What is Multifamily?
Multifamily Apartment in the United States has always been the most popular investment strategy in commercial real estate. The entry barriers for multifamily rental apartments in the US are low, allowing investors to enjoy stable rental returns. After the property has been renovated and upgraded, the rent can be adjusted, therefore driving the property price to appreciate. Multifamily is an ideal investment strategy that can generate cash income against inflation.
Multifamily Apartment refers to residential properties that host multiple units under a single title for rental purposes. In the US, a Multifamily with more than 5 households is considered a commercial real estate. While its financing, operation and leasing is being professionally managed, Multifamily is very different from a single residential rental property.
There are approximately 21.9 million multifamily apartments in the United States, hosting more than 40 million tenants, accounting for 46% of the overall rental population and 17% of all households.
US economic fundamentals have been impressive, while employment has remained strong over the past decade. At the same time, residential property prices have led to record highs, due to the shortage of housing supply under the low interest rate environment. People who missed the buying opportunity after the subprime crisis have been unable to catch up with the property price. Their buy-vs-rent decision has gradually tilted towards renting.
As the most popular commercial real estate sector, Multifamily investing can enhance the economy of scale. The investment not only generates stable rental income, but also produces great upside return potential.
Office buildings are divided into Class A, B and C based on quality. The premises can be multi-tenant or single-tenant, and some are even tailor-made for single enterprises.
Provide premises for industrial or logistics operations. Most of them are located outside the city center, generally close to major traffic hubs. Some low-rise buildings can also be classified as industrial parks, which can be further classified into heavy industry, light industry, warehouses, data centers etc.
Retail are usually store and restaurant properties. Shopping malls are multi-tenant, often anchored by a single anchor tenant, for the sake of adding traffic to the property.
A hotel provides accommodation, catering and banquet services for travelers. Hotels can be independent boutique hotels, including hostels and homestays, or chain-operated hotels. Limited-service hotels offer room service only and do not operate restaurants or concierge services, while full-service hotels offer a full range of facilities such as guest rooms, restaurants, and banquet halls.
Multifamily apartments are residential for rental purposes, while apartments with more than 5 families are commercial real estate. Like office buildings, multifamily properties are typically classified into Class A, B, and C.
Why invest Ｍultifamily?
According to the National Multifamily Housing Council (NMHC) and National Apartment Association (NAA) research, which predicts future demographic trends and rental preferences, to meet the needs of future tenant growth, the market will require an additional 4.6 million units by 2030. This is equal to an average of 328,000 new units built per year.
The decade of 2010s marked the lowest percentage of housing supply relative to population in the U.S. history. According to the Census Bureau, the ratio between new built housing units and new household formation further confirms this phenomenon. Between 2006 and 2008, the ratio was even higher than 2, validating the period of overbuilding. The ratio was then below 1 in years after the financial crisis and still remains underbuilt in 2020. The number of new apartment built in 2016-2020 averaged only 270,000 units per year (vs. 328,000 units in long-term trend demand).
Housing is always a necessities of life regardless of the economic environment. With persistent demand, the occupancy rate of Multifamily has remained around 95% in a long run, making it a recession-proof investment. Investment demand for multifamily apartments has remained resilient even during the pandemic.
The Association of Foreign Investors in Real Estate (AFIRE) in a 2021 market study of its members showed that in the next 3-5 years, 74% of its members will increase their investment in real estate in the United States, far more than anywhere else.
- Country’s macro environment ( economic and political stability)
- Market transparency and depth ( transaction volume, institutional participation, exit options)
- Financing support provided by the banking system.
The top three factors that attract capital into US real estate are: 1) asset quality, 2) portfolio diversification and 3) income returns.
Especially for foreign investors, the US has a large population and liquidity that can provide enough diversified investment options, which is difficult for other single-country markets to satisfy.
Cap Rate refers to the ratio between the annual net income (Net Operating Income, or NOI) and the prevailing market price of a property. It serves as a yardstick to compare market’s valuation of properties. For example, if a property has an annual net income of $50,000 after deducting the vacancy rate and operating expenses, and if the prevailing market’s Cap Rate for the property is set at 5%, then the fair market valuation should be $1 million. This concept is similar to the price-earnings ratio (PE Ratio) of a stock.
According to CBRE, the Cap Rate ranking of different types of commercial real estate in the United States (from low to high) is:
Multifamily Apartment < Office < Industrial < Retail < Hotel.
This is also considered the ranking from low to high risk.
Investment manager conducts due diligence to evaluate the asset’s potential for investment. The property’s neighborhood is essential, such as transportation, amenities, employment, school district, demographics, supply and demand in the surrounding market, etc.. These are the basic factors to consider for long-term investment. For value-add strategy implementation, the property itself must also have some room for improvement. Therefore, managers rarely acquire new properties and rarely acquire Class A properties. Class B properties built for 20-40 years and with more than 200 units with upgrade potential are generally favored by managers.
Value-add strategy is to renovate, upgrade and reposition the property, in order to improve living conditions and gradually increasing its rent and value. After the rent is stabilized and the property price increases, the property can be sold and cashed in for profit.
Out of the entire investment proceeds, around 5-12% is reserved for capital expenditure (CapEx) for renovation.
Take a 500-unit apartment complex as an example. The purchase price is $60 million, and there is an extra $4 million is reserved for renovation. The average renovation budget for each unit is $8,000. After the renovation, the monthly rent per unit is expected to increase by $200 and the annual rent by $2,400. This means the renovation budget alone can generate 30% extra investment return.
The goal of renovation is to improve the overall appeal of the property, thereby increasing the occupancy rate and rent income.
Renovation projects generally pursue visible results. Exterior renovations are mainly on appearance, such as repainting, aisles, gates, fences, and clubhouse facilities. Interior renovations focus on tenant experience, especially kitchen and toilet countertops, floors, paint and gates. Part of the budget is used to repair basic utilities such as lighting, water and electricity which can reduce property maintenance costs in a long run, and thus increase property net income.
From tenants’ perspectives, they value the surrounding neighborhood, quality, amenities and supporting facilities of the property. After major repairs, the living environment of the old premises can be comparable to that of new premises. Of the same location, Class B value-add property rents are less expensive than Class A property rents. Therefore, value-add properties are attractive to tenants.
The investment horizon of the real estate fund is more than 5 years. After renovation, the annual rental income of the unit can be increased by 10-20%. With the leverage effect of the loan, the Net Operating Income (NOI) will increase by 30- 50%.
Combining the rental cash incomes throughout the investment period, plus the capital appreciation at the final sale of the property, after deducting various expenses, the net investment return over the entire period can exceed 70%. This means an average annual internal rate of return (IRR) is more than 10%.