Challenges of & Alternatives to Multifamily Investing
Why did you begin investing in real estate? Financial freedom, right? And so you chose the multifamily asset class. Most investors just starting out do as well because it’s familiar. I started out the same way.
But was it the best long term decision? Is now the time to take the next step?
Let’s address reasons why now may just be the best time to move on from multifamily and possible alternative real estate investments.
Tenants
One of the most significant challenges of investing in multifamily properties is managing tenants. In addition to finding good tenants, landlords must also be prepared for potential tenant damage, which can lead to additional repair and maintenance costs. Additionally, fair housing law violations and penalties can result in costly legal fees and damage to a property's reputation. For example, landlords can face legal action if they are found to discriminate against tenants on the basis of race, religion, gender, or other protected categories. Lastly, some communities have long eviction processes sometimes exceeding nine months. That's after at least three months of non-payment; that's a year's rent lost. Each of these potential tenant challenges can reduce the overall value of your investment property.
Property Managers
Another challenge for investors in multifamily properties is selecting a trustworthy and reliable property manager. Having a truly excellent property manager is vital for operating a profitable multifamily property, especially if investing far from your location. However, in my commercial real estate practice, I hear 2-3 horror stories every week about ineffective if not unethical property managers. This type can cause irreparable harm to your investment. Many don't use modern reporting technology nor keep up with market rents. Mismanagement of capital expenditures can cost you more income while not even investing in vital property improvements. Remember those bad tenants mentioned above. That's also the work of bad property managers. Their lack of screening and qualifying can lead to stuffing the property's rent roll with less than desirable tenants. Lastly, this kind of property manager will take 6%-10% of revenues for their efforts in ruining your investment property! It's important for investors to do their due diligence and select a reputable property manager to avoid these risks. Lest you decrease the operational efficiency, profitability, and value of your multifamily property.
Competition from Institutional Investors
In recent years, institutional investors have become major players in the multifamily market, making it more challenging for individual investors to compete. Regardless of your beliefs about Covid, there is no doubt changes assured in since 2020 have led to a dramatic shift in the investment strategies of REITs, private equity, and investment funds. These entities have raised billions of dollars that must be deployed. And those funds are no longer moving into Class A & B office space. Their eye has moved to multifamily properties. Even Blackstone has announced a multi-billion dollar fund for single family investment. Their immense size and scale of investments allow them to invest at lower cap rates and ROI. This competition can lead to inflated prices for properties, which may make it difficult for investors to generate sufficient returns on their investment.
The Value-Add Myth
"I want only value-add properties" is today's investor mantra.
However, for many investors this turns out to be a myth if not an out right nightmare. Value-add opportunities can provide attractive returns, but they can also be challenging to execute successfully. These properties require significant capital investment in primary improvements such as structural and unit remodeling. As vacancy is often higher than market rates, the value-add investor will also experience reduce gross and net income. Moreover, the capital improvements, lease up time, and need for financial stabilization prior to sale may all take years to actually complete. The lender underwriting of 2020-22 is not the norm. Under normal conditions, lenders require at least two, if not three, years of financials that support the valuation. Lastly, and this point may cause me to receive hate mail, most value-add investors fail! Most are not capitalized anywhere near well enough to undertake these projects. Over the last six months, my team and I have once again begun seeing these investors selling at large losses with much of the work not even started. So, if you absolutely must be a value-add investor, make sure you have more than enough capital and an actionable plan in place before you begin. Lest, you fail!
Government Involvement
Multifamily properties are subject to a variety of government regulations and oversight, which can create additional challenges for investors. This particular challenge can be the most difficult to overcome. Why? Government involvement in multifamily real estate, as in anything else, is overarching, overwhelming, and often carries hefty fines for violations.
For example, landlords must comply with building codes and zoning regulations. Fair Housing laws on local, state, and federal levels are ever present while being extremely easy to violate. Asking how many children a tenant has even in normal conversation, refusing to install grab bars for a disabled resident, treating renters with children different than those without, and advertising your unit is close to a particular house of worship are all easy ways to have a complaint filed. By the way, these violations carry a $16,000 fine for first violation, compensatory damages, legal fees, significantly higher fees if DOJ involved, and possible punitive damages from federal district courts. In addition to Fair Housing, some cities no longer permit landlords to run criminal background checks and one city in New Jersey is even debating requiring landlords pay for legal representation of those tenants being evicted. Moreover, many of the most populous cities have rent controls in place dictating your potential income without considering improvement costs; one part of NY mandated rent reductions during 2022 as costs sored. Lastly, some multifamily investors, for sometimes legitimate reason, do not accept subsidized income, commonly known as Section 8. In the very near future, they may have no option. Currently fifteen states and many large cities mandate the acceptance of the government program. There is even debate underway on the federal level that would mandate acceptance nationwide.
So does this all sound like financial freedom?
No, then it’s time to reconsider your real estate investment strategy. The first step will be determining whether the whole or part of your portfolio should be sold. The second is obtaining a real, market driven valuation. Third, what are your post-sale plans? 1031 exchange or payment of capital gains or some combination? What alternatives are ideal for your investment philosophy?
Alternative Real Estate Investment Options
While investing in multifamily properties can be challenging, there are alternative real estate investment options that investors can explore to diversify their portfolios and manage risk. Here are a few examples:
REITs (Real Estate Investment Trusts)
REITs are a type of investment that allows investors to invest in a portfolio of properties, without having to purchase and manage the properties themselves. REITs typically offer higher liquidity and diversification compared to direct property investments, making them an attractive option for many investors. Also, due to the size of the institution and ability to raise capital REITs will often invest in large, higher quality properties. In theory, these properties will be more stabilized and provide predictable income.
2. DSTs (Delaware Statutory Trusts)
DSTs are similar to REITs in that they allow investors to invest in a portfolio of properties, but they offer some additional tax benefits. A primary difference between DSTs and REITs is that an investor actually owns fractional ownership of real estate. Therefore, DSTs are structured in a way which allows investors to defer capital gains taxes when they sell their investment.
3. Commercial Real Estate
Commercial real estate investments can provide attractive returns and are often less regulated than residential real estate investments. Yes, multifamily (5+ units) are commercial real estate. I'm speaking about industrial, office (especially medical), and retail to name a few. However, commercial properties can be more expensive and complex to manage, requiring specialized knowledge and expertise.
4. NN & NNN Lease Properties
NN & NNN lease properties are a type of commercial real estate investment that offers stable and predictable income streams. In an NN or NNN lease, the tenant is responsible for paying the property taxes, insurance, and maintenance costs, leaving the landlord with few expenses to manage. Many, if not most, net lease properties are publicly traded or well known national operators.
One common, shared belief is that wealth and independence are created through real estate investment. That's certainly why I started. Like many, I began my real estate investment journey with multifamily properties. What I found was that this asset class carries with it a lengthy list of inherent challenges. Some that just cannot be removed from the equation. From tenant issues, selecting the optimal property manager, competition from well funded public corporations, and the long reach of various governments the challenges can be overwhelming at times.
If like me, you've decided to move on from multifamily properties now represents a massive opportunity. Commercial grade alternatives such as NN & NNN and medical offices as well as DSTs are priced at levels not seen since before 2020. Essentially, you have the option to buy today at a discount of as much as 20% compared to only nine months ago. If now is the time to transition all or part of your existing real estate portfolio, CLICK THE BUTTON BELOW to schedule your free, no obligation consultation. My team and I can provide you with a comprehensive value analysis and review your goals and options.
Wes Purvis
Director & Founder
Purvis Commercial Group
Purvis Property Advisors
Coldwell Banker Schmidt Realty
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