Residential Multifamily vs. Commercial Multifamily
Updated: Sep 17, 2020
It’s a debate as old as time for multifamily investors, “Do I start small and work my way up to 1,000-unit sprawling complexes, or like a kid at summer camp, dive right into the deep end?” Spoiler alert! There is no one right answer. Everyone has different investing goals, resources, expertise, and risk tolerance. But after reading this, you should have a slightly better idea of which might be the best multifamily investing path for you.
Just so everyone is on the same sheet of music, let’s first define what we are talking about. Residential multifamily is any multifamily property in the 2-4 unit range, while commercial multifamily is any multifamily property with five or more units. They are similar in many ways, but they also have some very fundamental differences that are worth exploring.
Barrier to Entry
Probably the most significant advantage of residential multifamily is the lower barrier to entry, both psychologically and financially. From the psychological perspective, many people simply can’t envision buying a 100, 50, or even 10-unit building. With price tags easily in the millions of dollars, many just don’t have the exposure or expertise to know how it would be possible. For many, it seems like the investing playground of the rich and famous, or giant, faceless institutions. I completely understand this mental barrier because I had it myself. It wasn’t until I went to an apartment investing conference that I realized it wasn’t that I couldn’t do, I just didn’t know how.
The financial barrier to entry is not so easily brushed aside. Investors can purchase a 2-4 unit property for as little as 3.5% down with an FHA loan, and an amazing 0% down if you are a veteran. I know more than one veteran who has house-hacked for nothing down, buying a duplex, living in one side and renting out the other, effectively living for free. Like with anything, there are caveats here. These low-interest rates usually are only available if you will be living in the property, but it is still a great way to get started in multifamily investing. If you already have a place and don’t feel like moving, then an investment property is likely going to require a much more painful 20-25% downpayment. Banks think you’re more likely to pay the mortgage for your residence rather than that of an investment property, so they’re viewed as higher risk.
On the commercial side, you can expect 20-25% down requirements right off the bat, but it only gets more complicated from there. Many banks require someone with a net worth at least equal to the loan amount to be signing as well. So, unless your bank account balance has 7-figures, then you’re going to need to bring a high-net-worth individual in to sign and compensate them accordingly.
You also don’t necessarily need to have the 20-25% down payment lying around. This is where partnering or syndicating comes into play. You can always partner with someone, pooling your resources to take down a deal, or you can raise money from others (following strict SEC guidelines) to come up with the funds required for a deal. I hope it’s becoming clear that while you may be able to build a nice little empire of 2-4 unit buildings, commercial multifamily is very much a team sport.
Anyone who has made the leap from single-family rentals to 2-4 unit properties, probably did so because they recognized the advantages of scale. If you have four single-family homes and you wind up replacing the roof on each property over the course of the hold period, then you've done so over four different jobs. Contrast this to owning a 4-plex and only having to replace one roof, on time. You can certainly expect to pay a lower price on a per square foot basis for that one job. These advantages of scale are magnified for larger properties.
These advantages extend to services as well. Most property management companies charge 10% of the rental income for a small multifamily property, but when you have tens or hundreds of units, you can leverage your size to negotiate down to a more favorable rate.
One of my favorite aspects of multifamily units is the risk mitigation factor. As with any business, owning rental properties comes with its own set of risks. One of the greatest risks is having a tenant leave. If you have a single-family residence and they move out, you have 100% vacancy and, by extension, zero income. I probably don’t even need to tell the beginners out there, this is bad. Now assuming you have a 4-plex and a tenant moves out, you only realize a 25% reduction in rental income. With the rent from the other three units to keep you going, you can continue to have the mortgage covered even as you renovate the empty unit and advertise to get a new renter in.
Now assume you have a 100-unit apartment. At this scale, having one empty unit is negligible from an income perspective. In fact, anything above 90% occupancy is considered “stabilized” according to banks. Is it possible that a large number of tenants would move out all at once? Sure, but it’s also highly unlikely, and practices like staggering move out dates can avoid this.
Perhaps the biggest difference and the one you’re most interested in, the income potential. Residential multifamily properties are pretty straightforward in this respect. We understand how their value increases because it is the same factors that drive the value of the homes we live in. You can add an extra bedroom, renovate the kitchen or finish a basement to squeeze and extra $10-20k in value out of a house, beyond that though; the value is driven almost exclusively by the area and comparable properties. With residential multifamily, you could also separately meter utilities, which will undoubtedly increase cash flow but may not move the needle much on valuation.
Commercial multifamily in contrast, is valued like a business. To determine the value of a commercial multifamily property, we must first look at its net operating income. Without getting too far in the weeds, net operating income or NOI is simply the money an apartment brings in minus the expenses. The formula for the value of commercial multifamily is NOI ÷ Cap Rate= Value. Cap rate is beyond the scope of this post but think of it as a measure of risk. The higher the cap rate, the greater the risk.
Now assume there was a 50-unit apartment, and due to poor management or it just being outdated, the rents were, on average, $50 below market rates, and the owner was paying utilities. You being the savvy investor you are, having done extensive market research, recognize these below-market rents, and buy it for $5 million. In the first few years after closing, you update some a portion of the shabbier units and institute a utility bill-back program. These and other improvements get you an average increase of $100 per month per unit in income. This raises the NOI for the building to $410k, and that building you bought for $5 million is now worth $5.85 million. Those were relatively modest improvements for an $850,000 increase in value! Of course, this is a super simplified example, but it should help paint the picture of what is in the realm of the possible.
Many single and small multifamily investors have a tough time getting over the idea of sharing the pie. But remember, a small percentage of a big deal is better than 100% of no deal. Although you may have many members of the team and investors to get a syndication deal done, the scale of the potential profits should mean there’s enough to go around. If not, it’s not a deal worth doing.
When it comes to the residential multifamily versus commercial multifamily, I think of them like I think about my kids, they’re each special in their own unique way. One aspect I didn’t have time to cover was the time involved in the different assets. Commercial multifamily syndications can be very time-intensive, depending on your role. Of course, you could always be a passive investor in one of these deals and reap many of the benefits without the time commitment.
So which should you choose? Call me greedy, but I like to have my cake and eat it too, so I do both! I like the idea of owning some assets myself while reaping the benefits of scale with commercial multifamily syndications. Hopefully, this armed you with the information needed to weigh these different asset classes and decide what may be a good fit for your investing style and circumstances.
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