For the Love of Apartment Investing
By Ed Rogan, Owner, Co-Founder
So you’ve decided to take the leap and invest in commercial real estate – congrats! Now, where to get started? There are so many options to choose from!
Commercial real estate is a catch-all term for describing many different types of income-generating property. The primary product types include multifamily, office, retail, hospitality, industrial and land development. Each product type has its own nuances, and each can be equally lucrative. It is important to understand the differences between these before deciding to invest in one product type versus another.
Truth be told, we’re partial to multifamily for all of the reasons outlined below.
Multifamily real estate is relatable.
Most investors have either lived in an apartment or owned their own home at some point in time. Many have done both. Therefore, it’s relatively simple to understand the mechanics of multifamily real estate. Find a property. Run the numbers. Be sure the monthly rents exceed the net operating expenses (i.e., be sure there’s a profit). Determine whether there’s room for additional upside. Make renovations as needed. Show units to prospects, lease, and collect rent checks accordingly.
Sure, that’s a grossly oversimplification of multifamily real estate. But you get the point. Multifamily is probably the easier product type for people to understand. Units all include a kitchen, bathroom, and some combination of bedrooms and living rooms. Easy enough. There are HVAC and other building systems to maintain, but these aren’t all that different than those in our own homes. Pay taxes and insurance, just like you would a single-family home. Multifamily is highly relatable, whereas the nuances of other product types can be much more difficult to grasp.
The lease structure makes it easy to add value.
Multifamily leases are typically short-term, running either month-to-month or for at most a one-year term that converts to month-to-month. Rarely do leases exceed one year. Compare this to office, retail, or industrial, for example. Leases for these other product types usually begin at five or seven years, often running upwards of 30 years or more.
One of the benefits to owning real estate with short-term leases is that it becomes easier to add value over time. As units turn over, you can turn on the throttle and inject capital before releasing the unit. This allows an owner to add value in a cyclical fashion where, unlike the other product types, you might have to wait 5-10+ years before going in and making improvements that will enhance the property’s value—and when that time comes, the improvements must be done all at once, which can prove cost-prohibitive for some owners.
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Many short-term leases lower risk.
Not only do multifamily properties have short-term leases, they also have many short-term leases. This is beneficial for several reasons. First, you aren’t putting all of your eggs in the basket of one or very few tenants the way you might be with other product types. If one tenant defaults on their rent, you still have several others supporting the mortgage payment. Compare this to a single-tenant office building. If that tenant has a bad month and can’t pay rent, the owner has to foot the entire bill in the meantime. Imagine a scenario where the tenant in a single-tenant property can’t pay rent for months on end? An owner can quickly lose the shirt of his back.
The benefit to having multiple short-term leases is that it lowers risk. If there’s a problem tenant, it’s easier to evict that tenant when you know there are rents coming in from other units. Worst case, the lease will only last through the year, in which case you can elect not to renew the lease and bring in a new tenant in their place. Multifamily is one of the only product types to offer such flexibility.
Multifamily is easy to underwrite (though tough to do well)
For anyone considering investing in commercial real estate for the first time, multifamily is a great option because of how easy it is to underwrite, relative to other asset classes. While we generally suggest you do more than a “back of the envelope” calculation, most multifamily numbers can be run with relative simplicity. An excel sheet is really all you need to create a basic pro forma. There are fewer, less complicated inputs than other asset classes. Multifamily really comes down to fixed expenses (such as taxes and insurance), variable expenses (interest rates, maintenance) and projected incomes (rents + any income from ancillary uses such as laundry, parking, etc.). These number can be easily calculated to project cap rates, the internal rate of return (IRR), cash-on-cash returns, and more.
Starting with multifamily is a great way to become more familiar with the numbers behind a deal and this is probably why there are so many players in the space. For a wary investor, it’s important to acknowledge that there is a difference between a mediocre sponsor and a first rate one – and this stems from how they underwrite a deal. Here at Penn Capital, we have developed our own proprietary underwriting models that are derived from our experience in financial modeling for some of the largest institutions in the world. We utilize multiple data inputs to identify, not only undervalued locations for investment, but also to predict performance of individual assets.
Everyone needs somewhere to live.
Multifamily is a resilient product type. Regardless of where we are in an economic cycle, people need somewhere to live. During a strong market, people are willing to pay up for new multifamily buildings more so than they might be during a down market. Yet even in a down market, people need somewhere to live. In fact, one of the reasons multifamily holds its value so well is that even in a down market, demand for multifamily remains strong.
Consider the Great Recession. When the housing bubble burst in 2007-2008, hundreds of thousands of people lost their homes to foreclosure. Those who would otherwise have owned their own real estate were then pushed back into the rental market, creating further demand for multifamily. When the economy recovered, it took some time for these people to rebuild their credit in order to buy a home again. Some decided to forego homeownership altogether. This confluence of factors continues to drive multifamily housing to this day.
As you can see, there are many reasons to invest in multifamily as a product type. This isn’t to say that multifamily is foolproof. Quite the contrary. For example, some may argue that multifamily is much more management intensive than the other product types. Yet at the end of the day, we still feel compelled to invest in multifamily real estate for the reasons outlined above.
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