The best real estate investments that enjoy the most financial growth and make money in real estate are those that take advantage of economies of scale.
Economies of scale (EOS), refers to the economic advantage gained as the scale of your business or investment gets bigger. The advantages of EOS can easily be illustrated by contrasting residential real estate with commercial real estate.
Residential real estate is defined as 1-4 units and qualifies for residential lending. Commercial multifamily, on the other hand, is 5 or more units and requires commercial lending.
While commercial multifamily real estate enjoys multiple advantages over residential real estate, the main advantage is EOS. Most investors only understand EOS conceptually. However, without concrete understanding the true impact of EOS cannot be fully appreciated.
Economies of scale impacts multiple areas of multifamily investments: safety/risk, income, expenses appreciation, tax-savings, and principal pay-down. In this post, I will discuss how EOS decreases risk and keeps the investor’s money safe. Part 2 of this post will discuss the incredible impact of economies of scale on the other areas of multifamily investing.
For the purposes of this discussion, I am going to compare and contrast a two unit residential duplex with a 200 unit commercial multifamily property. I will be using one of my favorite safety numbers, break-even occupancy.
Break-even occupancy is the percentage of occupied units that must be maintained in order to break–even after paying expenses and debt service. Below this number, the investor will be in the red and coming out of pocket. Above this number, the investor with be in the black and enjoying positive cash-flow.
For this example, break-even occupancy is 75% for both properties. Consequently, one vacancy in the duplex leads to 50% occupancy and negative cash flow. As you can see, there is little to no cushion with residential real estate. One vacancy frequently leads to negative cash flow. This is why I liken residential real estate to living on the edge.
Even quality property management cannot save you from the fact that you are always one unforeseen life event away from negative cash-flow. Life happens and you will have tenants who experience job loss, relocation, divorce, death in a family and a myriad of other reasons that cause them to move. It’s hard to sleep at night knowing that at any moment bad luck can strike and you will have to work for your investment instead of your investment working for you.
On the other hand, a 200 unit complex with the same 75% break-even occupancy would have to have 51 vacancies before going into the red. In markets with average historical occupancies of 90% – 95%, a colossal failure in management on multiple levels would have to occur to get anywhere close to that 75% break-even occupancy.
As this example shows, economies of scale provide plenty of cushion to ensure that the investor makes money in real estate. I would much rather rely on skilled management in good markets utilizing economies of scale than constantly worrying about being one vacancy away from negative cash-flow.
Now that you have seen the safety profile that economies of scale can provide, part 2 will focus on the incredible wealth-building power of economies of scale.
To Your Wealth!
Dennis Bethel, M.D.
P.S. From a risk/safety perspective, larger commercial multifamily properties are the best real estate investments that provide economies of scale to make money in real estate and enjoy financial growth.