One type of investment property that continues to grow in popularity is multifamily housing. While many investors look toward real estate to diversify their investment portfolio and mitigate risk, they are often drawn toward multifamily properties since they are found to consistently outperform most commercial investments when invested over a long term. Multifamily can be defined as a residential property that has more than one housing unit. This refers to anything from a duplex to a townhome to a large apartment complex. Since everyone needs a place to live, there will always be demand for more housing, making multifamily an attractive alternative investment with self-directed IRAs.
Why Invest in Multifamily Real Estate?
Multifamily is consistently a steady performer. While the stock market is fast paced and tends to react quickly to outside influences, real estate turnover is slower and transactions take longer to complete, tending to be less volatile. It also tends to have high yields relative to the risk profile. Multifamily has consistency because it’s spread out among multiple tenants, and since wages tend to keep pace with inflation, that has the effect of moving the operating income line up, which makes it a good hedge against inflation. Plus, monthly rent provides a source of passive income.
Some of the main reasons investors are drawn to multifamily properties over other commercial properties are:
- Demand – Housing is a basic human need so there will always be a demand for it.
- Diversification – Revenue is derived from multiple leases, which broadly spreads financial risk over multiple tenants.
- Flexibility – With the ability to stagger leases into 6 month, 9 month, 12 month, or longer, investors aren’t locked in and can shift as needed according to market conditions.
- Enhanced Tax Benefits – Residential depreciation is shorter than commercial, which generates greater shelter of investment income.
Short-Term vs. Long-Term Investments
Short-term multifamily investing consists of opportunistic or speculative real estate development where the returns tend to be higher, but the investments tend to be riskier. It can also include value add type investments which are essentially fix and flips with apartment buildings where the property needs major work. Holding a multifamily property for 1 to 3 years can work well in a growth cycle, but successful exit is trickier and depends on timing and market conditions.
Tom Hoban, chairman and co-founder of the Coast Group of Companies said, “It (short-term multifamily) tends to not always be a great fit for self-directed IRAs because those by definition are intended to be more long-term strategies tied to protecting your retirement income, so there’s no real reason to get too aggressive on the risk side.”
With long-term multifamily investing, which Hoban likes to do with his investments, he looks for existing properties that need little to no renovation where he can ride the market for 10 years betting there will be growth in the area, or apartment buildings that are underperforming due to poor management, where he can make improvements and hold onto them for 5 to 8 years or more.
The advantage of long-term multifamily investing is it provides consistency through multiple market cycles. According to Hoban, “When we did a review over 30 years and took random 10 year slices, no matter where in the market you bought and sold it, if you held it for 7-10 years it almost always produced that same 6 or 7 yield and a 12-14 IRR (internal rate of return) at least in the markets we’re in and there are many other markets that can do that, so you don’t really have to time your market cycle. You just have to buy them right, you can’t overpay, but if you play the market cycle and you’re patient inside that and you seek that management alpha, those returns are shockingly consistent.”
Start With a Good Purchase
When investing in real estate, it is critical to start with a good purchase. While some investors may have the skill and expertise to evaluate their potential real estate investments, for many people the best course of action is to find the right general partner or sponsor who have been in the business a long time and have a solid track record finding good deals. When evaluating multifamily investment properties, the following areas should be considered.
Look for properties in supply constrained markets
Look for any constraints in the market, such as geographical, structural, political, etc. Geographical limitations could be mountains, water, highways, or anything where people are constrained to live in a certain area. Structural issues would include growth management acts where government is trying to move population density into certain areas where there are already existing utilities and infrastructure and limit it in others. That can tell you where you can get supply and where you cannot.
Look for “NIMBYisms” (Not In My Backyard). What level of appetite do people have to allow room for others around where they live? Apartment buildings come with a reputation, and not everybody wants big apartments built next to them. According to Hoban, “When new supply comes in at a price point 15% higher than the existing B+ quality apartment stock that’s already in the market, that tells you they are in a supply constrained environment.”
Understand current market conditions
It’s important to know the current market conditions and how quickly the value of the investment may change, especially when interest rates are rising. While the seller might have an idea of value based on what it was yesterday, buyers’ expectations are based upon where they think the interest rates are going to be when it closes in 60-90 days and what it will cost to carry and own a building when they are financing a large portion of the cost. This can create a gap between the buyer and seller. It’s important to know how to negotiate in a cap gap market and navigate through the process, and often the answer is to look at a lot more deals and then be picky about which to pursue.
Don’t underestimate operating expenses
The top five operating expenses associated with multifamily are utilities, taxes, insurance, repair and maintenance, and management. Multifamily homes are not publicly traded buildings and people have different levels of skills and methodology when they do the accounting on their buildings. Investors need to be able to spot opportunities to gain some income or reduce expenses to stay competitive in the market.
Know your target tenant
You need to understand what is important to your target tenant and does the immediate neighborhood have that. Is there access to good quality schools, grocery stores, and public transportation? What type of employment opportunities are nearby and are they limited to one major employer which could cause issues if they close or relocate? Think about how you can create community when you have people from diverse backgrounds where they can feel safe and thrive.
Use Management Alpha
Management Alpha is the ability to achieve above market returns via day-to-day execution of a clearly defined strategy for a property and it is critical to success in long-term real estate investing. In order to achieve consistent above market returns, management must maximize value and cash flow by reducing expenditures and increasing revenue sources, being aware of what will work with your residents. Some examples of this are being aware of market rents at each lease renewal, testing the effects of light renovations on rent growth, and transferring utility billing to tenants.
Once you have done all of this, then reducing turnover is essential. “If you can buy a building turning 60% of the tenants in a year, which is market average, and tap that down to even just 50-55%, there’s just a lot of lift and a lot of cost savings in not having to go through the cleaning and painting and the re-leasing and the marketing costs and the staff demand on time and all that goes into losing a customer,” advises Hoban.
“We are chronically undersupplied with apartment housing in the United States just about everywhere,” said Hoban. While some areas may have had an oversupply due to an exodus of residents because of employment, many areas are seeing an influx of new residents for other reasons, such as social or political. Hoban recommends being cautious about where you gather your information and carefully evaluate it because prevailing thinking may not be what it seems. He also recommends looking for business friendly places with lots of job creation. “Look for where the jobs are going and where the people want to be because you can’t win this game unless there is net positive migration in that market tied to people who have a good job.”
Multifamily and Your Self-Directed IRA
A self-directed IRA gives you the ability to invest in alternative assets like real estate, promissory notes, and syndications, and the flexibility to invest as an active or passive investor. If you would like to learn more about self-directed IRAs and how to use them to invest in multifamily housing, schedule a 1 on 1 with one of Quest’s IRA Specialists.
This article is information excerpted from Tom Hoban’s webinar “Investing in Multifamily Real Estate for the Long Term.” Tom Hoban is Chairman and Co-founder of Hoban Family Office and the Coast Group of Companies, a diversified group of property management, facility services, specialized construction, brokerage, and investment companies serving private and institutional owners and investors throughout the Pacific Northwest. His real estate investment firm, CEP Multifamily, owns and operates over $400 million in institutional quality multifamily assets.