In a prior article we discussed the benefits of investing in multifamily (vs. other commercial real estate asset classes). After making the decision to focus on multifamily, many investors are then often faced with having to choose between small (5-50 units) or large (100+ units) multifamily properties (multis). While one has the potential to earn more income with large multifamily, there are also advantages of pursuing small multifamily properties. In today’s quick snippet, we will explore just that.
Small multi properties (5-50 units)
1. Less competition: For some of the reasons discussed in the large multifamily pros below, many investors choose to go BIG from day one. This in turn reduces competition for smaller multis and may help one acquire a property at a more reasonable price point (though in the past couple of years, many have encroached into the small multi space too, leading to price inflation).
2. Less capital to raise: Given the lower overall price point (not necessarily price per unit), small multis present a great entry point for investors with smaller amount of start-up capital. They can either purchase a property on their own (e.g. $1MM or less), partner with a small group of active investors (by forming a joint venture “JV”, usually applies to 15 units or less), or need to raise a smaller amount of capital (for 15+ units that are likely to be syndicated).
3. Less costly mistakes: Starting small allows one to take that first step into the multifamily journey without fear of large costly mistakes or losses. You should always have reserves set aside for a rainy day, and owning/operating a small multi makes it easier to financially tackle those unexpected rainy days when additional capital needs to be put into the property. A loss is still painful regardless; however, a $1MM mistake likely hurts less than a $100MM mistake.
4. Multiple exits: Small multis are attractive to both a starting/newer operator and a mid-size operator. In addition, small multis are more likely to be a forever buy and hold with multiple refinances in-between, which is how wealth is built in the long run.
1. Potential lack of complete information, systems and processes: When looking to purchase a small multi, one is more likely to encounter mom and pop owners, which often implies a property with incomplete or poor records and lack of systems and processes. That is not to say that you cannot professionalize the property and the management. However, you need to be aware that you may not be able to obtain all documents or information needed during your diligence and may have to get creative on how to obtain such missing info important to you or your lender. In addition, you may have to fill in some of the gaps (systems, records, processes) in addition to any other already contemplated projects essential for execution of your business plan.
2. Higher cost base: As the potential revenue base is smaller (given there are less units), there is less topline income to spread against the expense base (particularly fixed costs). And while certain fixed costs may be lower for properties with fifteen units or less (e.g. typically structured as joint ventures with lower legal fees) generally costs are similar (e.g. syndication attorney fees, advertising and subscriptions to various MLS sites, etc.). This in turn results in a higher break-even occupancy thereby elevating the risk of one or two vacant units leading to compressed or negative cash flow.
3. Hands on operations: As an owner of a small multi, you are more likely to be involved with the day to day operations as an asset manager, working hand in hand with the property manager (PM). In some cases you may even have to self-manage the property, if you face difficulty finding a good PM (larger or a professional PM firm with good systems, reporting, access to contractors, and processes) or a PM motivated to manage a smaller unit count.
4. Lack of economies of scale: It may be more difficult to scale, especially if your small multis are scattered throughout different markets or various cities across the state. In addition, before purchasing the property you typically need to perform the same level of diligence (financial, legal, and property-specific), time and effort. Some investors may opt to do that same amount of work for a larger investment property with the goal of generating better return on their time.
Large multi properties (100+ units)
1. Economies of scale: Unlike small multis, you have a larger revenue base to spread over certain fixed costs (e.g. syndication attorney, advertising site subscriptions, etc.). If managed properly, you are likely to have a lower break-even occupancy point and therefore more cushion in the event of a temporary increase in vacancy. In addition, given the larger unit size, you may be able to negotiate better terms on various services (e.g. lending, PM fees, etc.).
2. Working with professional firms: Given the larger scale, you are likely to work with larger and more professional firms as your strategic partners who have established systems and processes in place. This in turn helps make your operations and access to information more efficient. For example, a larger unit count is more likely to attract an established and professional PM firm for day to day operations.
3. Ability to hire an asset manager: Due to the economies of scale, you may be able to afford/hire a professional asset manager who will work more closely with your property manager to ensure the PM is executing on your business plan as intended and to ensure efficient and effective day to day operations. This frees up your time to further grow your overall commercial real estate business.
4. Multiple exits: Larger multis are attractive to both large multi operators like you as well as institutional investors, which increases your buyer pool when you are ready to sell the property (and hopefully also leads to higher valuation due to more competition).
1. Higher competition: With larger multifamily properties (particularly once you start heading into the 300+ unit space) you are more likely to compete with large institutional firms who have deeper pockets and a lower cost base.
2. Additional absolute $ expenses: Given the larger unit count, large multi would require additional staff – an onsite property manager and assistant property manager, a leasing manager, and a number of maintenance staff. The size of the property would dictate how many people to hire and how many will be full time vs. part time. You will need to ensure that you and your PM have good HR systems in place.
3. Must raise more capital: Given the higher price point of the property and therefore higher capital requirements (e.g. more units to update or bigger grounds to catch up with deferred maintenance to), you will likely need to bring more cash at the closing table. You will need a deep pool of passive investors to contribute capital and invest with you as well as qualified key principals with high net worth and liquidity to sign on the loan. Especially in the past couple of years, this has resulted in larger GP teams (adding individuals with deeper pockets and access to capital), which also dilutes the sponsorship ownership share.
4. Short-term horizon: For the most part, large multis tend to be short to medium term flips, as investors want their money back sooner and/or operators are eager to get paid (in the current market environment, the sponsor team usually gets paid at exit, given limited excess cash flow throughout the life of the deal, which excess cash flow is typically distributed to the passive limited partners first). Thus, in order to generate a consistent income stream, the operators is always on the hunt for the next deal.
As we mentioned before, the beauty of real estate is that one can choose to pursue multiple strategies. You could start with smaller multis, transition to mid-size multis (50-100 units), and graduate into large multis, gaining valuable experience and developing your strategic partner teams along the way.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.