Rule Number 1: Never lose money.
Rule Number 2: Don’t forget Rule Number 1.
Keeping your money in the bank today means you are losing money. It is risky to invest but even riskier not to. So, what is a safe investment? It used to be Government bonds. They are still a safe investment, but you will not get an interest rate above 2% so you have the same dilemma as keeping money in the bank.
Investing in Multifamily solves this problem and is relatively low risk. The average return has been around 15% in recent years and some investments do much better. According to a 2017 report by CBRE, between 1992 and 2017 the multifamily asset class generated an average annual return of 9.75%. It is a higher average annual return than any other type of commercial real estate. Notice this is through the Great Financial Crisis (GFC) of 2008.
Recently the returns have been even greater because inflation is driving up replacement costs and rents are rising. Large amounts of capital are moving in to Multifamily because it is a relative safe haven that still has a decent yield.
1. Capital Protection
You work hard for your money. You should also work hard to protect it. A bank offers no interest so you could lose money in terms of purchasing power. Keeping money in the bank may seem safe but what if inflation is 15% this year. If you have $100,000 in savings, you basically lose $15,000.
Investing in multifamily allows you to protect that money. There are risks with investing but if you invest with the right team in the right market, the risk is low.
Multifamily was the greatest asset during the GFC because people still needed a place to live. There was a lot of downsizing and multifamily was there to support. You do not need a $500,000 home, but everyone needs a place to live. There is not enough supply to cover the demand currently.
Demand may be greater in a downturn as people will ditch the expensive mortgage for cheaper rent. This ensures the likelihood of losing money on a Multifamily investment is unlikely.
2. Tax Benefits
Disclaimer: I am not an accountant. There are certain situations where you can and cannot do certain things. States have different rules, and you will want to consult a tax advisor for your individual situation. This is just a general overview of what is possible.
The IRS legally allows real estate investors to use depreciation to offset earned income. Someone who buys or invests in a multifamily building can use depreciation or bonus depreciation to deduct earned income.
Depreciation
Depreciation is an income tax deduction. Real estate values usually go up over time in value or appreciate. However, the IRS allows owners and investors in real estate to depreciate an asset. Typically, you think of a car when you think of depreciation because it goes down in value or depreciates. Depreciating real estate then would seem counterintuitive because it generally appreciates. Nonetheless, the IRS says that the building depreciates so you can deduct it from your earned income and reduce your tax liability.
You can depreciate the physical building but not the land. You will need to figure out purchase price minus land value to come up with building value. Then you can depreciate the building over 27.5 years. Otherwise known as straight-line depreciation.
Example: You buy a house for $3,000,000. The land is worth $250,000 and the building or improvements is worth $2,750,000. You can depreciate the building over 27.5 years. $2,750,000/27.5 years = $100,000. This means each year for 27.5 years you can deduct $100,000 from your income (limitations may apply).
Recent tax changes allow you to use bonus depreciation where you can accelerate parts of the building and take all the depreciation in year 1.
Bonus Depreciation
Using a cost segregation study, you can break down the components of real estate into 5, 7, 15, and 27.5 years. You can then depreciate the 5,7, and 15-year items in year 1. This typically works out to about a third of the building but can vary based on the study.
Example: You invest $100,000 in a multifamily deal. The purchase price of the property is $10,000,000 with a $3,000,000 down payment. The land value is $1,000,000 and the building value is $9,000,000. The cost segregation study says that a third of the building is 5 to 15-year items that can be depreciated 100% in year 1. This means about $3,000,000 of depreciation year 1. Invest $100,000 in this deal and you get $100,000 in tax deductions.
It is important to note if you are not a qualified real estate professional then you cannot deduct against your earned income in this example, only your passive losses. The depreciation should be able to be carried forward and will help reduce capital gains at sale. A spouse can qualify as a real estate professional, and you would be able to use all the depreciation for earned income.
2022 is the last year for 100% bonus depreciation. It phases out by 20% each year until it hits 0% in 2027.
The IRS will want to recapture some of that depreciation if you sell. There are ways to defer this through a 1031 exchange. You roll your capital into a like-kind asset of equal or greater value. It is key to consult with an accountant for individual situations.
3. Built-in Diversification
Diversification is how you reduce risk. Multifamily assets have diversification built into them. Each apartment unit produces income. When a unit becomes vacant, there are other units producing income while a replacement can be found.
Single-family homes can be great investments but if someone moves out, then your income goes to zero.
4. Price Appreciation
Real estate value over the long term goes up. There are market cycles and downturns, but 20 years from now prices will be higher. There is a paragraph in the book Paper Money by Adam Smith that I like.
$8,000 was the full price of the house—Eric Larrabee wrote in Harper’s, in 1948: “Nearly everyone is agreed that today’s housing values are inflated, and that the collapse will have to come some day.
This idea that the price is too high and saying the market will collapse is not new. If there is another collapse like the GFC then multifamily is where you would want your capital. Property value is determined by income produced. If tenants can continue to pay rent, then the property retains its value. Rent will also likely not go down there will be increased demand during a downsizing.
Market conditions have a lot of tailwinds for real estate appreciation. There is demand for affordable housing. There is a shortage of housing. There is a shortage or labor to build the houses. There are supply chain issues. All these factors are causing replacement value to go up. Interest rates are low, and the government cannot really afford to raise them by much. If all those things start reversing, then it would be time to be cautious.
5. Cash Flow
Receiving monthly or quarterly dividends from real estate is a big reason to invest. Protect the principal and spend the cash flow if needed. If you continually protect and smartly invest the capital you work hard for, your wealth will grow over time.
Cash flow is the benefit of a well-run property. When buying multifamily, cash flow is calculated and is what attracts capital. I doubt you would invest $50,000 in real estate if the sponsor said you will not receive any cash flow while your money is tied up for 5 years. Deals are put together to entice investors. Sponsors typically offer an 8% cash-on-cash return for an investment. If you invest $100,000 you can expect $8,000 in cash each year while the original $100,000 is still equity in the deal.
Over a 5-year period you could reasonably expect $40,000 in cash distributions over the holding period on a $100,000 investment. Then you could expect some appreciation on the sale and get back more than $100,000 upon sale if the property goes up in value. Some deals do better and some deals not so great. The person running the property is usually the difference. Invest in a deal with a sponsor that has a good track record over time.
Conclusion
There are 5 great reasons to invest in Multifamily. I will add a bonus too: you are investing in main street. Wall street has designed the system to make everyone believe you have to give them control over your money for 30 years. They did not do a good job as the IRA and 401(k) plans are retirement age and the median retirement savings is dismal. They took advantage of the middle class. Investing your money into multifamily helps you and helps main street.
