Multifamily housing refers to apartment complexes larger than four units. Luxury multifamily housing describes the high-end segment of those complexes. Luxury properties of the highest quality are meant to appeal to households capable of owning a residence but that choose instead to rent for the lifestyle advantages. Apartment living entails fewer responsibilities than home ownership and can allow residents to live in areas where single-family, stand-alone homes are rare, such as in city centers.
Luxury is measured by amenities inside the units and within the complex. Amenities can be highly practical, such as 24-hour concierge service and a spacious dog park, or sumptuous. The level of sumptuousness is increasing in luxury multifamily housing. Special-purpose common areas, such as yoga spaces and film screening rooms, are distinctive characteristics of this class of housing. Units feature custom finishes, high-quality appliances, and high building standards.
Luxury multifamily housing holds its value longer than other classes of housing, and is therefore considered a more reliable way to preserve wealth than investments in other classes.
What Is Luxury Multifamily Housing?
A Profile of Multifamily Housing
Like the general real estate market, the multifamily housing market is affected by many factors, including the broader economy. Sometimes, apartment housing is also affected by the single-family housing market (high house prices encourage renting, for example)—but characteristics of the two markets differ strongly.
Multifamily housing is divided into four classes—A, B, C, and D. The most appealing housing is Class A, but not all complexes in that class are luxury. Class A housing is most often less than 10 years old, in a desirable location, and offers the most—and best—amenities. Class A buildings, particularly in the luxury segment, command the highest rent, but they have the lowest capitalization rate (a measure of profitability), at around 4-6 percent.
Buildings drop through classes as they age and as appliances and large systems (HVAC, plumbing, electrical) become outdated. Class B properties are typically 10-20 years old; Class C properties, sometimes called workforce housing, are usually at least 20 years old; and buildings in Class D are roughly synonymous with slums. Regardless of its class, income generation, rather than the book value of its components, determines the value of a multifamily complex. Older properties are still disadvantaged by their shorter income-generation horizon, however.
Investing in luxury multifamily housing requires certain knowledge and skills that develop with experience. To make that experience as positive as possible, an investor begins with a clear idea of needs and goals. A business plan is always helpful, as it’s an effective way for an investor to organize thoughts and to present them neatly to partners and associates. A sound risk management strategy goes hand-in-hand with a business plan. Since all risk can’t be avoided, a balance must be reached between potential risk and potential profit.
The next step toward making a multifamily real estate investment is research. The time an investor spends honing market research skills and valuation techniques, and studying financial projections and market trends will be rewarded with keen deal analysis abilities and sound investments. Professional advice can also be a key element in an investor’s success, of course. An additional perspective can give the new investor valuable tips and insights.
Development vs Acquisition: Deciding Between the Two
An investor may choose to build (develop) a multifamily complex from the ground up or buy (acquire) one that already exists. As discussed in detail below, there are cities and neighborhoods where it is more profitable to build a complex than buy one, and vice versa. Profitability is far from the only factor to consider when making a final determination, however. Acquisition and development are entirely different processes, and investors enter into these projects with differing motivations.
New investors who choose to develop properties face more complex financing because the risk is higher—the collateral for lenders has not yet been built. The investor risk is high for the same reason. Development and tenanting of the complex is usually completed in two to five years, at which time investors receive their returns and often exit the project. A property that is acquired after development produces income immediately and is usually held for a longer period, since it has no “completion” date and income from it comes in steady, smaller increments. With this long-term income generation, a luxury property tends to hold its value well, making it a good choice for wealth preservation, whereas development is better suited for investors who are seeking faster ROI.
Choose a Location
The national multifamily housing market is lively and diverse. Economics and demographics exert a strong influence on the market. This does not mean that investors must flock together in the current “hot” cities. An investor’s choice of area to invest in will also depend on whether the intention is to develop a property or acquire one.
Selecting a property location in which to acquire or develop is where an investor’s research pays off. An investor should be aware of market trends, including peaks and recoveries, to make an informed investment decision. People move around the country as employment opportunities and lifestyle choices dictate, after all, driving housing markets as they go.
The selection process is likely to begin at the regional level. Depending on various circumstances, an investor may want to invest in a property close to home for convenience, or determine locale based more on economic and financial factors. Once a city or region has been selected, there are submarkets to consider. For example, a city center may be desirable in one region, while the suburbs are more promising in another. Individual towns and neighborhoods have their own cycles of popularity as well. Ultimately, the choice boils down to a few properties, and a new set of criteria comes into play to evaluate their past performance and future potential, and to judge between specific buildings or projects.
Repositioning Is Also an Option
Multifamily housing can be acquired and managed as an investment without a need for major changes. But repositioning a property, meaning to renovate it and/or add amenities, serves to increase its value and derive more income from it by raising rents to market level. Complexes are often bought with repositioning in mind.
Repositioning opportunities are highly situational. Before committing the time and money to a project, an investor must examine the ROI potential in the move, which means complex location, apartment demand, and other factors that determine rent prices must be considered.
Repositioning possibilities might include taking modest steps, such as passing on utility costs to residents or finding a more economical or efficient management company. Cosmetic changes, such as repainting, improving the landscaping or installing new signage, can be made with a small capital outlay. Big-budget changes may be possible, in light of ROI, in some complexes. Amenities like high-end appliances and fixtures can be added in units, for example. In common areas, entrances can be renovated, clubhouses and fitness centers can be added, and pools can be upgraded. The investor and tenants should be prepared for the disruption that can result from major construction.
Look at the Financial Big Picture
Investors have a multitude of investment options, so the decision to pursue an opportunity in multifamily housing probably comes after long and careful consideration. Still, even after the choice is made, care must be taken to ensure that the investment is suitable and responsible.
Multifamily housing should fit an investor’s needs in terms of investment horizon, diversity, and risk. Because an apartment complex is considered a low risk and low liquidity investment, the investor holding period for such a property is at least seven years.
Investing in multifamily housing has a number of financial factors and advantages. The relative simplicity of securing financing is a major benefit. Banks look favorably on multifamily real estate because of the stability of the investment. The large number of tenants means that individual vacancies have only a small impact on cash flow. In addition, operations and maintenance are not complex, resulting in comparatively low overhead.
Due Diligence Is a Must
Due diligence—an audit conducted before the purchase of a property is finalized—is intended to identify potential problems with the performance of an investment property. It examines the physical property and more, including its title, its financial and legal status, and its compliance with zoning, environmental and building codes. Time should be allotted for due diligence in the sales agreement. Typically, 30-45 days after the payment of a security deposit is sufficient.
There is no official checklist for due diligence, but one should be drawn up for every property being considered. Due diligence is a complex process that requires the participation of several specialists, including a lawyer to review the contract, an accountant, a building inspector, and potentially others. Since due diligence is a standard procedure, it is not difficult for an investor to obtain competent advice on the necessary steps to take. Issues uncovered in due diligence can affect the course of the sale and should be settled before the sale proceeds.
Managing Your Assets
Every property must be managed. Some investors take on the role of manager themselves; others hire management companies. Property management requires a lot of skills, ranging from accounting and advertising to maintaining a stable of reliable contractors and making minor repairs.
Property management also requires a lot of an owner’s time—hours and even days that can be spent more profitably on investing. The challenge of office hours and being available round-the-clock for emergencies are compounded if the owner/manager is located at any considerable distance from the property.
When a busy investor owns more than a single property, self-management becomes practically impossible. In such cases, investors turn to management companies. Because property management companies are extremely efficient, they save property owners money as well as time. Tenants are generally more satisfied with professional management as well, which can lead to higher retention rates.
Plan an Exit Strategy
After about seven years, an investor may choose to sell a property to avoid a mounting depreciation recapture bill or as an alternative to renovating it. But regardless of the expenses that can be avoided by a timely sale, the investor will still face capital gains taxes. A reliable way to defer those taxes is to engage in a 1031 exchange of like-kind assets. The 1031 exchange, named after the section of the Internal Revenue Code that contains its rules, has been a mainstay of the commercial real estate market since 1921, just three years after the introduction of income tax in the United States. Since the tax reforms of 2018, its use has been restricted to real estate.
A 1031 exchange offers great benefits, but it is quite complicated. It requires many steps, the use of a reliable intermediary (referred to as a “qualified intermediary”), and strict observance of deadlines. Investors can generally structure an exchange to meet their specific needs. Assets can be consolidated or divided, for example, or used in a partial sale and partial exchange. Capital gains taxes can be deferred as long as the assets are exchanged rather than sold. On the death of the investor, the deferred capital gains taxes are eliminated as the property is “stepped up” to market value.
Many of the standard practices of 1031 exchanges have never been promulgated as rules, however, and are therefore subject to interpretation and potential challenge by the IRS. For this reason, it is essential to seek the advice of an experienced professional and a qualified intermediary.
Consider Partnering with a Real Estate Investment Management Company
Many investors choose to take advantage of the services of a real estate investment management company, which allows them to pool their funds with other investors to invest in diverse and high-quality properties they would otherwise not have access to on their own. Along with pooled funds come pooled, and thus reduced, risks. An investment management company employs a staff of experts who can address an investor’s specific goals and needs, including property management and 1031 exchanges, and provide support and advice in other ways.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
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The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.
Advisory services are provided by CWS Capital Partners LLC, a registered investment advisor.
Securities offered by CWS Capital Partners LLC are through an affiliated entity, CWS Investments. CWS Investments is a registered Broker Dealer, member FINRA, SIPC.