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In the multifamily real estate market, the promise of profit often takes center stage, overshadowing the critical consideration of risk.
As multifamily investors, it’s essential to understand and balance both sides of the equation to maximize returns while minimizing exposure.
So what causes the risk? Let’s find out.
Understanding the Debt Dilemma
Almost all multifamily challenges stem from debt on the deal. The debt (mortgage) is typically the largest monthly expense for a property. It’s comparable to food; you can never outrun a bad diet.
Similarly, you can’t outearn too much debt. Aiming for less than 80% on a home and 60-75% for commercial real estate is advisable. It’s a balance between a safe investment and being able to use debt to your advantage.
This conservative approach ensures a healthy financial foundation.
When evaluating debt, several factors come into play. Here are three of the most important to consider before proceeding further:
Variable vs. Fixed Interest Rates
Imagine locking in a predictable cost for borrowing money. That’s what fixed interest rates offer. You agree on a specific interest rate upfront, and that rate stays the same for the entire loan term.
This provides stability and peace of mind, especially during periods of rising interest rates. You know exactly what your monthly payment will be, making budgeting easier.
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With variable rates, the interest rate on your loan can fluctuate over time. This can be risky if rates go up, as your monthly payment could increase significantly.
However, if rates go down, you could end up saving money. Variable rates are often offered on adjustable-rate mortgages (ARMs).
These can be a good option if you plan to sell your house before the rate adjusts or if you believe interest rates are likely to stay low.
Loan-to-Value Ratio
Think of the LTV ratio as a measure of how much “skin in the game” you have on a loan. It’s calculated by dividing the amount you’re borrowing by the property’s appraised value. Here’s how it works:
- Lower LTV (Higher Down Payment): Putting down a larger down payment (say 25% instead of 20%) lowers your LTV. This translates to several benefits:
- Reduced Financial Risk: The lender is taking on less risk because you’ve already paid a significant portion upfront. This can lead to better loan terms for you, like lower interest rates.
- Lower Monthly Payments: A lower LTV typically translates to a lower monthly payment because you’re borrowing less money. This can free up more cash flow in your budget.
- Equity Advantage: The more you pay upfront, the more equity you own in the property from the start. This gives you a financial cushion and makes it easier to sell the property later if needed.
Debt-Service Coverage Ratio (DSCR)
The DSCR paints a clear picture of your overall debt burden. It’s calculated by dividing your total debt obligations (monthly payments for mortgages, car loans, etc.) by your gross monthly income.
- A High DSCR: This indicates a healthy balance between your income and your debt. A higher ratio signifies you have more than enough income to cover your debt payments, even if your income fluctuates. This provides a buffer and financial security during economic downturns.
- A Low DSCR: This suggests you might be spending a significant portion of your income on debt payments. This can leave you vulnerable to financial difficulties if your income decreases or unexpected expenses arise.
The Importance of Choosing the Right Partners
When it comes to multifamily real estate investments, who you partner with matters just as much as the deal itself if not more. Because when challenges arise, how your partners handle them can make all the difference.
In every deal, we team up with an operator who oversees the day-to-day operations while we maintain close oversight. Think about it as a primary care doctor working hand-in-hand with a specialist.
We trust but verify.
For instance, if they exceed a spending threshold of $1,000, we want to understand why.
This approach allows us to focus on both the operational and strategic aspects while benefiting from the experience and proven track record of our selected partners.
Evaluate who the players are and what roles they take in the deal, and understand who is making which decisions when it comes to the asset and your investment.
Three Critical Factors in Evaluating Deals
Let’s consider some key factors below:
Avoid Overpaying
Property prices have soared in recent years, leading many investors to overpay. However, the purchase price is a crucial determinant of your monthly mortgage payments.
Syndications, on a larger scale, echo the same dangers as individuals overextending themselves during the 2007 collapse.
We’re acquiring properties at remarkable discounts, with a per-door price significantly lower than comparable properties.
Invest in Cash Flow
We prioritize deals that generate immediate cash flow, covering all expenses and allowing for investor distributions right away. Why? Because cash flow is crucial for weathering economic downturns.
Fixed Long-term Debt
A property’s biggest risk lies in its ability to meet mortgage payments. While adjustable-rate mortgages made sense during periods of low interest rates, there’s always been a looming concern about rates rising.
Failure to secure rate caps on adjustable-rate mortgages can lead to significant interest rate hikes.
To mitigate this risk, properties secure fixed, long-term loans, ensuring stability even in fluctuating interest rate environments.
Commitment to Quality and Resident Satisfaction
When considering investing in a multifamily deal, make sure you look up the Operators portfolio – don’t only look at the numbers, but check out tenant reviews of the properties as well.
The importance of maintaining property quality and ensuring tenant satisfaction can not be overstated.
By prioritizing the right partnerships, prudent financial strategies, and a commitment to quality, you can navigate the multifamily real estate market with resilience and success.
When done right, multifamily investments have extraordinary upside potential. And we’re not the only ones who think so.
Get in before the Institutional Buyers
Multifamily investments are becoming increasingly attractive as institutional buyers flood the market.
Institutional investors, like Blackstone, are increasingly turning to multifamily investments.
With stocks at all-time highs and bonds volatile, multifamily properties are becoming increasingly attractive. Areas with growing populations and job opportunities are particularly promising.
Hear it from CBRE, a leading commercial real estate firm wrote: “Going-in cap rates, exit cap rates, and unlevered internal rates of return (IRRs) targets for prime multifamily assets improved slightly in Q1 for the first time since the Federal Reserve began raising interest rates in early 2022.”
As more investors turn to multifamily, returns for savvy investors are expected to rise, especially as interest rates decline.
What does this mean for us?
Seize the Opportunity
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When things go wrong, whether you’re a seasoned investor or just starting out, losing hard-earned money is never easy. That’s why choosing the right team is crucial.
We’re dedicated to empowering investors through education and offering deals that prioritize capital preservation and cash flow.
Balancing risk and reward is essential in multifamily real estate investments.
By focusing on conservative debt structures and seizing opportunities in growing markets, investors can position themselves for long-term success in this market.
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