Perhaps you have thought about looking at commercial multi-family real estate but aren’t sure how to compare that space to other asset classes in real estate? In this article I review some of the factors that make commercial multi-family real estate such an appealing asset class. First off, “commercial” does not apply only to properties such as industrial space, office buildings, retail stores, etc. Commercial in the residential space simply means that a property is 5 or more units as financing on any 5+ unit property will be done with a commercial loan instead of residential loan.
So, what’s to love about this asset class?
1. EVERGREEN ASSET
In Maslow’s 1943 Hierarchy of Needs, shelter falls under the most basic needs of humans. It has been this way since the beginning of time and will continue to be this way for all foreseeable future. Everyone needs shelter, and for a huge portion of the population that need is met by multi-family residential housing (i.e. apartments). In addition to the ongoing need for all humans to have shelter, the demand for affordable housing and apartments is projected to steadily increase in the coming years for reasons of affordability as well as generational preferences. The bottom line is that housing is an ongoing need and that demand keeps an ongoing demand for multi-family housing.
2. ECONOMIES OF SCALE
With a larger number of units under one roof, the per unit cost of doing business is significantly optimized as the revenue from multiple units is utilized to cover the fixed, shared expenses of the entire property. Since many of the costs of operating a property (insurance, maintenance, property management) do not increase proportionate to the number of doors the property expense ratio is more efficient with more units. As a result, a lower expense ratio ultimately means better cash flow and a higher return on your investment.
3. VACANCY FACTOR
Along the same lines as the economies of scale factor, the impact of any one vacancy decreases in significance as the number of units goes up. If you have a single family house and have one vacancy you have a 100% vacancy. That one vacancy can wipe out several previous months of positive cash flow which can really hurt. However, if you are invested in a 200 unit property with 5 vacancies or a 20 unit property with 1 vacancy your vacancy rate that month is only 2.5% or 5%. It is true that tenants of single family homes tend to rent for a longer period of time than multi-family tenants, but the impact of each turnover can still result in a significant impact on your returns over time.
4. VALUATION ON NOI
The valuation of commercial real estate is based on a valuation of the revenue stream (net operating income) it generates. The net operating income, or NOI, is determined by subtracting operating expenses from all income. Note, this does not include debt service in the calculation. Any increase in income or decrease in expense that can be accomplished directly impacts NOI and thus property value. This can be utilized favorably by improving on operational inefficiencies to either increase income (increasing rents to market rate, doing property upgrades to capitalize on higher rents or superior tenant mix) or reduce expenses (bill back utility services, renegotiate service contracts, improve tenant experience to maintain longer leases and reduce turnover). Any of these improvements to operations go directly to improving the bottom line of the property and subsequently increase the valuation of a property by boosting NOI. With capitalization of these increases in NOI, what seems like a small improvement in NOI turns out to be a large increase in property value.
5. LOW RISK
The commercial multi-family sector has historically outperformed nearly all other commercial real estate sectors (office, retail, industrial) throughout multiple economic cycles. Not only has commercial multi-family had better risk-adjusted returns than other asset classes within real estate, but the space has had significantly lower volatility compared to other investments outside of real estate like stocks, bonds, and REITS.
The superior risk-adjusted returns and relatively low volatility of commercial multi-family investments is the reason this asset class has attracted huge amounts of investment dollars from insurance companies and large institutional investment funds.
With so many advantages to commercial multi-family real estate, this asset class is definitely something to consider for either your own hands-on portfolio or through passive participation in the category through syndication opportunities.
Have you invested in commercial multi-family properties or have questions about doing so? Feel free to share your experience or questions.