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3 Key Steps Before Making Your Next Multifamily Investment
August 18, 2022
Investing in real estate as an active or passive investor requires a few key pieces of knowledge and skills to ensure the deal is a good one for you and your goals. Multifamily real estate is a powerful investment that has proven itself to be capable of both high returns and to be safe in difficult times.
However, not all multifamily investments are created equal, nor are they all equally suited to all investor types. The first step in investing in multifamily is to decide on whether you prefer to invest actively or passively. As an active investor, it is your responsibility to source and negotiate acquisition opportunities as well as put together the debt and equity for the project. After closing, an active investor is fully responsible for the operations of the asset, including management, taxes and accounting, and renovations. Conversely, the work involved in being a passive investor includes meeting and vetting deal sponsors and picking which deals to invest in. From there, the role of the passive investor is to collect distributions and be truly passive.
To decide between active and passive, one must evaluate their main source of income and how much capital he or she has to invest. For example, a successful doctor making $1,000,000 per year probably shouldn’t look to become an active investor because their time is much more valuable focused on their main career. In a similar example, if an investor has a $50,000,000 war chest, their time is best spent finding the most efficient and lucrative ways to allocate their capital. Conversely, if an investor only has $50,000 total to invest, spending lots of time trying to squeeze every last percentage point of return out of a small passive investment is not worth the time and effort.
The next step is to evaluate your investment goals and tolerance for risk. The main distinction between the types of investment strategies is between risk versus return and cash flow versus appreciation. The riskier a project is, the higher the potential returns. However, with greater risk comes a larger variation of outcomes. As an investor, you must evaluate your level of risk tolerance and whether you would be willing to endure your perceived worst-case scenario. An element of risk versus return is the return profile of the investment. Investments with healthy cash flow are generally lower risk than investments which rely more on appreciation. In addition, investors should match their investment goals such as a certain percentage or dollar amount of monthly/annual cash flow.
Other investors are solely concerned with total returns and therefore do not make cash on cash metrics a priority. For these types of investors, development investments which are higher risk and don’t produce any cash flow may be a good fit. On the other end of the spectrum, retired investors living off their investment income are usually mostly cash on cash focused and therefore invest in existing assets which produce cash flow from day one of the acquisition. These types of investors also stay away from riskier investments since they rely on their investment income to live.
The final step before moving forward with your next multifamily investment is to evaluate the deal itself. Underwriting is the financial analysis process of real estate investing and derives return projections relied upon to make a purchase offer or relied upon by investors when making a passive investment with a sponsor. Underwriting is one of the most important aspects of multifamily investing. Proper, conservative underwriting can save an investor from jeopardizing their retirement or career. Warren Buffet often explains the key to making a smart investment is to ensure the investment has a sufficient margin for error. This means if some of the assumptions of the investment turn out to be too ambitious, the investment still can perform and most importantly, avoid a permanent loss of capital.
Underwriting can be a complicated process which includes market research, rental and sales comparables, putting together pro forma revenue and expenses, as well as structuring and evaluating debt and equity. However, the basics should be mastered by all investors regardless of whether they are active or passive. The best way to learn to underwrite is by familiarizing oneself with an underwriting model, such as Lone Star Capital’s which is available for free on their website (www.lscre.com) and begin underwriting deals as they come across your desk. The next step in learning the basics is to review your underwriting compared to others’ models to see where your assumptions differ.
As a passive investor, a quick review of a sponsor’s underwriting can be extremely illuminating in helping make the decision of moving forward with an investment. For those interested in a deep dive on multifamily underwriting, you can buy Rob Beardsley’s The Definitive Guide to Underwriting Multifamily Acquisitions, available on Amazon.
With the right knowledge and strategy, investing in multifamily can be a tremendous addition to your investment strategy or even become your main source of income.