Are you as much of a cash flow hog as I am? I always have been but I have grown to appreciate the benefits of being an appreciation-focused investor. Fortunately in multifamily real estate investing we can be both, but it is important that we make our choices from an informed perspective.
Investing in multifamily real estate means you should be able to share in the excess cash flow that rental income generates every month. After all the expenses and the mortgage payment and reserves there should be some left over that the property doesn’t need. After all, it’s not Apple or Microsoft, needing to hoard cash so they can buy other big companies. A property is not going to do that. We invest in just one multifamily property, unless it’s a fund of course. That property pays cash flow, operators like us make improvements to it, rents increase, and the value increases. That’s it. We don’t use that money to go buy other properties. We distribute it to our investors.
Investors also share in the appreciation of the property. If we’ve done our job well, the Net Operating Income has risen and so has the property value.
Then we sell it. Or we refinance or we decide to keep holding it for a long time. All are good options but mostly we’ll sell it, then distribute the gains to investors.
Two ways our investors make money, but which way makes them more money? Which way is more favorable for taxes? And even more to the point, which way benefits you as the investor? That’s the choice you have to make as an investor.
Take an example. You are offered a deal with an average annual return of 20%. It will also probably quote you a preferred cash flow of something, say 7%. Keep in mind that the average annual return takes cash flow into account.
But giving investors a preferred cash flow doesn’t mean that is projected to be the average cash flow. It only means that of all the cash flow this property is going to generate, it will all be distributed to investors until it adds up to 7% of their investment. Then if there’s more, maybe it all goes to the sponsors or maybe it’s shared with investors, and that depends on the terms of your deal.
If cash flow adds up to less than 7%, like say 0%, then that’s what investors get. Sucks, huh?
Maybe not.
Look at the property being acquired. What’s the business plan for growing the value of this property? Is this property already in great condition and high occupancy? Then yes, you should expect some cash flow. But if it isn’t those things, there is work to be done and there may not be cash flow for awhile, maybe a long time. It might be “distressed”, which is a very general, not well-defined term that means there have been serious problems at the property. It could be any of a number of things, like low occupancy, high level of unpaid rent by tenants who are still living there, criminal activity like drugs or gangs, a neighborhood that’s become pretty scary, a fire or natural disastrous event took place, or the owner really didn’t care and never fixed anything.
Believe it or not, many investors love those kinds of properties, and make big money with them. But buyers of those properties need to have a level of skill (and fortitude!) that is higher than most of us have. They need to know that the problem can be fixed, how much it’s going to cost, and how long it will take. Gangs? Tell them they need to leave and they may not go quietly. Flood? How many times have we seen the 100 year flood come back two years later.
So those investors pick up properties like these for a song, and then they go to work making the improvements, fixing the problems. If this appeals to you, be sure you invest with a team that has done this successfully multiple time, that the returns are higher than other multifamily returns to account for the extra risk they’re taking on, and that their projections are reliable, not optimistic.
There is a happy medium, the kind of property that throws off some cash flow but has big appreciation potential, although these opportunities are rare. Every sponsor wants the property to have huge upside potential without having to do much work. It just needs some superficial upgrades and the owner has kept rents several hundred dollars below market. These are rare and you’ll end up with no real estate investments if that’s the threshold you set.
You’re thinking about your taxes as well. If a property is going to pay you 7-10% cash flow distribution, that’s all taxable income. If you’re already making decent money in your job, this cash flow probably doesn’t change your life. You’re not going to spend it, you’re going to save it.
So then, why do you even want it if you have to pay taxes at your ordinary income tax rate? If you get your investment and your gains back only when the property is sold, you’re paying a capital gains tax rate on the gains, usually better than your marginal rate, most of the time much better.
Why not trade cash flow for appreciation? That opens up a lot of opportunities to you that you may have missed. Sure, cash flow is a sign that the property is doing well. That’s what they say, but if you don’t have other ways to determine this, you’re not looking very hard.
This is investing for the long term, making bigger returns, growing your wealth faster. When you have enough, you put it in real estate that pays cash flow and you retire.
If you want an investment that only pays you when it is sold, look closely at the property, and even closer at the team. You have to truly believe they can do what they say they can do, because deals “with a little hair on them” as they say, come with risks. Personally I won’t touch most of them because I’m more of a risk averse investor, but there are absolutely a lot of multifamily properties who have slipped into a condition where the owner is just not able to bring it back. They might have even given it back to the bank. A lot of properties like that.
And there are very good operators who know what these look like, who know if that submarket will provide the income to make an investment in renovations pay off. It doesn’t have to be scary. It does have to be better returns than you’d get from a stabilized property, though.
Market update
Richmond, VA – Not generally considered a hot multifamily real estate market, Richmond has shown surprising strengths over the last several years. It suffered the same job reductions as nearly every city in the beginning of covid but has averaged 3.7% job growth per month year-over-year over the last 18 months. Job growth over 2% is a good sign of an emerging market.
Its population of 226,000 represents growth of 15% over the last 20 years. Generally we like to see more substantial growth but it points to a strong future, and certainly not out of line with U.S. population growth of 16% in that same time period.
What’s exciting about Richmond? Start with its history, its first settlement in 1611, both Revolutionary and Civil Wars. Why do we care about the history? Because cities rich in history are cities that featured special physical and geographical qualities that were recognized long ago. They were settled early and attracted population growth and commerce because of those features. And they still have those qualities today.
Richmond was discovered and settled because it was on navigable water but was protected because it was upstream on the James River. Then the colonies were formed and it was central in Virginia, and now it is Virginia’s capital. As a capital city it has benefited from the growth of the state government, but there’s much more to Richmond than the government.
In a trip I made to Richmond 30 years ago, people smoked in the offices. No other office environment I had been in for years prior to that was allowing smoking in the office, but these offices in Richmond still did. They emphasized that Virginia had been a primary tobacco growing region since the 1600’s. And as you recall, tobacco was America’s leading export to European countries for decades – centuries actually. When the rest of the U.S. was coming down hard on public smoking and second-hand smoke, Virginia was one of the last holdouts. Tobacco, safe to say, was the prominent industry through at least the 80’s and 90’s.
But not any more. Like oil & gas in Oklahoma, times change, industries change, and smart city leadership embraces the change. Richmond has clearly embraced several new industries through tax and regulatory encouragement but also through recruiting incentives.
Altria, previously named Phillip Morris, is still a big employer but of the 50 companies with the most employees in Richmond, Altria is the only “Cigarettes” company. The others include financial services, health care, energy, banking, insurance, chemicals. These are high paying jobs, reliable employment, not subject to the cycles, and – you guessed it, highly recession resistant.
These are qualities we look for in real estate markets.
As if that wasn’t enough, household income rose 65% to $51,000 over the last 20 years, and house values rose from $87,000 to $311,000, an increase of 257%. That’s almost unheard of.
What we hear over and over is “these real estate prices have risen so far, no one can afford it any more”, or “… the massive price increases are all behind us”. That’s almost always wrong.
Average rents have dropped about a percent since this time last year but are up about 3% so far this year. Richmond’s rent growth rate of .7% over the last month puts it at the #34 position of rent growth in large cities in the U.S., according to ApartmentList.com. That’s a very positive trend.
Add to that a very comfortable southern lifestyle and easy access to the east coast’s most attractive cities, coastal towns, and mountain retreats, and Richmond should be one of our target markets for multifamily real estate investment.
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Finer Points of Multifamily Properties
Advantages of 1-Bedroom and Studio Apartments
I can speak from experience that 1BR and Studio apartments can be great investments. My team purchased a property two years ago with only 1’s and Studios and are selling it, getting strong interest even in today’s high-interest rate market. We did the renovations and lease-ups, left a lot more for the next owner to do, and buyer interest has been impressive. I’ll share more as it progresses but I can say it is a sign of two things: that the market for multifamily assets has improved in recent months, and that smart buyers recognize the benefits of smaller, nicely remodeled units.
Many of us have been taught that we should buy properties with more 2BR units than 1BR, even as much as twice as many, and preferably some 3BR units too. 2BR units are sought by families and families are more stable tenants. There’s a lot of truth to that, but there are other aspects to consider.
First is your submarket. Who is looking for apartments. Are they families or singles. You can learn this from property managers.
Second, check Costar reports. What is the vacancy of 1BR units vs. 2BR units. That tells you where the demand is and what the availability is. If vacancy is lower for 1BR units, maybe there aren’t so many 1BR units in this market.
Third, who are the employers. When the employers are in high tech, research, or manufacturing, the employees are better paid and more likely to have families. Certainly other industries have these qualities as well but you need to know who they are. But if the big employers are in medical services such as health care and hospitals, and when the industry is highly cyclical like oil and gas, there tend to be more transient workers. These workers will stay for a couple of years but know that they’ll probably move on after that. They’re less likely to have a family and less likely to want to plant roots.
Fourth, look at rent per square foot. For a given building square footage, you can get more 1BR and Studio units in it than you can 2BR units. This isn’t a huge difference and by itself would not justify choosing smaller unit properties.
And fifth, look at turn times. Turnover rates too. The time it takes to find singles to rent a 1BR or Studio is typically less than it takes to find renters for 2BR units. Not always, and if marketing is good, the difference is negligible. Conversely, turnover is higher for 1BR and Studio units. That’s a downside, and it could be a significant one. Your marketing needs to be finely tuned so you’re ready to do any fixups or renovations as soon as a tenant moves out, and you’re ready with prospective applicants.
I’ve had several properties with only 1BR and Studio units, and would not hesitate to acquire more. We take care of the tenants, we’re proactive with turnovers, and we create communities. These all go a long way to minimize the disadvantages of owning smaller units.
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