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The Benefits of Investing in Multifamily Real Estate

Updated: Jul 11, 2023

Real estate has long been recognized as a solid investment option, providing both income generation and long-term wealth appreciation. Within the vast realm of real estate investments, multifamily properties have emerged as a highly attractive and rewarding asset class. In this blog post, we will explore the benefits of investing in multifamily real estate and shed light on why it has become a popular choice among savvy investors.

Apartment building

1. Stable Cash Flow:

One of the key advantages of investing in multifamily real estate is the potential for stable cash flow. By owning multiple units within a single property, investors can benefit from a diversified rental income stream. Even if one unit becomes vacant or faces a temporary setback, the cash flow from the remaining occupied units helps mitigate the risk and ensures a consistent flow of rental income. Moreover, rental income from multifamily properties tends to be more predictable compared to other real estate sectors.

2. Scalability and Economies of Scale:

Multifamily real estate offers significant scalability opportunities. Investors can acquire properties with multiple units, allowing for the potential to generate higher returns compared to single-family homes. The more units within a property, the more potential income streams and the greater the economies of scale. By spreading operating costs and management expenses across multiple units, investors can benefit from cost efficiencies and higher profitability.

3. Long-Term Appreciation:

Beyond cash flow, multifamily real estate has the potential for long-term appreciation. Over time, well-located properties in desirable neighborhoods tend to appreciate in value, allowing investors to build equity and increase their net worth. Population growth, urbanization, and limited housing supply often contribute to the appreciation of multifamily properties. Additionally, improvements made to the property and the ability to increase rental rates over time can further enhance the overall value.

4. Hedge against Inflation:

Multifamily real estate investments are considered a natural hedge against inflation. As living expenses rise, rental rates tend to increase as well, enabling property owners to adjust their rental income accordingly. This inflation protection feature helps preserve the purchasing power of rental income and provides a valuable safeguard for investors during inflationary periods.

5. Professional Property Management:

Investing in multifamily properties offers the advantage of professional property management services. Hiring a reputable property management company can alleviate the day-to-day responsibilities of property upkeep, tenant screening, rent collection, and maintenance, allowing investors to focus on other aspects of their portfolio or personal endeavors. Professional management expertise ensures efficient operations, tenant retention, and maximizes the property's performance.

Investing in multifamily real estate presents a compelling opportunity for individuals seeking steady income, long-term appreciation, and diversification within their investment portfolio. The combination of stable cash flow, scalability, potential for appreciation, inflation protection, and access to professional property management makes multifamily properties attractive choice for investors.

Apartment building

As with any investment, thorough due diligence, market research, and a sound investment strategy are essential. Engaging with experienced real estate professionals and financial advisors can further enhance the likelihood of success in the multifamily real estate market.

By harnessing the power of multifamily real estate, investors can unlock a wealth-building asset that combines ongoing income generation, long-term appreciation, and the potential for significant financial rewards.

The cap rate formula

Annual net operating income (NOI)/the property’s market value

Calculated by dividing a property’s net operating income by

Cap Rate

its asset value, the cap rate is an assessment of the yield of a property over one year. For example, a property worth $14 million generating $600,000 of NOI would have a cap rate of 4.3%. That means that you can expect a roughly 4.3% annual operating cash flow given the price paid for the property.

What’s a good cap rate? It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return.

Some elements that affect a property’s cap rate are hyper specific. For example, a gas station may have a different cap rate based on which side of the street it’s on—en route to work or on the way home. But larger forces are usually at play.

Source: CoStar, Q2/2022
Source: CoStar, Q2/2022

The impact of interest rates on cap rates

High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. Cap rates tend to have a narrower range than interest rates, particularly over the short term, Gilbert said. For example, if a building’s cap rate is 4.3%, it may only rise to 4.6%, depending on economic conditions and the property supply and demand balance in a given market.

In recent months, the relationship between interest rates and cap rates hasn’t followed a 1:1 relationship. Rather than mirroring interest rates, cap rates have remained stubborn, especially for multifamily and industrial properties. But according to First American’s 2022 Q1 Potential Capitalization Rate (PCR) Model update, that is changing due to decelerating price growth and continued interest rate increases, both putting upward pressure on cap rates in the second and third quarter of 2022.

How other macroeconomic factors affect cap rates

Interest rates aren’t the only economic element influencing cap rates. Other factors include:

  • Rent growth: Rent growth can accelerate during periods of higher inflation, particularly in apartments with short-term leases. The anticipation of higher rents and greater NOI can offset higher interest rates. Likewise, deteriorating economic conditions can add upward pressure on cap rates and slow rent growth. “Through the second quarter of 2022, apartment and industrial rent growth has been strong, allowing cap rates to remain relatively stable in the face of rising interest rates,” Gilbert said. “More recently, rent growth has slowed. It remains to be seen if the pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rate.

  • Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment reflect the health of the economy. When GDP is high and unemployment is low, commercial real estate investments tend to have lower cap rates. When GDP is low and unemployment is high, there’s a greater risk associated with investment properties. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint—as well as the prevailing economic conditions and outlook.

  • BBB spreads: “These investment bonds really measure the perception of credit risk of the market,” Gilbert said. “If we think things are overbuilt or there’s going to be a recession in the near future, BBB credit spreads tend to widen, which would drive cap rate spreads higher above the 10-year Treasury rate.”

  • Location: Proximity to the city’s employment center, highways and public transit also influences cap rates. Higher demand and stable locations generally have lower cap rates, while transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand. This can lead to higher tenant turnover, leasing costs and other factors that impact operating cash flows.

  • Asset class: Cap rates vary across asset classes. Multifamily and industrial buildings usually have the lowest cap rates. The weight of several economic measurements may also vary based on asset class. For example, personal income is a major factor for multifamily and retail properties, and durable and nondurable goods spending is especially important for industrial properties.

The formula to calculate the cap rate is as follows:

Cap Rate = Net Operating Income (NOI) / Property Value or Purchase Price

Let's break down each component of the formula:

  • Net Operating Income (NOI): Net Operating Income is the total income generated by an investment property after subtracting operating expenses but before deducting interest, taxes, depreciation, and amortization (commonly referred to as EBITDA). NOI is a key figure that provides a clear picture of the property's cash flow potential. It includes rental income, additional income sources (such as parking fees or laundry), and other revenues from the property, minus operating expenses like property taxes, insurance, maintenance, utilities, and property management fees.

  • Property Value or Purchase Price: The property value or purchase price represents the market value of the property, which can be determined through appraisals, comparable sales, or market analysis. It is the amount an investor paid or the estimated value of the property.

Interpreting Cap Rate:

The cap rate is expressed as a percentage and helps investors understand the expected return on their investment. A higher cap rate indicates a higher potential return, while a lower cap rate implies a lower return.

Here are a few key points to consider when interpreting cap rates:

1. Market Comparison: Cap rates provide a valuable tool for comparing similar investment properties in a market. Investors can assess whether a property's cap rate is higher or lower than the average cap rate in the market. A higher cap rate relative to the market average may indicate a potentially higher return, while a lower cap rate might suggest a lower return.

2. Risk and Value: Cap rates are influenced by factors such as location, property type, market conditions, and investor preferences. Higher-risk properties or those in less desirable locations may have higher cap rates to compensate for the increased risk. Conversely, prime properties in sought-after locations might have lower cap rates due to their perceived stability and value.

3. Individual Investment Strategy: Every investor has their own investment strategy and desired return. Cap rates serve as a benchmark for assessing whether an investment aligns with an investor's financial goals and risk appetite. Some investors may prioritize higher cash flow in the short term, while others may focus on long-term appreciation potential.

It is important to note that cap rates have limitations. They do not take into account financing costs, taxes, or potential changes in the property's value over time. Additionally, cap rates should be used in conjunction with other financial metrics and considerations to make a well-informed investment decision.

Cap rate is a fundamental metric used in real estate investing to evaluate the potential return on an income-generating property. By comparing the property's net operating income to its market value or purchase price, investors can gain insights into the property's profitability and make informed decisions. While cap rates provide a valuable tool for assessment, they should be used in conjunction with other financial analyses and considerations to fully evaluate an investment opportunity.

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