Have you been in the real estate investing world for a bit and are looking for some higher-level strategies you can implement?
Perhaps you’re newer to the space, but you’ve already brushed up on the basics of real estate.
You know about cash flow, depreciation, active vs. passive investing, and the like.
The purpose of this article is to reveal some secrets that full time industry professionals use when making their multifamily investments that you might not be aware of.
Some of these secrets are simple to understand, but often overlooked…
Others are a little bit more sophisticated and are a chance to peek behind the curtain to see how the big players in the industry make their investing decisions.
1. Use Strategies that Produce Favorable Risk-Adjusted Returns:
If you’ve been in the real estate space for a while, you’ve probably heard the phrase “risk-adjusted return” thrown around.
Risk adjusted returns are a method of tracking the return on an investment when weighed against the risk that is undertaken by participating in the investment.
This is very popular for real estate investing, as it can allow investors with different strategies to hone in on opportunities that fit their appetite for risk.
One commonly used method for calculating risk adjusted returns is known as the Sharpe Ratio and is calculated as follows:
Sharpe ratio = [ Return of portfolio or investment – Risk-free rate of treasury bond ] / Standard deviation of the portfolio’s excess return.
As you might expect, when we’re looking at sensible investments, it is commonly the case that the higher the risk, the higher the reward.
For low-risk multifamily real estate investments, you’re usually looking at an IRR around 11-14%, but this return can be boosted while still maintaining a low degree of risk.
There are several ways to do this that we use here at Winterspring. First and foremost, you need to acquire properties for a favorable price.
This is done by extensive networking with brokers who feed you “pocket listings” as well as off-market, direct to seller prospecting.
Next, you need to target submarkets undergoing strong growth and economic expansion.
Once you’ve located those markets, you need to find underutilized properties, typically B and C class and owned by mom and pop investors.
These are properties that haven’t kept up with the times in the market and have below market rents and usually a good deal of deferred maintenance.
Upon locating and purchasing these kinds of opportunities, we then execute our business plan through strategical property renovations.
These renovations produce a new building that is competitive or superior to comparable properties, giving us the opportunity to boost rents, increase occupancy, and increase the property value in the process.
This strategy leads to more favorable risk-adjusted returns for our investor base.
All investments carry some degree of risk, but there is also risk involved with failing to do your homework about sensible strategies that can produce heightened returns with minimal added risk.
If you or your company chooses to follow that path, the risk you’re taking is that your investors will start putting their money elsewhere!
2. Target Transit-Oriented Properties:
One of the biggest demographic shifts that has been observed in the past decade is the influx of residents into already crowded urban metros.
We’re noticing an increased trend towards density into urban environments and closely orbiting satellite communities.
It seems the 60-mile morning commuter is becoming an endangered species.
While I won’t get too deep in the weeds of why this shift is occurring, it’s hard to miss in many areas of the United States.
The biggest symptom is an explosive ramping up of traffic in many major cities across the country.
This is making it increasingly unrealistic to live so far away from major centers of employment, despite those more distant areas often having a more favorable cost of living.
If the reason people are moving into or closer to the city is motivated in part by concerns around traffic, you need to keep that in mind when investing in these areas.
If you want to see this for yourself, choose a major city in one of the submarkets you invest in.
Then take a look at the rental rates for apartments within walking distance of public transportation as opposed to the rates received in transportation deserts (urban areas that are 15+ minutes walking distance to public transportation).
The properties closer to public transportation, all else equal, are always more valuable.
Enter the transit-oriented properties. If you’re a developer, you’re probably familiar with these, as we are often provided additional incentives to build in these areas by zoning codes as the municipalities would also like to encourage increased density there.
City officials like density around public transportation because it reduces gridlock, while also benefitting the environment due to the reduced reliance on automobiles.
It also has indirect benefits to the economy by increasing commerce due to the ease of access to retail, as well as an expanded base of prospective employees for areas businesses.
A property is considered transit oriented if it is within a half mile of public transportation.
These are the types of sensible development projects that should be encouraged as an effective measure against the housing shortage.
Just remember, even as an investor purchasing an existing building, all of these same reasons to invest in transit oriented developments apply to you as well.
You just happened to find a property that was already in a strategic location for this purpose!
Just remember that these areas are typically more expensive to invest in and often have more red-tape than suburban areas.
That barrier to entry may be too high for some people.
3. Leverage Investor Retirement Funds (and your own):
Did you know there are more than $33 trillion invested into retirement assets in the United States?
The vast majority of those dollars end up in mutual funds and stocks.
We think this is based more on a lack of information than a conscious choice on the part of the future retirees.
Most people simply aren’t aware that the IRS permits you to use your retirement funds for real estate investments. This is a path many would choose if they were aware of it.
It not only allows for you to more closely control how your retirement funds are invested, but allows you to seek out better returns for your retirement dollars through real estate.
The tremendous tax advantages of real estate can also be tapped into even if you are investing via your retirement funds.
You still need to keep in mind that there are rules in place that can vary from retirement fund to retirement fund as it relates to investing in real estate.
An example of this is that real estate investments made through your IRA must be in properties strictly for the purpose of investment. The IRA investor can’t live in the property, for example.
Not only that, but all cash inflows and outflows must flow through the IRA.
Violating these provisions can cause your IRA funds to lose their tax-deferred designation, so you need to pay close attention to them.
For those who have a 401(k) option, you have the ability to take out loans from your 401(k) funds that can then be used to invest in real estate.
It’s becoming increasingly popular to use your retirement funds for real estate investing.
Just be sure that you have a proper conversation with the manager of your retirement plan account.
They’ll know the exact guidelines you’ll need to follow and can help you through any forms you need to file along the way.
4. Utilize Floating Rate Debt with Interest Rate Caps:
Many multifamily investors may be drawn to the idea of a fixed rate loan as they can lock in at a low rate.
You might be surprised to find, however, that when looking at historical averages, floating rate loans actually end up being less expensive over the long term.
Floating rate loans provide you with the opportunity to access more favorable interest rates as the environment shifts over the course of your ownership.
They also allow you to avoid the steep prepayment penalties that often come attached to fixed rate loans.
Floating rate loans typically have a simple… whereas fixed rate loans come with byzantine and expensive yield maintenance or step down prepayment clauses that heavily penalize the seller.
You can enhance your floating rate loan by purchasing an interest rate cap from one of the government agency approved rate cap providers.
What this means is, you pay an up front fee to an agency-approved third party that caps how high interest rates could float on the loan.
This is essentially an insurance policy from the rate cap provider.
If interest rates float higher than the specified cap, also known as the strike rate, the third party provider needs to pay the cap purchaser for the difference in debt service payments.
Rate cap providers are compensated with an up-front payment for their services.
5. Use Return on Cost Rather Than Cap Rate for Value-Add or Development Investments:
The cap rate is often considered the king of real estate investing metrics.
When you’re looking at properties that have already been stabilized and have established streams of income, cap rate is particularly useful.
It starts to lose its lustre a bit when you’re looking at value-add projects with a lot of planned improvements or development projects.
An example would be a mismanaged apartment building that is only 40% occupied. At present, that building will have a negative cap rate because it is losing money.
We’re more interested in what potential the building holds.
What if this is actually an amazing investment opportunity once stabilized?
In these situations, it’s more appropriate to use the cap rate’s cousin metric, called return on cost.
This is essentially your “future cap rate.”
It incorporates the stabilization costs (renovations), as well as the projected NOI upon stabilization.
Return on cost is calculated as follows:
Return on cost = (Purchase Price + Cost Associated with Stabilization) / Projected Future NOI
Return on cost is useful when you’re comparing an asset that’s already stabilized with a “project” that will need some work to get there.
Let’s look at an example to give you an idea of what we mean:
Let’s say you’re trading in a market where stabilized properties are selling at 5% cap rates.
You’re comparing a $30 million property that is already stabilized with an NOI of $1.5 million to a value-add opportunity.
The value add property can be purchased for $25 million, but requires an additional $5 million in renovation costs.
This property was managed improperly, leading to a current occupancy rate of only 75% and an NOI of $900,000.
Your projections, however, show that after you renovate and stabilize the property, you can boost the NOI to $2 million.
This means your return on cost for this investment is 6.6%, significantly higher than the 5% cap rate for a stabilized asset.
Since the property is now stabilized, we can then use the market cap rate and the new NOI to determine the new property value.
$2 million / .05 = $40,000,000 new property value
Through your efforts, you’ve added $10 million in excess value above what you spent.
To circle back to secret number one from this article, this is the type of investment that provides hefty returns on a risk-adjusted basis.
Remember that while the cap rate is a valuation superstar, you can’t compare apples to oranges.
Cap rate is only appropriate for stabilized assets. Otherwise, return on cost is the metric you should be using.
There’s no silver bullet in real estate investing. It takes a lot of time, effort, and education to form a holistic viewpoint that accurately judges investment opportunities that come your way.
That said, the secrets from this article are priceless when implemented properly to your investment strategy. Make use of them and thank me later.