking. Consider whether you will manage the property yourself or hire a property management company. A property management company can handle everything from tenant screening and rent collection to maintenance and repairs. However, they will charge a fee, typically a percentage of the gross rental income.
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Property Condition: Before purchasing a multi-family property, have it thoroughly inspected by a licensed inspector. Look for any structural issues, water damage, mold, or pest infestations. Also, assess the condition of the roof, HVAC systems, plumbing, and electrical systems. Factor in any necessary repairs or upgrades into your budget.
Conduct thorough research, analyze the cash flow potential, and factor in all expenses. Work with a reputable lender, hire a property management company if needed, and thoroughly inspect the property before making an offer.
It’s also important to have a contingency plan as real estate investing comes with risks, especially when the housing market is widely expected to have a severe downtown. Consider unexpected events such as economic downturns, changes in local regulations, or property-specific issues. Have a financial reserve to handle emergencies, unexpected repairs, or vacancies to mitigate potential risks.
Pro Tip: The best way to cash in on price appreciation is to have a deep knowledge of the area. That comes from noticing changes in the neighborhood. A good way to notice the details is to go jogging in a neighborhood you want to invest in. This way, you’ll notice the day by day changes that will give you an early signal that a neighborhood is improving.
