Cash Flow or Appreciation? Understanding Your Goals
Which is better: Investing in commercial multifamily or single family Residential?
Together we’ll be walking through apartments vs. rental houses and looking at them side-by-side. Some definitions will help us stay clear on what we’re talking about.
In this writing, commercial multifamily will be defined as apartment buildings with over 100 units. Most of the time anything over five units is considered commercial. However to stay ultra focused, when we say multifamily apartments, we mean large apartment complexes. With the same goal in mind, single family will be defined as any single family homes or small multifamily buildings under five units. These are typically lumped together from a financing perspective, and a favorite option of new real estate investors.
Personally I have been investing in real estate for years, with my primary focus being on the single family space. We’ve bought and flipped over 200 properties in two states, buying all of our properties directly from sellers and raising 100% of our capital from private investors or passive investors. I’ve held on to a handful of these properties building a small portfolio before I made the decision to switch my focus to multifamily real estate. I know upsides of single family… and the downsides that lead to my switch. Because I’ve experienced both sides of the industry I can speak from personal experience some of the key benefits of each, while outlining why we have stopped buying single family homes.
The Downside of Large Multifamily
Multifamily Low Liquidity
One of the downsides to investing in real estate versus something like stocks or mutual funds is that inherently the assets are less liquid. It usually takes weeks or months to sell a property depending on the market conditions. This becomes magnified when investing in large multifamily apartments. Single Family homes are much smaller investments (typically) that have the ability to be sold within a few weeks to a few months.
Selling quickly can happen with any asset, if you’re willing to take a price cut. Yet assuming normal disposition timelines, commercial assets typically can take months to prepare for sale before ultimately closing. This is why when you invest in real estate you’re making a conscious decision upfront to trade your liquidy for a hard asset with potential to earn a return – making it inherently less liquid.
I’d argue that this is actually one of the benefits of investing in real estate and therefore magnified with multifamily. By spending time upfront to perform due diligence on a market, the specific deal and the operating sponsor you’re doing the work upfront. Once the investment is made it typically can’t be easily moved, which actually allows you to free up the mental space to focus on something else, relieving yourself from the grueling question: “Should I hold or sell today?”
One of the worst things an investor can do is make the emotional decision to sell low. This is prevalent within the stock market, where every year trillions of dollars of networth are lost because of emotional decisions. Yet when you invest in real estate, particularly when buying investing in apartments, you’re removing yourself from this emotional decision cycle – eliminating your emotional ability to hit the sell button. This is particularly true as a passive investor because you’ve delegated management control to the operator based upon their experience, expertise and emotional fortitude to weather these ups and downs that typically happen within the market.
Now when we look back to single family real estate, it has a real advantage of being more liquid than apartments, yet less liquid than stocks. A single family home can be listed with a real estate broker and sold to a homeowner or landlord within a matter of weeks (sometimes in days – ask me about how many we’ve purchased in under 7 days). Typically, single family homes have a single owner, meaning they are in full control of the decision to sell.
We’ve explained the downside of this, yet for some this type of control is the only way they’ll feel comfortable. They are willing to trade the time, potential stress and money to manage these investments fully themselves. This underlines the importance of understanding what your level of control is required for you, which will help you decide what type of investments fit your personality.
Requires Expertise to Succeed – Lower Direct Control
Buying apartment buildings requires a level of experience, expertise and track record that just isn’t required in a single family. With more capital at risk and more moving pieces it’s absolutely critical that investors are true experts at buying, funding and operating these assets. This is one of the key reasons why I’ve focused my energy to align and partner with expert operators who have a serious track record of success – buying and managing thousands of units and millions of dollars of investor capital. Where I bring my real estate experience, track record and relationships to the sponsorship team so together we can deliver better returns with a consistent income stream to our passive investing partners. As a passive investor you have the same ability to partner, by investing alongside experienced operators.
Why is investing with an experienced operator important you might ask? At the core, an operator (aka the sponsor) is responsible for actively managing the investment for the life of ownership. As an active or passive investor, it’s critical that the sponsor team (operation team) has a track record of delivering these results. This is especially true with commercial multifamily. This is why it’s critical they have the experience and track record to succeed. In both cases these operators are happy to work together because this allows them to focus on their core strength: finding and operating lucrative deals which is a win-win scenario for all involved.
Without having this track record, you really have two options in commercial multifamily: Invest Passively as a limited partner or Invest Actively by building a team of experienced operators around you. I personally do both because I have the time, experience and background to match. And you can decide what works best for you.
Because the level of competition is higher than in a single family, it’s critical to work with operators who have a track record of success buying and managing large apartment buildings. Rather than competing against another mom and pop landlord, we compete against highly educated investors and hedge funds who’ve been succeeding in this space for years. This doesn’t mean there isn’t plenty of room to earn consistent returns. What it does mean is for multifamily apartments, it’s non-negotiable to have a team of experts managing the assets you’ve chosen.
On the flipside, a single family has the advantage when getting started from scratch. Anyone can get started buying single family houses, with a little bit of education, a little bit of money and some hard work. This is a huge advantage, because it’s through that experience that you begin to understand more about what type of investor you are. With a simple financial analysis and a few thousand dollars to cover the down payment you can buy your first house.
Now there is a downside here, that you’re competing against both sophisticated house investors and newbies, the market can be driven up based on demand from the latest seminar rolling through town. But as a single family investor, most likely you live in a home yourself and you may even own your own, so you start with experience in this space. That makes the level of competition or barriers to entry much lower than commercial real estate.
Higher Cost of Direct Ownership
Direct ownership means that you’re the owner or company on title of the property. You may have a partner or two, but you’re in control of the asset. As we’ve discussed this is a must for some and a disadvantage for others (based on time, capital, diversification or experience). For those interested in this route, a single family has the lowest cost of entry to the space. Most investors have the capital required to buy single family or small multifamily residential homes relatively quickly. These investors can place their $50,000 deposit down on a new purchase and be the owner of a shiny single family home pretty cheaply. Compare this to a 100 unit building ranging in price, depending on location, in the multimilions. This may require a solid $1,000,000 downpayment to buy an apartment building outright.
This is where the partnership model comes into play. A group of partners each bring their own down payments of $50,000-100,000. A group of investors that pool their resources together, placing a sponsor or operator in charge to manage the investment, is called syndication. In multifamily these investors choose to forgo “direct ownership” for the ability to own a piece of a much larger pie. We call these inventors limited partners or passive investors, because they pool their money together under the direction of a sponsor or apartment operator. They choose to invest in the sponsor’s experience, expertise and track record, giving up the need to manage the property day-to-day to benefit from the benefits of investing in large assets.
It’s clear that Single Family wins out in the direct ownership category.
The Upside of Large Multifamily
Economies of Scale
Finding the sweet spot, the perfect area of focus that gives the biggest returns for the least amount of risk or time invested, is the objective in any investment. Scale leads to a new set of challenges, yet when done well results in more effectively run buildings and more consistent returns. In real estate we look for economies of scale in property management, building renovations, leasing, asset management and much, much more.
Property management is the core driver of success in real estate. Being able to effectively manage each property, reduce its expenses and increase its income are core of the investor mindset. Because of the size, large multifamily investors are able to dedicate onsite property management to focus on getting the most out of each property.
By being on-site, managers increase efficiency in leasing, managing tenants satisfaction and overseeing ongoing maintenance leads to better running buildings. Having dedicated maintenance staff leads to lifts in efficiency because often we see similar finishes, materials and paint colors being used throughout all units within the buildings. There’s a reduction in the cost per maintenance call and better manage material inventory.
On the single family front, property management is spread out over many more properties over a much larger area. This leads to inefficiencies in traveling and non-standardization of elements. On the maintenance side this is even more pronounced, leading to the price of small repairs like a clogged toilet or leaky drain increasing on each job. Maintenance often has to individually purchase materials, as every home is different. As we know, this reduces return on investment (ROI).
There is a clear quality difference in the type of professionals or contractors between the two asset classes. This doesn’t mean that it’s impossible to find wonderful property managers or reliable maintenance contractors, however it’s quite common for there to be issues with the quality or cost of work completed on these single family homes.
As an owner you want to make sure things are done cost effectively and at a high quality, yet it’s hard to manage both of those unless you’re dedicating the time personally. Compare this to the size of commercial multifamily, the operators are able to invest the extra time and due diligence to ensure they are selecting the right contractors. This leads to higher quality results.
Efficiency to Scale (How fast can you grow?)
The ease of getting started is such an advantage of single family, however the major downside is what we call “efficiency to scale.” It is much easier and more time effective to buy 100 units in an apartment building than to buy 100 single family homes or small multifamily units.
Why is that?
First the process for finding, analyzing and offering on these is more just more time consuming. Yet what is even more important is the increased efficiency in performing the necessary due diligence on each property.
Due Diligence is one of the most important steps when investing in real estate, yet when buying lots of single family homes it can easily be overlooked. I saw this first hand as we scaled our business rapidly. Missing one small issue in a home could cost us thousands if not tens of thousands of dollars, wiping out our profit in the deal. This is even more true when buying an apartment building. We follow a thought process of due diligence on each unit, the buildings and the market itself.
But here’s the difference: I can afford to spend weeks of due diligence time on a large property, more so than I can on a small. Typically we’re looking at similar units, in one location and are able to perform this process in a focused period of time, versus spreading it over multiple time windows and multiple different home styles. Plus, each small property will have their own unique issues.
Multiple Income Streams & Diversification
What is one key way to reduce risk when investing? By creating multiple streams of income with diversification. With each apartment we buy, we create multiple streams of income within each investment. Each renter makes up a smaller percentage of your overall income, leading to a more conservative spread of risk.
How does this playout in a single family? Typically it works out great when the building is rented. Each property typically has one renter and one mortgage. If that renter should stop paying or vacates the property the investor is responsible for the full coverage of that debt.
Compare this to a multifamily property, where the investment team has 100 renters that together pay the debt for the entire property. Conservative operators understand exactly where their break even point is – aka their debt service coverage ratio is (DSCR). Meaning they understand what percentage of leases are required to cover the ongoing expenses. Typically this number is pretty substantial such as allowing for a 30% vacancy to breakeven. By capping the downside these investors increase the return to risk ratio. That’s a good thing in my book.
Now of course you can spread your investment risk over multiple single family homes or even multiple properties in multiple different areas. If you’re doing the single family strategy, acquiring multiple properties is key to making it worth the effort to manage these properties. Yet some would argue that investing in multiple markets can be a disadvantage in single family because of the reduction in focus and market expertise. The ability to specialize in your market or property type leads to a reduction in risk, an increased market advantage and in my opinion better returns.
Achieve Diversification Without the Downside
One of the ways multifamily apartment operators and investors reduce risk is by diversifying across three potential areas: Across Deals, Locations and Operators.
First, by diversifying across individual deals, investors spread out their investments into multiple properties the way you would in single family, with the advantage of economies of scale. This scale advantage actually increases as operators purchase more units.
Next, operators and investors have the ability to diversify across locations or markets. Because of the scale, it’s both easier and cost effective to buy in multiple markets. By buying hundreds of units, operators replicate the same model, adjust it for the specific deal, and plug-n-play the business model within each market.
Finally, a passive investor or limited partner is able to diversify by spreading their investing dollars over deals with multiple operators. This means passive investors can invest with different sponsor teams, who are investing in different deals in different locations.
Valuation With Control
Each asset class is valued differently – in other words, how we determine what the asset is worth. Each single family home’s value is based on the comparable properties that have sold around it recently. The layout, neighborhood and overall market sentiment plays a major role here. This means the house is worth what other houses like it have sold for in the past.
In Commercial properties values are based on income minus expenses. This is called Net Operating Income (NOI). This means multifamily apartments are valued specifically based upon the overall NOI – the income minus the expenses. This means an apartment investor is buying a business that has a current income or potential income every month. It also means an operator can increase the overall net operating income (NOI) of the asset by increasing the income or decreasing the expenses. Each time I’m able to increase income or decrease expenses the value of the property goes up. The amazing advantage here is it doesn’t just increase a little, it increases A LOT.
For example, say I decrease expenses by $1 on a 5% Cap Rate property. The value goes up by $20 for every dollar saved or new dollar earned. Isn’t that amazing?
The Cap Rate (aka Capitalization Rate) is just a term that means the annual rate of return if we’d invested all cash. However, since we never buy real estate with all cash our returns are actually much higher.
This difference in valuation is a huge advantage that you just can’t find within the single family space. If you are able to increase rents dramatically, the house typically is still going to only be worth what it’s valued at as a single family house.
Each asset class has its own advantages. With single family you’re able to get started quickly, with direct ownership and the ability to go liquid much more quickly. There are some downsides when it comes to scalability, the amount of effort or time it takes to grow a single family portfolio and some challenges in economies of scale.
Multifamily on the other hand is designed for scalability. Having multiple units within one investment, allows management to more efficiently manage the buildings, allowing for better oversight of the property to increase income and decrease expenses. We saw just how powerful this can be for multifamily investors, when valuing properties, turning $1 into $20 at a 5% Cap Rate. Spreading out our risk over multiple leases, investments or markets can lead to much better risk adjusted portfolio. It’s likely clear at this point that I strongly believe in the advantages, so much so that I’ve pivoted from a successful single family business to take advantage of the opportunities within this asset class.
If you’re interested in learning more about investing passively as a partner, I encourage you to reach out or learn more here.