From a recent conversation with one of our investors:
“You mentioned going from 5 units to a 60 unit building. That seems like a big junp? What are the risks of using leverage? I’m hesitant to do this, but then I hear about people being able to achieve this “perfect” situation where they get a mortgage and the tenant essentially pays for it while the property cashflows. Is this realistic?”
I thought that others may also have similar questions.
There are many ideas wrapped in here. I’ll unpack them one by one:
I also thought that going from 5 to 60 units is a big jump.
Buying apartments isn’t that much different than buying a 5-unit. It’s scalable. It’s like buying in bulk. One deal. One selling party, one contract, one transaction, one loan, one inspection, one appraisal, one property management company, etc. Compare this to what it would look like for acquiring 60 single family homes. There will be 60 sellers, 60 contracts, 60 inspections to pore through, and much more. Not to mention 60 commissions and title/recording/legal fees for each property. Depending on the location, one may need to hire multiple property managers, too. There are efficiency and scalability in buying in bulk. Not only is the acquisition process more efficient, but ongoing management/maintenance of the units is more streamlined. One management company, one roof(or few), one(or few) lawn to maintain. One unit becoming vacant has a minimal impact on a 60 unit apartment, but a single family house can have the entire year’s profit wiped out with even one month vacancy or a big repair.
One needs to do proper research for finding and underwriting deals, finding lenders, and building a competent team. There are many moving parts, but if the investor studies them one by one, it’s not really that complicated. The best news is that these information are publicly available and what I did is within the realm for most people. For me, the realization that this was within my reach was the pivotal point. I was trying to sell my triplex to buy another 3 or 4 units, but an experienced investor explained to me that buying apartments instead is smarter. I had no idea how to do it, and I didn’t even consider it because I didn’t think that it was feasible. It seemed so daunting, but the investor patiently explained how I can qualify for a commercial loan, how managing an apartment isn’t harder than managing a few units, and how buying an apartment is more efficient than buying single family houses. He wasn’t necessarily my mentor, but my brief conversation with him had a huge change in the trajectory of my life. He planted a seed in my mind, and I kept watering it. I read and watched everything I can find on apartment investing and talked to everyone that I could including brokers, lenders, property managers, and other investors. I put together the building blocks one by one, and eventually consummated on 2 deals in Columbus with my partner. Now having done those deals, I understand the magnitude of the advantages of multifamily compared to smaller properties.
As far as leverage and risk is concerned-
There is always a risk. Always. The buildings can have problems, the tenants can be problematic, the economy can take a nosedive, and one can incur some black-swan event like a world-wide pandemic. In order to mitigate the risks, Elevate Real Estate Investments applies 3 principles to our investing strategy –
Buying for cashflow, securing a long term debt, and having adequate reserves.
Buying for cashflow
In San Francisco or Los Angeles, unit prices are very high compared to the rents. Most assets won’t cashflow if you take out a loan with high leverage. A common strategy there is to buy in cash and hold because market appreciation is particularly strong in these areas. This is similar to speculating on a stock that looks promising and buying it. The downside is that you won’t be able to capitalize on leverage. A large amount of capital is required and is tied up to one asset. The performance of the asset is also dependent on the accuracy of the investor’s speculation. If the investor decides to use leverage, he/she may incur break-even or negative cashflow while waiting for the asset to appreciate. This style can be more volatile.
Now if you were to invest in the Midwest or other markets with lower unit prices, you can certainly structure the deal where it cash flows. The investor can also take advantage of leverage to supercharge the growth of his/her portfolio. With relatively smaller amount of capital, the investor can acquire larger deals. The downside is that market appreciation is much weaker in these areas compared to LA/SF. One might expect 3% increase per year in the Midwest compared to 10% in coastal cities. The good news is that the 3% appreciation is based on the full price of the asset, but since you are leveraged, your returns compared to the deployed capital is still very lucrative. If the asset is $1M, you deploy $200k. It appreciates 3%/year. $30k gain on the full asset price. But the deployed cash is only $200k. 15% gain.
There are pros and cons for both strategies, and our core strategy is buying for cashflow rather than appreciation. This doesn’t mean that we don’t expect appreciation; it’s that our underwriting is based on the property being able to cashflow so that it can withstand market downturns. If we encounter recession, we can still enjoy the monthly cashflow and patiently wait out the market to recover. This can be a lot more stressful and challenging if the property is not cashflowing.
Securing a long term-debt
This strategy calls for getting a loan term that is at least as long as our projected hold period, with some contingencies baked in. This is important for mitigating market risks. If one were to have a loan term that is shorter than the projected hold period, then the investor is forced to sell or refinance at the maturation of the loan. If the market has turned South at that point, this could be a precarious situation. The investor may not be able to refinance and be forced to sell at a loss. By securing a longer term debt, the team can have more option to wait out the economic cycles and sell/refinance at an opportune time. For our current portfolios, we secured 10 year loans, but our projected hold period is 3 years. This gives us plenty of options to wait for and sell at a favorable time. In addition to securing a long term debt, the investor must not be over-leveraged where the property can go underwater during economic downturns. Leverage can be a great tool for supercharging the returns, but the investor must use it wisely where he/she procures a term longer than the hold period of the investment and also avoiding over-leveraging.
Having adequate cash reserves
This one may seem obvious, but it’s very important for our risk mitigation strategy. In addition to conservative underwriting, the investor must account for a generous capex budget and have adequate reserves. Capex are things like roofs, parking lot, AC, furnaces, hot water heaters, appliances, floors, window, etc. These are not regular operating expenses, but still need to be accounted for. If the investor has to replace the roof one year and he/she didn’t budget for it, they are in for a nasty surprise. So all these expenses must be budgeted for ahead of time even though they are not imminently required. On top of accurate capex budget, the investor must account for adequate reserves. Rainy day funds for unexpected events. It’s nice to have emergency money to hold over for a few months while dealing with an unexpected catastrophe. The amount of reserves depend on the asset class/location/age, but we typically keep anywhere from 5-10% of the asset price in reserves.
While it’s impossible to eliminate every risk, at Elevate Real Estate Investments, we do our best to mitigate the risks by applying the 3 key principles mentioned above – Buying for cashflow, securing long term debts, and having adequate reserves. The good news is that a lot of these variables are within the investor’s control.
The tenants paying down the loan and having cash flow?
Yes, it is very possible and feasible. In fact, we can do even better. In addition to cashflow and principle pay down, real estate can enjoy market/forced appreciation and various tax advantages.
These are what I call the 4-pronged approach in generating returns.
Cash-flow
This is what you have leftover in rents after all expenses. If the investor bought right, this number should be positive. Even if the market fluctuates, if the asset is cash-flowing, the investor can patiently wait for the market to turn.
Principle pay down
The tenants pays for the mortgage on the property, and each month, the loan principle gets paid down. If the investor holds for long enough, he/she will own the building free and clear! This is why banks are eager to lend on residential real estate vs if one were to get a loan for investing in stocks, for example.
Appreciation
Real estate enjoys 2 kinds of appreciation – Market appreciation and forced appreciation. Market appreciation is simply dictated by the supply and demand of the market. As mentioned above, some coastal cities are strong in market appreciation.
Forced appreciation is pretty cool in a sense that the investor can have a direct impact on the appreciation of the asset. Commercial properties(4+ units) are valued based on the income the property generates. If the investor can increase the financial performance of the asset, he/she “forces” the asset to appreciate. This is where things get really exciting. Basically if the investor increases income for the property(increasing rent/decreasing expenses), he/she kills two birds with one stone-
Monthly cashflow increases, and the asset value increases. The increase in cashflow has a direct and predictable impact on the increase in asset price, therefore it’s called “forced appreciation.” Forced appreciation is very formulaic, and it gives the investor control of the performance of his/her asset. The investor can also generate excellent returns from forced appreciation. Returns of 16%+/year are not uncommon.
Tax advantages
There are many unique tax advantages that are available to the real estate investor. It’s as if the IRS supports and encourages real estate investing. Among many, 1031 exchange allows the investor to defer his/her capital gains tax and roll it in to his/her next investment. Depreciation allows an investor to decrease his/her taxable income by claiming “depreciation” of the asset although it is actually increasing in value.
In addition to the 4-pronged approach outlined above, multifamily real estate has proven to be resilient during recessions and less impacted by inflation(rents typically increase with prices of other consumer goods)
To sum it up, going from 5 to 60 units was a big transition, but something that is very feasible to those who are willing to take a big step and work hard. There are risks to leveraging, but a lot can be mitigated through conservative underwriting, buying for cashflow, securing a long term debt, and having adequate reserves. Not only can one cashflow and pay-down the principle, he/she can also enjoy market/forced appreciation and many tax advantages on top.
Ki Lee