Class A. Class B. Single-family. Multifamily. Turn-key properties. Value-add opportunities. Primary market. Secondary market. Tertiary market? Gut rehabs. Mixed-use. Student housing. Housing for young professionals. Rent controlled. Non-rent controlled.
When it comes to investing in multifamily real estate, there are so many different types of properties you can buy. So how do you narrow it down and decide what to buy?
In Part I of a multi-installment series on real estate investing, we shared some guiding principles to help investors decide where to buy a rental property. In Part II of this series, we explore a few key considerations to help guide you when evaluating what types of rental property to buy.
Condition of the Property
How much renovation work are you willing to take on? This differs for every investor. Some investors have construction and rehab experience or are eager to manage the multiple contractors that are needed when taking on a major renovation project. Buying an older, outdated, or otherwise “rough” property can make much sense for those with a lot of experience or access to capital. As successful flippers know, one can realize much financial upside by purchasing an underutilized asset, renovating it, and then holding onto it for some time.
But renovating a property isn’t for everyone. If you have less experience, less capital, or are less interested in being a hands-on investor, buying a newer property makes more sense. More modern properties – or properties that are older but have been newly-renovated (particularly with new heating systems, electrical and plumbing) – require less frequent repair and maintenance. You might pay more for these properties on the front end, but new properties also tend to command higher rents.
Avoid the Diamond in the Rough
This may sound counter-intuitive, especially if you’re looking for a turn-key investment, but hear us out: avoid buying the most beautiful property (the diamond) in an up-and-coming neighborhood (the rough). This is often an indication that an investor overspent on renovations.
A better investment strategy is to look for the worst property in a great, stable community. People are always willing to pay up to live in an excellent neighborhood (e.g., good schools, well-maintained parks, access to transit, restaurants, and shops). It’s easier to improve a single property than to improve an entire neighborhood, so suggest looking at value-add opportunities in high-demand areas instead of vice versa.
Single-Family vs. Multifamily
There are certainly advantages to both types of real estate. Single-family homes can be an excellent investment because when it’s time to sell, you have a broad range of buyers—from institutional investors looking to add to their portfolios to owner-occupants willing to spend more for their “dream home” than would be justified on a cap rate basis alone. The price point of a single-family home can also be an advantage for investors with a limited amount of capital. Single-family homes are usually easier to finance, and if it’s someone’s first purchase, they might be able to qualify for as little as 3.5% down.
Multifamily properties usually require a considerably more upfront capital outlay, with lenders typically looking for investors to put down 20-25% as a down payment. On a $1 million purchase, this means coming up with at least $200,000 as a down payment, which is hard for many investors to do (especially those who are first-time investors). That said, investing in larger multifamily properties can be a great investment strategy, particularly if you’re willing to bring in co-investors.
One of the reasons investors are drawn to multifamily properties is that they are inherently less risky than investing in single-family rentals. If one tenant moves out or stops paying rent, you still have the cash flow coming in from the other units to balance expenses. The repair and maintenance costs tend to be more predictable, and when large capital expenditures do arise (like a new roof), the costs are lower on a per-unit basis.
Rent Control vs. Non-Rent Control
It used to be that only a handful of communities still supported rent control here in the U.S., but that pendulum is beginning to swing in the other direction. Several cities have recently adopted new rent control policies, so this is something that all apartment investors should have on their radars.
Here are a few things to consider when evaluating rent control vs. non-rent-controlled properties:
Investing in non-rent-controlled buildings has generally proven to be a great investment strategy. The ability to raise rents with the market allows for a substantial increase in cash flow and appreciation during periods of increasing rents.
Rent control leads to a reduction in the available supply of rental housing in a community by discouraging new construction. Far fewer investors have the ability or the will to buy or build rental homes in a place with rent control. When the government enacts rent control, some investors will continue to invest, but it’s mostly large investors with the most money building high-end units. Effectively driving market prices up due to lack of supply. Other owners stop improving apartments because they lack the funds to perform adequate maintenance. Some will convert buildings to condos and sell them along with greater competition for affordable housing — supply and demand economics.
That said, investing in rent-controlled properties can still prove worthwhile. The cash flow is more reliable due to lower vacancy rates, along with less sensitivity to declines in market rents. If a resident in a rent-controlled unit is paying 30% below market rent, and market rents go down by 10%, they are unlikely to move out or ask for a lower rent. Furthermore, there is an upside for the owner when residents move out, and units reset to market rates, which is guaranteed to happen eventually (although it may be a very long time).
Ability to Produce Cash Flow
Buying rental property is an investment, so you want to be sure this investment is generating meaningful cash flow.
There are a few instances where investors might be willing to forego cash flow in the short term, such as buying a rent-controlled property with dramatically sub-market rents or buying a fixer-upper that will need substantial investment. Otherwise, investors should look to buy properties at a reasonably high cap rate. In other words, you want to be taking some money off the table each month.
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So many investors focus on where to buy a rental property that they often forget to put thought into what types of rental property to buy. We hope that Part I and Part II of this investors’ series has left you feeling well-equipped to make smart, informed decisions as you look to purchase your next multifamily investment property.