3 Decrees of Multifamily Investing
Multifamily investing is a simple idea, but complex in practice. There are many moving parts and people, plus lots of cash on the line. There are numerous ways to anticipate challenges in a deal such as underwriting conservatively, but there are three decrees to multifamily investing that when followed, protect investors from inherent risk.
Decree #1 Buy for Cash Flow
Purchasing properties that have in-place cash flow that is sufficient to pay all expenses is critical. In today's market with compressed cap rates leading to high sticker prices, it is too common to see in-place cash flows not meeting basic lending requirements or meeting them only in a best-case scenario (which never happens). The solution is not overpaying. Offers must be made based on current performance and the current performance must be adequate enough to account for dips in occupancy, maintenance pitfalls, or an unforeseen costly scenario.
Decree #2 Have Cash Reserves
Ensuring a property's performance is on par upon purchase will safeguard an investment from many risks. However, even when cash flows meet the criteria, there must be cash reserves in place as well.
Cash reserves are a secondary safeguard against further pitfalls that a property will experience. They are especially needed when a major issue arises (HVAC system breaks down, pest infestation spreads rapidly, etc.) and the in-place cash flow is not enough to cover the major expense.
If there are no cash reserves, either a capital call is needed or the property cannot pay its bills. Either way is a worst-case scenario. It is essential to have at least three months of all expenses (including debt payments) in cash reserves, plus ongoing contributions to the reserve account.
Decree #3 Secure Long-Term Debt
Securing long-term debt is a more discrete but essential protection in a long-term business plan. Most business plans for multifamily value-add properties span five to seven years. It is very difficult to predict the market five to seven years in the future. Securing long-term debt is a safety against the external environment should it be unfavorable once the business plan is complete.
For example, it is wise to secure a 10-year loan even if the business plan is calling for a sale after year five. If year five comes around and the property is ready for sale, but cap rates have decompressed substantially or interest rates have soared, it is a good move to hold on for another year or more until the external environment is favorable.
When securing long-term debt, the operators have options. If a property is purchased without long-term debt, say a five-year note on a five-year hold, and the external environment is unfavorable, the operators have no options. The options are refinancing in the unfavorable terms available (if possible) or selling regardless and receiving less than anticipated.
In-place cash flows ensure the property can operate even with small issues arising, in addition to investors being paid. Cash reserves ensure that if any major unexpected issues arise, the issues can be taken care of. Securing long-term debt ensures that there are options available upon sale should the external environment be unfavorable for sale or refinance. When these three decrees of multifamily investing are followed the inherent risk of investing is dramatically reduced.