Bigger is better!
Now I’m not talking about your backside, your waistline, or your private parts.
What I am talking about is the great debate among investors who invest in real estate. Which is better – residential real estate or commercial multifamily real estate?
Just so we are all on the same page, let’s start with a couple of quick definitions.
Residential real estate = 1 to 4 units (single family homes, duplex, triplex, and quads). Commercial multifamily real estate = strictly means 5 or more units. However, for the purposes of this article, I’m talking about bigger properties 100 units and up.
In the old days, there really wasn’t much of a debate. After all, affluent investors typically had only one choice – residential real estate. Historically speaking, access to commercial multifamily real estate was reserved for institutional players and the very wealthy.
But then something changed…
Fractional investing, where like-minded investors pool their money together to buy bigger properties, opened the door and gave accredited investors access to these bigger properties.
That is when the debate began in earnest. Which is better investing in single-family homes and other smaller residential properties or the larger apartment buildings?
When it comes to real estate investing, there are a lot of ways to become rich, so either strategy can work. However, for those looking to get from point A to point B as quickly as possible and with the least amount of risk, there is a clear winner.
That winner is the larger commercial multifamily real estate properties. Let me give you 6 reasons why:
Less Risk: On all of my properties, I track a metric called break-even occupancy (BEO). This number tells me what occupancy I must maintain to break even on the property. Occupancies above that number make me money while those below it creates negative cash flow.
For illustrative purposes, let’s say that my BEO was 75%.
If I owned a single family home, a duplex, or a triplex and had just one vacancy, then my BEO would be below 75%. In those scenarios my occupancy level for the single-family home would be 0%, for the duplex it would be 50%, and the triplex would be 67%.
Just one vacancy in residential real estate can create negative cash flow situations in which you have to go out-of-pocket to feed that investment property.
On the flip side, a 75% BEO on a 100-unit property means that you could have 25 vacancies before you hit the break-even point. With a 200-unit property that number would be 50 vacancies.
Non-Recourse Lending: Another area in which commercial multifamily real estate is less risky than residential real estate is in lending. These larger properties qualify for non-recourse lending. That means that the banks cannot come after the owners should the properties fail.
Typically, they won’t do that for residential properties. Most lending for residential real estate is full-recourse in which the owners have to personally guarantee the loan. This allows the bank the ability to come after the owners and their assets should they default on the loan.
Given the fact that the banks are usually the biggest investor in a property, doesn’t it say something that they would provide non-recourse debt for commercial multifamily and not for residential real estate?
They do this because the bigger properties are safer than the smaller ones. If you dig into the data on default rates, you will see that commercial multifamily GSE conforming loans have a historical track record of default that is sub 1%. Currently, these same loans are under 0.5%.
With such minuscule foreclosure rates is it any wonder why banks don’t require owners to personally guarantee these loans?
Ability to Scale: As stated previously, with residential properties, full recourse lending is the rule. Again, that means that the borrower has to personally guarantee the loan.
Banks look hard at borrower’s debt to income ratios when it comes to residential real estate. Consequently they will cap the residential real estate investor’s number of loans somewhere between 4 and 10 loans.
After that, residential investors cannot qualify for any more loans. Even if they are buying the biggest residential properties that they can (4 units), the most they will be able to obtain is 40 units.
If they want more residential properties, they will have to pay all cash for the property or figure out some other creative source of financing (perhaps a rich uncle?).
Being capped at 10 loans makes scaling a successful business next to impossible.
In contrast, bigger properties typically qualify for nonrecourse debt and have no such limits on the number of loans that can be obtained. As such, successful commercial real estate investors can scale their businesses in such a way as to buy more properties and make more money.
Valuations: Residential real estate is valued based on the per square foot comp model. Typically an appraiser looks at what properties have sold within a half-mile radius of the subject property over the last three months. Given what those properties sold for, they can come up with a comparable value for your property.
The problem with this model is that it doesn’t allow the owner to add much value to their property. Even worse, what if the comps were foreclosures that were sold as fire sales?
I mention that because I had that exact same scenario happen to me once when I went to refinance a four-unit property. The appraisal came in $50,000 lower than expected because of two foreclosures that had sold prior that were used as comps.
This situation doesn’t happen in commercial multifamily real estate.
Instead these properties are valued based on the money they bring in. Their valuations are centered on net operating income (NOI). This is the number you get when you take the revenue you make from the property and subtract out the operating expenses.
Experienced operators can increase NOI by increasing rents, decreasing expenses, or increasing retention. By increasing NOI, they increase the value of the property. In this way, they can force appreciation of the property irrespective of what other properties in the neighborhood are doing.
Professional Property Management: Unlike with commercial multifamily real estate, residential property management is expensive and tends to be more mom and pop. They commonly charge 8% – 10% of gross rents compared to 3% – 5% for the larger properties.
Additionally, commercially multifamily has the scale that affords them access to professional property management. These are management companies with people who have gone to college to work in management. They have special professional designations and buy in bulk to lower the expenses for the owners.
Economies of Scale: The term economies of scale refers to the cost savings realized through operational efficiencies as the size of the property increases. On a per square foot basis this savings is material.
Just as Walmart and Costco obtain goods at a lower price due to the volumes of their businesses, bigger properties can obtain volume discounts for many of their expenses.
Additionally bigger properties warrant hiring onsite maintenance and management that can significantly decrease costs over hiring outside venders to do this work.
Conclusion: There are numerous ways to get wealthy by investing in real estate. However, it is undeniable that commercial multifamily real estate is the safest of all real estate asset classes.
Unfortunately, many investors dip their toe for the first time in real estate in riskier investments like residential real estate.
If you are looking to develop stable streams of passive income without having to become a landlord it really is hard to beat commercial multifamily real estate.
If you’d like to learn more, download your free copy of Evidence Based Investing.
To Your Wealth!
Dennis Bethel, M.D.