- Money
by John Casmon
August 24, 2020
In the midst of a pandemic and record unemployment, stocks are reaching a new all-time high. Understandably, many investors are concerned about a bubble and seeking stock alternatives. Real estate is a popular option, in particular, multifamily apartments. Multifamily is seen as recession resilient, evidenced by the high rent collection rates during the pandemic.
Apartments can be bought by large institutional investors, but more and more everyday professionals are buying apartments or investing through private investing groups. Multifamily intrigues investors because it’s a real, tangible asset. In addition, it provides various benefits to round out investing portfolios for stock and rental investors.
Here are some of the top reasons to consider multifamily investing:
Rising Apartment Demand
The demand for rentals continues to increase. According to RentCafé, 34% of America’s general population are renters. And since 2010, the number of renters has increased two times faster than the number of homeowners, climbing by 9.1% and 4.3%, respectively. Many rent by choice to have greater flexibility in an uncertain environment. These renters want their apartments to feel like home, without the weight of a mortgage to limit their options.
Developers have responded by building the largestnumber of new apartments since the 1980s, but as much of 80% of the rentals are high-end luxury units. The vast majority of renters can not afford to rent these luxury units, creating an opportunity for more affordable apartments that reflect the designs tastes of today’s renter.
Strong Returns on Multifamily
Cash flow and appreciation make a dynamic duo for multifamily returns. Cash flow is driven primarily by rental income, but also includes other income such as pet fees, late fees, utility fees, laundry, and parking. Investors can increase cash flow by improving the property or adding new revenue streams. In addition, they can lower expenses through smart upgrades and renegotiating contracts and services.
Appreciation is the increase in value over time. Appreciation is driven by inflation, surrounding developments, or renovations to a property. Renovations force appreciation; this is common with flip projects, where someone remodels an outdated property to increase the value. Investors can do the same thing with apartments with greater scale, efficiency, and impact than renovating a single house.
Apartment Valuations
Unlike residential properties, which are valued on what your neighbor fetched for his house, commercial real estate is valued as a business. The two metrics that determine value are net operating income (NOI) and cap rate. NOI measures profitability, while cap rate is the expected rate of return based on demand for an area.
NOI/Cap Rate = Value
When apartment investors increase the NOI, they are also increasing the overall value of the property.
As an example, let’s say a property has a net operating income of $100,000 and a cap rate of 6.5%.
NOI/Cap Rate = Value
$100,000/6.5% = Value
The value is $1,538,431.
If an investor is able to add an additional $15,000 of income, it would boost the NOI to $115,000. While that may not seem significant, the real kicker is what it does to the valuation.
NOI/Cap Rate = Value
$115,000/6.5% = Value
The value is $1,769,231.
At a 6.5% cap rate, the initial value was $1,538,461. With the $15,000 increase to the NOI, the new value becomes $1,769,231. That $15K increase in the NOI added over $230,000 in value to the property!
The strategy of buying multifamily properties to increase the value creates wealth-building opportunities, but protecting this newfound equity is where this asset really shines as a stock alternative.
Unrivaled Tax Benefits
Many wealthy people invest in commercial real estate as a stock alternative for tax advantages. Houses and buildings can be depreciated over time. Commercial buildings are also depreciated but have the option to use an accelerated schedule that can create a significant paper loss. These paper losses can be used against any profits from the actual rental income and can also offset other qualifying passive income gains in an investor’s portfolio. Savvy investors use this strategy to reduce or eliminate their tax liability.
Capital gains taxes can eat up a significant portion of profits on any investment. However, with multifamily, you have two options to lock in gains without triggering capital gains taxes. The first is to refinance the property and pull out some of the new equity. This is a tax-free event. The second is to do a 1031 exchange, which allows investors to defer the capital gains indefinitely and roll the equity into the acquisition of a new property.
A note on taxes: Some may criticize these tax benefits, but the government recognizes that it is awful at providing housing, so these incentives encourage private companies and investors to create, provide, and sustain housing. Real estate investors help drive the economy by hiring vendors, employees, buying materials, and providing Americans with a basic necessity. These tax breaks are incentives to encourage that contribution.
Portfolio Diversification
Many financial advisers state that professionals should create a diversified portfolio with at least a small portion of their holdings in real estate. Multifamily helps investors diversify their portfolio and spreads the risk across multiple units. When factoring in future demand, cash flow, appreciation, value-add opportunities, and tax benefits, it’s easy to see why multifamily is a popular alternative investment.
Multifamily has served as a wealth driver for generations. These assets can be a hedge against a looming downturn. If you are seeking alternatives to the stock market, it would be prudent to consider multifamily investing.
- real estate investing
