Multifamily Investing Part 1
Multifamily housing is one of the major asset classes of commercial real estate investing. In this series we’ll discuss the specifics of multifamily housing including demand drivers, class types, risk profiles, and profit generation, and show why this is an attractive asset class for investors.
Many people have lived in some type of multifamily housing at some point in their lives. In the U.S., 39 million people (almost 1 in 8) currently live in apartment homes. I’ve lived in five different U.S. cities, and during that time, I’ve rented in 8 different apartment complexes. People will always need a place to live and affordable housing will always be in demand.
Certain demand drivers such as population and job growth fuel the demand for affordable housing. In good times and bad, there is always a need for housing, and in many primary and secondary markets, there is not enough supply of affordable housing.
According to new research from Hoyt Advisory Services and the National Apartment Association, there is unprecedented demand for rental housing. Since 2010 the number of rental households has increased by 800,000 to 1.2 million on average each year,
America needs to build 4.6 million new apartment homes at a variety of price points by 2030 to satisfy growing demand. And as many as 11.7 million apartment homes need renovation by 2030. This means building around 325,000 new apartment units each year, a rate the industry has not been able to achieve in decades. From 2012 to 2016, developers have only built 244,000 units each year on average.
Demographic trends of millennials, the largest generation in history (currently numbering 83 million), favor multifamily units as the preferred housing of choice. Many of them are just starting out, saddled with large student loans, and don’t have enough money for a down payment on single family housing. Or they simply prefer to be within walking distance to work and play. In addition, they are getting married later in life which also helps sustain demand for multifamily housing.
On the other end of the age spectrum, baby boomers, the second largest demographic (currently numbering 74 million), are retiring and downsizing their housing needs. Subsequently they are moving into smaller rental units and assisted living homes.
A large part of the general population simply cannot afford to buy a home due to income stagnation and are limited to renting in multifamily housing. Nationally, the homeownership rate is at a 51 year low of 62.9%.
Overall demand for affordable housing remains strong and the demographics will continue to bolster this.
Multifamily housing come in a variety of classes, styles and sizes. They can be as small as 5 units to hundreds of units. The larger apartment complexes may be composed of more than one buildings. Quality and amenities of multifamily can range from class C, garden-style, no-frills, utilitarian for lower-income families, to ultra-luxe, amenities-rich class A high-rises. Because these types of assets are more expensive in dollar amount than single family homes, and can cost upwards of tens of millions of dollars, they are all but out of range for the single private investor. Therefore, many of the larger apartment buildings are purchased by pooled investor money in the form of a syndication or REIT.
There are different ways to invest in multifamily assets according to risk profile. The four main categories include core, core plus, value add, and opportunistic. This classification applies to other real estate assets like office and retail as well.
Core assets are typically class A apartment buildings. These properties are best-in-class in the best locations. They are stabilized with near full occupancy at market rents and have very little to no renovations needed. Most of these properties are in primary markets like New York, San Francisco, and Los Angeles. Owners purchase these properties using lower leverage, therefore with lower risk. REITS and institutional investors purchase these assets for income stream. The lower risk profile results in lower returns in the 8-10% IRR range.
Core Plus assets have characteristics of core properties and are located in primary or secondary markets. Examples of secondary markets include Denver, San Diego, Austin, and Nashville. The property may have a light value add component or there may be lower vacancy which can be improved upon. Location of the asset may be not as desirable as core properties. There may also be capacity to raise rents to market rate. The risk profile is higher than that of core assets and the returns are higher, typically in the 10-14% IRR range.
Value Add assets are properties that have significant appreciation potential. Value add properties can be class B or C in any type of market. The building may need renovations which in turn can generate higher rental / lease income. Occupancy may be lower than core assets so there is opportunity to lease up the building. Also, there may be areas to decrease property management expenditure. Value add can mean improving landscaping, remodeling the common area, and updating the individual units (new flooring, appliances, paint). All of these efforts increase the NOI (net operating income) which increases the value of the property. This is also known as forced appreciation. Many non-institutional real estate companies invest in value add assets because there is generally less competition from institutional investors and more room for profit. However, a higher return means higher risk. The performance of the property is dependent on the experience, skill, and execution of the sponsor. Higher leverage is applied when purchasing these properties. Returns are typically in the 15-20% IRR range. In a previous post, I wrote about a value add apartment investment here.
Opportunistic assets include ground-up development, major renovation, or land development. These are the highest risk investments but also yield the highest returns. There is usually no cash flow and returns are in the 20+ IRR range.
Multifamily Crowdfunding and Syndication:
Smaller non-institutional private real estate companies often target value-add investment opportunities in the “in-between” market. Those range in price from $5 million to $20+ million – too big for the individual investor and too small for the institutional investor. In this space, there can be a lot of existing operator error and inefficiencies to capitalize upon. In addition, in older vintage class B and C properties, there are value-add opportunities that can generate healthy returns in the form of forced appreciation. Most of the opportunities seen on online crowdfunding platforms offer either value add or opportunistic investments.
Individual Multifamily or Fund:
Investors can choose to deploy their capital by investing in individual assets or through a fund. Each has their benefits and drawbacks. In an individual asset investment, the investor can do their own due diligence and pick and choose exactly which properties go into their portfolio, based on their own financial and geographical criteria. A fund investment is a blind pool investment. The investor allows the sponsor to select multiple properties to be placed in the investment fund and owns a fractional share of each property. This allows the benefit of diversification of capital. However, the investor has no control in the selection of the individual property. In either case, sponsor selection is critical for success. In fact, I believe choosing the right sponsor is more important than selecting the property itself. The performance of a multifamily investment hinges on the ability of the sponsor to execute the plan, from acquisition to management to disposition.
In Part 2, we’ll discuss how income and value is generated in multifamily investments.
Thanks for reading,
Invest In Life.