Defining your Investment Strategy for Multi-family Properties- what do you want from your investment?

Hi everyone!

First I want to welcome our new subscribers that have recently joined us onMulti-family Investing Blueprint.

The last month and a half has been incredibly busy for me. I’ve given a couple of interviews on multi-family investing, I had one speaking engagement (on the topic of purchasing multis in smaller & remote markets – I’ll write a blog post on this soon) and I have 3 more speaking engagements this coming week.  I attended 3 real estate trades shows, including the Investor Forum in Toronto organized by the Canadian Real Estate Wealth Magazine where I gave a small workshop. Finally, I took a 12-day vacation in Costa Rica with my wife and 3 kids and our friends.

Costa Rica was fantastic! Of course, I went surfing, saw lots of wildlife in the jungle, went zip lining at a height of 600 metres with the Arenal volcano as a backdrop – simply exhilarating… Plus I mastered the art of making ‘ceviche’(seafood marinated in lime juice & cilantro) – got a batch marinating right now for tonight… with an ice cold Corona beer and some nachos, as an appetizer = bull’s eye !

 

 

 

 

 

 

 

 

 

I enjoyed attending real estate trade shows because it gives me an opportunity to chat directly with investors such as yourselves who are considering switching over to multi-family properties. I get to hear first hand the challenges many of you face in this regard. Accordingly, I decided to write a blog post on the topic of devising an investment strategy for multis.
I’ll tell you right now, there is no perfect investment strategy that fits all because the goals of each investor will vary. There are a lot of moving parts too. Hence, you must be clear what you’re trying to accomplish by investing in apartment buildings.
What do you want your investment to do for you?
Two critical questions you must answer for yourself are:

1) Are you looking for an immediate cash flow?
OR
2) Are you interested in creating long-term wealth?

I’ll give you here my personal perspective on these 2 questions.
Upfront, I can tell you that multi-family properties are not nearly as liquid of an investment as smaller rental properties defined as 1 to 4 units. For one, multi-family properties, given their larger size, require a stabilization period that’s longer than for small investment properties. In addition, they also take longer to sell in the event you need to raise money. However, small investment properties don’t have nearly the same financial leverage to create huge wealth as the multi-family properties do as you’ll see below.

For starters, I’m inclined to say that most of us who invest in apartment buildings are in it for the long-term wealth, rather than for the short term. That’s because a large portion of the ROI is in the form of capital appreciation which takes time and because, as mentioned above, multi-family investment properties generally require a longer ‘stabilization period’ during which there usually is no significant cash flow. During this period the investor, after taking possession of the property, brings it up to optimal condition by addressing deferred maintenance issues and or by making up-grades, reducing operating expenses namely by making the building more energy-efficient, and also likely raising rents as a result of these improvements.

Obviously, the more suites there are, the longer it takes to address maintenance issues versus a condo unit or a single house where you only have one kitchen and perhaps only one or two bathrooms. In addition, the cost of up-grading a multi-family property is significantly greater due to the larger number of suites and the investor faces the choice of either completing them as quickly as possible or spread them over a longer time frame perhaps using the property’s own cash flow to finance them. If the up-grades are spread out, this further extends the stabilization period and delays the availability of cash flows.
Accordingly, whether or not an investor has much capital upfront makes a big difference. In an ideal world, the investor would likely want to complete the stabilization period as soon as possible in order to maximize the rental income, since in the multi-family realm, the annual income the property generates is what drives value of the property. The higher the income, the higher the value!
If, on the other hand, the investor’s focus is to get a cash flow sooner rather than later, this can be achieved by putting more money down at purchase, which will reduce mortgage payments as a result of a lower loan amount.

Although the achievement of an ROI in multi-family investing usually occurs later compared to small investment properties, if the potential exists to increase the annual income, also called net operating income or NOI (NOI is defined as all income minus vacancies/bad debts, minus operating expenses which exclude mortgage payments), the return for the investor is immediate. Not only the return in the form of an increased cash flow, but also in the form of capital appreciation.

Indeed, the financial lending industry and CMHC by and large rely on the ‘income approach’ to determine the value of properties, more specifically on the ‘income capitalization approach’. This valuation method consists in converting the property’s annual income into its capital value for the current year. In other words, the current value of the property is arrived at by determining what percentage (%) of the property’s ‘capital value’ the NOI represents. To do so, you first need to establish what is the prevailing market capitalization rate, commonly called ‘Cap rate’, based on recent comparable sales or ‘comps’. For each comp sale, you divide the property’s NOI by the purchase price, which gives you the cap rate for this property and you repeat this division with all ‘comp’ sale and compile the market average cap rate. You can obtain prevailing cap rates in your market in an appraisal or either from banks or mortgage brokers. Large realtor brokerage firms, such as Colliers, Cushman & Wakefield or CBRE Richard Ellis may produce cap rate reports and/or market reports on multi-family properties in large centres.
Then to establish the value of a given property you’re considering to purchase, you divide the property’s NOI by the prevailing cap rate (average/prevailing cap rate). (for more details on the Income valuation approach, please download my free EBook called ‘Blueprint for Multi-family Investing’ at www.MultifamilyBlueprint.com)

In order to maximize the value of the property, an owner must ensure the is maximized at all times. Here is an example of the kind of financial leverage, or value appreciation you can get by increasing the income for a multi-family property. This is what my professional property manager calls the ‘big lift’. Let’s say we have a 20-unit apartment building that generates an NOI of $100,000/year and that the prevailing cap rate in the market is 6.25%.
Current NOI = $100,000
Cap rate = 6.25% = current Value = $1,600,000 ($100,000 ÷6.25%)
Increase rent by $25/month/suite & the new NOI is increased by $6,000 to $106,000/year
New value = $1,696,000 ($106,000 ÷ 6.25% = 1,696,000)
Return in capital appreciation = $96,000

The ability to create this kind of ‘lift’ or instant value appreciation does not exist with smaller investment properties where value for these is not derived from their income, but rather by using the ‘direct sales comparison’ approach. Of course, you cannot buy bread with that capital appreciation and you only cash in on this appreciation when you sell or refinance the property.
In a market such as Alberta where I personally invest and where there is no stringent rent control – the provincial landlord/tenant legislation does not impose a cap on rental increases but limits them to one per year, I have personally witnessed as a CMHC multi-family underwriter and benefitted as an investor from one of those big lifts during the last economic boom. Between 2004 and 2011, rents have increased around 40%!!!

During those years also, once they had accumulated sufficient equity, multi-family owners would then refinance and do large ‘equity-takeouts’ and take that money and buy more multi-family or make other forms of investments. Many investors have made their fortunes during that time. There is no end to this cycle as long as the property is well maintained and continues to produce a reliable income stream, the property will generate wealth for many generations to come. Even during the peak of the recession, multi-family owners refinanced their loan at lower interest rates and took larges sums of equity out.
In my opinion, the ideal investment strategy would include a mixed portfolio comprising both small rental properties and some multi-family properties. As indicated at the beginning of this blog post, the availability of small properties would enable the investor to quickly raise cash when needed to either effect repairs or buy multi-family by selling some of them, whereas the apartment buildings would contribute to greater wealth creation.

Alright folks! I’m all pumped for this week’s 3 speaking engagements at REIN workshops in Edmonton, Calgary and Vancouver. After my Vancouver talk on Thursday night, I’m off hiking on Friday in the mountains surrounding Chilliwack. Look forward to that day off.
I still have seats available for my up-coming ‘live experiential training event’ in Edmonton on May 26 & 27. Here is the link to the detailed agenda:
http://www.multifamilyblueprint.com/events/

You can listen to testimonials from my students at the last training event last November. This one is going to be even better as I keep improving the tools and content. This is an exclusive training event in Canada.

I’m also working on the online version of my live training event, which I expect to be ready before the end of the summer.

Please, don’t hesitate to contact me if you have questions about my live training event.
I wish you success with your real estate investments and in all areas of your life.

“I am the master of my fate. I am the captain of my soul”. (Invictus, by William Ernest Henley)

Pierre-Paul Turgeon
pturgeon@MatterhornInvesting.com

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