The reasons why multifamily apartments are a safest and smartest investment for active and passive investors is that they have several near term and long term benefits not available in any other asset class. In this series, I’ll highlight six standard ROI and income drivers you should keep in mind.
Cash flow is total income minus the expenses. In other words, the money you have left over from the collected rents after all expenses have been paid. With stocks, mutual funds, art, etc. an investor is hoping what they purchase will appreciate in value allowing them to sell it later for a profit. Because this is the most commonly practiced form of investing, people are left with is the subconscious understanding that to “invest” means to buy something you believe will be worth more later. In my opinion, this is more gambling and speculation than investing. As wise multifamily apartment investors we don’t bet on appreciation. We along with our passive investors, purchase properties based on cash flow. Better said, the property will generate more income than it costs to own. That way, we decrease our market condition-based investment risk. If prices drop, we are safe. If prices rise, we have more options.
Forced appreciation refers to the value that is created when an investor improves a property to make it worth more. Unlike natural appreciation, where you are at the mercy of the market and factors you cannot control, forced appreciation allows apartment investors an option where we can increase the property’s value. Forced appreciation with apartment investors is to buy a value-add property and improve its economic performance through interior and exterior renovations/upgrades and by decreasing operating expenses, thereby adding value. The key is to look for apartment properties with less property amenities or unit features, add what they are lacking to create value then raise rents. For companies like ours, Syndication Capital, we work hard to find and purchase these types of apartment properties. The resulting forced appreciation makes a big positive financial impact for us and for our investor partners bottom lines.
Principal Pay Down
When you take out a loan to buy multifamily apartments, you typically pay it back with the rent money from the tenants. One of the best parts of investing in this asset class is the fact that not only are you cash flowing, but you’re also slowly paying down your loan balance with each mortgage payment. In the beginning of these loans, the majority of the payment is going towards the interest of the loan, not the principle. This means you aren’t making much of a dent in the loan balance until you’ve had the loan for a significant period of time. With each new payment, a larger portion goes towards the principle instead of the interest.
After enough time passes, a good chunk of every payment comes off the loan balance, and wealth is created in addition to the monthly cash flow. The best part is, it’s your tenants are paying this off for you, not you. It’s typical to see 2-4% of nearly automatic equity created every year because of this. For us and our passive investor partners, principle pay downs of the loan is another way apartment investing works to grow our wealth passively, with each payment bringing us one step closer towards financial freedom.
A multifamily apartment is one of the most tax advantaged investments anyone can ever make. As one of the tax benefits of investing in apartments with us, the depreciation amount is such that passive investors won’t pay taxes on their monthly, quarterly, or annual distributions during the hold period, which can be anywhere between 5-7 years depending on the business plan.
Another tax benefit is tax-free refinancing. Extraction of excess equity in the property via a cash-out refinance can be reinvested into an additional income producing asset. The ability of passive investors to redeploy received equity them to accelerate a return on equity dramatically. The money pulled from such a refinance is tax free and not considered by the IRS as a taxable capital event.
Lastly, when a multifamily apartment is sold the capital gain realized can almost indefinitely be deferred using a 1031 Exchange. This strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long another like-kind property is purchased with the profit gained by the sale of the first property. While there are rules you have to strictly follow when completing an exchange, the ability to defer capital gain and leverage that into a new investment removes a huge obstacle on performance that no other investment class has.
Multifamily apartments are one of the easiest assets to leverage. Not only is it easy to leverage the financing of it, but the terms are incredible compared to any other kind of loan. Interest rates are currently below 5%, and loans are routinely amortized over 30-year periods. Where else can I borrow money from a lender to purchase a value-add property for 25% of its total value, increase the value of the property through forced appreciation, while simultaneously paying the loan back with the money collected from the tenants…but there’s more. The lender financing ultimately creates a multiplier effect on invested capital. Here’s an example of what that looks like: If we purchase a 250-unit property for $25 Million in cash and it appreciated
$2,500,000 due to rental increases in the market, that’s a 10% (equity gain). On the other hand, if we purchased the $25 Million property with 30% down ($7,500,000) with a debt lender (say Fannie Mae) provides the remaining balance…that same $2,500,000 equity gain is now a 33% return on investment. This is a 230% increase in our returns and allows us to control an asset with a lot less initial capital.
It may not be talked about often enough, but inflation is a huge reason why real estate creates wealth so powerfully over time. When you consider all the benefits of investing in real estate, then include inflation, it’s amazing why more people aren’t taking the steps necessary to invest in multifamily apartments as they can. The fact is as the Consumer Price Index and the Producer Price Index indices rise so do rents and building costs. This increases the value of currently operating assets because increasing rental income increases the value of the property. And, increasing build costs create some degree of a value floor for operating assets. And, that the majority of the big expenses (mortgage, property taxes) typically stays fixed for the time the property is held. When you put all the benefits together in this series it’s easy to see why multifamily apartments are a strong investment for active and passive investors and should be a part of any serious investor’s portfolio.