Multi-family Investment 101
An Introduction to Multi-family
Any property that is more than one unit, like duplex, triplex, fourplex and beyond are called multi-family. Typically properties with more than 5-units are considered commercial multi-family and are treated differently by the banks or lender when you secure debt against these properties.
Why invest in multi-family?
One of the golden rules to any investment we pursue is to not lose money on a constant basis. What it means is that the investment has to be cash-flow positive from day1 that can support operations. We have seen umpteen number of instances where an investor bought a property for capital appreciation ignoring cash-flow and in the current scenario where the market has softened and rates have gone up significantly, either they are left with selling the property at a loss or doing a cash-in refinance to barely float above the water.
Smaller rental units lack scale and at the current borrowing rate, the properties hardly break-even. Added to this, if there is tenant churn, and/or a small/medium unplanned maintenance could make or break the profitability of the investment. All this comes with the investor having to actively manage the property.
Multi-family investments offer a more passive investment opportunity, are better resilient to tenant churn and unplanned maintenance issues as all these would be factored into the business plan. Hence these offer a better risk-to-reward ratio compared to single family or smaller multi-family rental properties.
Having said this, a lot depends on the discipline of the team putting together the deal on how aggressive or conservative they are with their assumptions and if they have factored in the rainy day contingency to be able to weather the challenges.
Does it help with diversification?
Single-family and smaller multi-family units are very dependent on the market and are often driven by the sales comparables (comps) in the market.
However, multifamily property values are not determined based on comp but the risk associated with the market (typically measured by CapRate) and the performance of the property (typically measured by NOI - Net Operating Income). We will detail these terms as we go through this guide.
Given the above, multi-family investment is a good way to diversify your investment portfolio to ensure you have assets that are tied to the market (your job, ESOPs, RSUs, primary home, stocks, mutual funds etc) and assets that are decoupled from the wall-street.
Type of opportunities
There are different types of multi-family investment opportunities. There are investments that are focused on new ground-up construction, cash-flow oriented investments and value-add oriented investments. All of these have various hold periods and risk-to-reward.
We mainly target the value-add investment segment.
What is a value-add strategy?
The value-add strategies are determined at the time of underwriting to make sure the property is capable of generating the revenue required to support the returns promised to investors. When these strategies get implemented over the period of ownership, the performance of the property significantly improves resulting in a higher value. The intentful process of doing these value-adds and increasing the value is termed forced appreciation.
What is forced appreciation?
The value-add strategies are determined at the time of underwriting to make sure the property is capable of generating the revenue required to support the returns promised to investors. When these strategies get implemented over the period of ownership, the performance of the property significantly improves resulting in a higher value. The intentful process of doing these value-adds and increasing the value is termed forced appreciation.
Avenues to multi-family Investing
One could invest in multi-family investment opportunities through the below means.
Syndication
Simply put, syndications are a group of individuals (or companies) coming together to do something that they couldn't do individually otherwise. These could be due to lack of time, resources, expertise and risk tolerance.
Syndications are formed to target a specific investment opportunity like an apartment complex. All your investments are directed towards the property acquisition and improvements. These are analogous to stocks in the stock market.
Investment Funds and REITs (Real Estate Investment Trusts)
These types of investments, you invest in a fund and the fund manager will make the decision to invest in properties that they feel confident in. Typical to any funds, these come with fund management overheads eating into the returns. However, these potentially could be less risky as the investment is spread across multiple properties. These are analogous to mutual funds in the stock market.
Who are parties to the syndication?
There are 3-parties to the deal with explicit responsibilities.
Active Partners | Managing Partners | Sponsors | General Partners (GPs)
These terms are used interchangeably to refer to the team that puts the deal together, manages and takes it to the exit. This team handles day-to-day operations of the property and ensures the business plan put in place is executed delivering the promised results to the investors.
Passive Partners | Limited Partners (LPs)
These are the investors who bring money to the table. They invest in the property through the Active Partners and are not involved in the day-to-day operations of the property.
Certified Property Manager (CPM)
They are employed by the active partners to manage the day-to-day operations of the property and implement value-add strategy under the guidance of Asset manager from the active partner team.
How is the syndication deal put together?
The GP team finds the investment opportunity, and puts the deal together. They acquire, operate, perform and take the deal through an exit. They bring sweat-equity to the deal. The LP team brings money and invests in the deal.
For the sweat-equity put in, GP team typically splits the gained equity in the 70:30, 75:25 or 80:20 ratio in favor of LP team.
Make sure to understand the complete deal structure and ensure you equity is treated equal or better to other equity investors.
Who is eligible to invest?
Investors could be Accredited Investors, Sophisticated Investors and Non-accredited Investors. The financial requirements for these categorizations are set by the SEC guidelines.
Every investment opportunity explicitly states who is eligible and its important to pick the right investment to make sure you are able to tolerate the risks associated.
What to look for in a deal?
Preferred Return (Pref)
Pref indicates the return LPs must get first before GPs. This shows the confidence of the GPs in the deal. Typically this is set between 7-9% and there are deals that have given 10-12% and more in some cases.
Cash on Cash (CoC)
CoC is the return you get from operations, typically also referred to as cashflow from operations.
Internal Rate of Return (IRR)
IRR is the expected compound annual rate of return that will be earned on a project or investment.
Annualized Average Rate of Return (AAR)
AAR is the rate of return averaged over the investment period. This is a flat rate and is not compounded.
Equity Multiple
Equity multiple is represented as the total return including CoC and IRR as a factor of original investment.
Each of these metrics may not alone tell the whole story but a combination of them should be able to indicate the relative confidence of GPs. More than anything, the trust and integrity of the GP team is very important. They can make a good deal turn bad or a bad deal turn good.
Potential red flags...
Number of deals in a year
Some sponsors are super aggressive in putting together multiple deals in a year. Each deal takes anywhere from 3-5 months from the acquisition time to closing time. Hence if someone is doing more than 3-4 deals a year, one should use extra caution to vet the deal completely.
Varying partnerships across deals
The deal performance is mainly depends on the performance of the GP team. Its important to invest with a team that is not opportunistically coming together but through a real complement of skillsets they bring to the table.
Not setting a Pref return
Not setting a Pref return indicates lack of confidence in the deal. One should exercise caution to understand if the GP team is putting their investors interest first.
Not willing to disclose the deal details or keeping it abstract
Not every deal is created equal. There are lots of variations and the GP team should be transparent about the deal structure. Make sure to ask the relevant questions and how deep they go in answering them.
Not being conservative in underwriting
Ask of underwriting assumptions and make sure you resonate with them. If something is too goo to be true, it definitely is. Dont rely on the GP team expertise. Do your due diligence.
Investment Opportunities are by invitation only.
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