Why Bigger is Better in Multifamily (and why it sometimes is not)
Have you ever heard that bigger is better in Multifamily? If you haven’t there are a bunch of “tiers” that point to that direction. Price reductions on property management, Cost segregation, non-recourse loans through Fannie and Freddie…
But today I wanted to talk more about the smaller things, especially if you aren't a big player in the Multifamily space, and actually dig into some numbers! Back in April of 2019, I closed on my first Multifamly, a 6-unit deal. I was so happy because I finally broke into the commercial real estate space! By all the metrics I've learned and discussed with other investors, I finally found a deal that both met my personal investment needs and provided the "real-life" experience to be more credible to JV and syndicate to scale. Now don't get me wrong, I am VERY happy with this investment and it is doing great. But I wanted to highlight some specific examples of the title line of this article with REAL numbers and real experiences I have had. Let's get into it!
At a local meetup, I was casually talking to another investor who owned a 10 unit. I was saying why an established property management company is crucial and an amazing ally on your team. I told this example of how the previous owner was paying $120 / month for trash collection, and because my PM manages 3500+ doors they can easily get deals from companies. We got a new contract and paid only $90 / month, increasing the value by about $4,000! I’m pretty smart, right? This investor was telling me how they pay $110 / month and they should look into that. But wait, who’s the smarter guy here? When you break it down to cost per unit, I am paying $15 / unit and they are paying $11 / unit. Same service, lower expense ratio. Same goes for lawn care, snow plowing, etc.
All in all, this is the reason why stabilized small properties operate around 55% expenses and larger properties operate more to 50% expenses, or lower. Property management costs also are tiered, where price breaks by % points at certain number of units. Each % point is another ½% in your cash flow (about), and they are important!
The other big thing is spikey expenses. This is very true with SFRs, where cash flow is amazing when nothing goes wrong, but the second there is a vacancy or anything needs replacement, it takes months to recover. In a real-life situation, one of the furnaces in my 6 unit died, in the middle of the winter in Cleveland. Now, in a SFR this would be a crisis, but luckily, the other units had residual heat to that unit. BUT we still had an unhappy tenant. With an emergency call on a Saturday, we patched it up and scheduled a full replacement 2 weeks later. This turned into a $3,000 charge that would take me about 2.5 months of cash flow to recover from (this is also why it's important to have a healthy cash reserve to operate from and deal with unexpected issues! Also, stash some money away each month for these big events). So in reality, I was overly cautious with the cash but being my first apartment I wanted to be safe.
Final item I will go over is cost segregation. This is surprisingly one of the most unknown tax advantages people don’t know about. I can’t tell you how many people who are much more experienced than me don’t know about this and I end up educating them on this! Essentially, if you don’t know, Cost Segregation is literally segregating the “costs” or value of the building into different buckets, specifically 5 years, 7 and 15 years. For example, carpet lasts only 5 years so why depreciate it at 27.5 years? This study accelerates the depreciation of the asset so you get more of your money now and not later. A dollar today is worth a dollar tomorrow! And don’t get me started on 100% bonus depreciation! The point is, on smaller deals, it doesn’t really make sense. It’s an expensive study and becomes exponentially more valuable the bigger the asset. For example, there was a 20 unit deal recently I wanted to buy and did a quick cost seg estimate that I got free from the team I work with. Here are the numbers:
$210,000 all in cost (including reserves, light rehab, down payment, closing costs, and cost of study). Cost seg study showed an accelerated (extra) depreciation of $170,000 year 1, which at a conservative 25% tax rate is $42,500, minus the estimated $4,000 cost is a gained value of $38,500. That means, if you can claim all of that loss in year one, that is a ROI of 18.3% on tax savings alone! (NOTE: I am not a CPA and far from a tax expert, so always check with your CPA on if this makes sense for you and your personal strategy. There are restrictions and limitations!). Therefore, I must take a slow, boring 27.5 year depreciation.
Ok, that is all for now. While bigger deals are definitely better, there are more smaller ones, and they are more accessible and trade more often. At the end of the day, what matters is the %s, not the numbers. I hope you gained some value and while I am VERY happy with this deal and it has been great, there are pros and cons to each investment. I got what I needed out of this small deal, and ready to expand.
What are other reasons you like bigger, or smaller deals?
