One of the things that attracts me to real estate as a vehicle to wealth creation is that there are hundreds of ways to use it to get to the end goal of financial independence. When people ask me how to use real estate to provide wealth I respond with they first have to read a little bit about all the ways then choose the ONE strategy that resonates with them most and pursue that. For some it will be notes, others like tax sales and still others are comfortable with fix and flips. My strategy involves MHPs and MF. This week we will discuss why multifamily makes sense.
- Economies of scale
Multifamily properties, and by that I mean those properties that are five or more units, allow the investor to control the value of the property. At 5+ doors the property is viewed as commercial. Commercial real estate is valued on its income stream, unlike properties that are less than 5 doors, they are valued on comps.
Let’s look at some numbers. You buy a 10-plex for 500,000 @ a 10 cap. That means that your NOI (income-expenses) is $50,000 (500,000 * .1). You raise rents by $25 a month which equates to an extra $3000 of income. So your NOI is now $53,000 and at that same 10 cap your property is worth $530,000 (53,000/.1). So a $25 rent increase created Thirty Thousand Dollars is value. Now this is a very simplistic example, very real but very simple so that you can gain the knowledge. How hard do you presently have to work to earn $30,000? Yeah I thought so. Pretty powerful stuff. But wait it gets even better.
How much work would it take to increase the price of a SFR or a duplex by $30,000? Multifamily wins hands down.
Some other controls you have are in keeping expense down. Billing back things like, water, electric, and trash to the tenants. Negotiating contractual services down, challenging the amount of taxes you are paying the county. These all decrease your expenses and when your expenses goes down your NOI goes up. When NOI goes up so does the value.
Economies of Scale
In keeping with our 10-plex there are 10 units but only one roof so even when I have to replace that roof it will be cheaper to do so than to replace 10 separate roofs. My favorite aspect of a MF is that when I have 2 or even 3 vacancies I can still pay the bills with the income the property is producing. I don’t have to take money from Peter to pay Paul. With smaller properties it becomes harder and harder. In a SFR once it’s vacant you are footing that mortgage payment, so you better get it back on line quick.
I told you it would get better and these next two are powerful.
Depreciation simple says that the improvements that were done to the land will lose value over time and that you may take that amount as a loss on your taxes. This is pure magic. So you purchased your 10-plex for $500K. For this example let’s say you paid 20% of the purchase price for the land and the other 80% was for the improvements. So you paid $400K for the improvements, this is the amount you can depreciate. Depreciation on MF is based on 27.5 years. So $400,000 / 27.5 = $14,500. So when you file your taxes for the next 27.5 years you can deduct $14,500 from your total income, leaving you with an adjusted lower income to pay taxes on. On larger MF properties you can accelerate the depreciation, resulting in a bigger loss over a smaller period of time. Depreciation also applies to SFR, but it would not be cost effective to accelerate it. Real estate is one of those magical times Uncle Sam acts as your Uncle.
It is true that leverage is an advantage to all of real estate as oppose to just MF but I would be remised if I didn’t discuss it here.
Leverage just means that you use someone else’s money to pay for your property. You are leveraging their financial strength for your gain. Normally this is done through a lending institution and the money you leverage is secure by the property through a mortgage.
Going back to our 10-plex. When purchasing commercial property most lenders will require 20% down payment so that you have some skin in the game. I am always a bit more conservative so we will put 25% down. What other asset can you control for a fraction of the value. Certainly not stocks, or gold, or oil. So at a $500,000 purchase price I will put down $125K. At a rate of 5.25% for a term of 15yrs and an amortization (AM) of 15yrs your payment works out to be roughly $36,000. So $50000 – $36000 = $14000 in cash flow or actual income you are putting in your pocket. That’s an 11% cash on cash (COC). Not too bad. But wait you forgot that you have $14,500 in depreciation, so not only will you not have to pay taxes on that $14000 in cash flow but you also have an additional $500 reduction in your overall income. So your return is really 28500/125000 for a return of 22% so in just over 4 years you get all of the cash you used as the down payment back. That’s the velocity of money and a topic of a future article.
This just touches the tip of the ice berg as they say. When done correctly, meaning you negotiate the best price based on the actual income the property is presently producing, you finance it right by getting the best terms on your loan and manage it right by implementing systems and providing more value than is expected Multifamily properties are a true driver of wealth creation.
How many SFR would you need to research, analyze, make offers on, close and manage to reach your independence number. It’s possible with just one or two MFs.
I’m giving you homework this week.
If you found 100 units cash flowing $100 a door monthly how much would have on an annual basis? How about at $150 a door?
Now do you see the power of Multi-Family.