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Avoid These Common Mistakes When Passive Investing in Multifamily Real Estate
Last Updated: August 02, 2o24
Steve Nabity
Introduction
Markets, including real estate and stocks, work like tides. When the tides swell, they lift all the boats. In a bull run, prices appreciate and the animal spirits kick in. But when the tides recede, as Buffet famously once said, people find out who has been swimming naked. A down phase can be especially difficult for investors who make mistakes in their decision-making.
In this article, we shall highlight some of the common mistakes investors commit when investing in multifamily real estate. Passive real estate investing is a thoughtful choice, as it allows one to have exposure to the asset class without becoming a property manager. However, as famous investors have stated in the past, more than half the battle is won by understanding what not to do and minimizing mistakes.
Understanding Passive Investing
Passive investing is like choosing to take a cab over walking. Imagine going to a meeting about a mile away. If you have time and are up for it, you may walk to your meeting. If you don’t have the time or need to reply to some emails, you might take a cab, pay the cab fare, and instead use your time for replying to the emails.
Passive investing is similar. Instead of training yourself and then finding, negotiating, and managing investments, you work with someone knowledgeable and qualified who can do all of that for a small fee. This “partner” of yours can either be a fund, an ETF, or a syndicator. You can spend your time on your job or building a business while your money is put to work by the trusted partner/entity that you choose to work with.
Robert Kiyosaki and Warren Buffet are examples of successful passive investing. Warren Buffet did not become a mixologist or a beverage expert to make money from Coca Cola while Robert Kiyosaki did not become a real estate analyst to generate passive income from real estate.
Multifamily real estate has been one of the most popular sub-segments within real estate for passive investment strategies. Multifamily investing, if done correctly, can offer steady cash flows, some hedge against inflation, investment diversification, and the ability to leverage an investment prudently.
Mistake 1: Insufficient Due Diligence
If one visits any of the popular multifamily broker websites and looks at offering memorandums of properties on sale, the picture looks really positive. There have been cases in the past where investors evaluated the deal based on these broker-prepared rosy-looking memorandums and the information given without conducting thorough due diligence. The result? Nasty surprises like discovering structural issues with the buildings and deferred maintenance resulted in substantial expenses that were never planned for. Such issues can lead to capital calls or a scramble to borrow more, straining cash flows from the investment.
Due diligence in real estate involves studying the market, analyzing what rents comparable properties can achieve, visiting the property, understanding what maintenance work has already been done, understanding what the neighborhood is like, and identifying inconsistencies in the rent rolls and T12s. Investors also need to anticipate payroll expenses, especially in the case of owner-managed properties that show no such expense.
Mistake 2: Overestimating Cash Flow
Estimating the income from and the value of a multifamily property is mostly about cash flow assessment. The deal underwriting process analyzes various factors that drive the cash flows available to investors.
One of the factors is the occupancy rate. Every submarket has a certain physical vacancy level as it is generally not practical to assume 100% of the units will always be occupied. Savvy investors will also think about having some margin of safety and account for unexpected expenses or cost overruns, especially when renovating or spending maintenance capex.
There have been several instances in the past when investors, during a raging upcycle, have lowered their underwriting standards and overestimated cash flows to make their bids more competitive. Reality tends to hit a few months or years down the line when projected rents cannot be achieved or there is too much bad debt.
It is, therefore, important to work with someone who knows the benchmarks regarding expenses or tax reassessments or how conservative the deal analysis should be. Being too conservative can make the bid less competitive while being too optimistic can lead to nasty surprises down the line.
Mistake 3: Ignoring Property Management
There have been instances in the past when property owners have tried to save on property management expenses and instead tried to go solo and do it all themselves. The result, in some cases, was lower occupancy levels and lower rents. Significant maintenance work also got deferred and that made it difficult to sell the property at a price sought by the owners.
Property management is an important aspect of owning real estate. The asset class is not a buy-and-forget option like mutual funds or ETFs. Real estate investors have to incur certain expenses just to maintain the property in its current state.
When choosing the right property management team, you may want to consider the experience level of the company not just in terms of the number of years, but also in terms of managing a similar type and size of property as yours. You may want to ask about any certifications or licenses that the company holds if your county or state has such requirements. You might also want to know about their tenant screening and selection process. Lastly, you may also want to inquire about what property management tools, software, and technology the company uses.
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Mistake 4: Underestimating Market Cycles
Real estate market cycles are like seasons during the year. Summertime is when the temperatures peak and so do real estate prices. Demand is at a high and there is plenty of activity. Fall is a transitional period with the color of the leaves changing and temperatures just cooling a bit. Real estate during the autumn is also usually in a stabilization or consolidation phase. Demand and supply are more balanced. Next comes winter, when temperatures drop and so does the demand. Prices also cool off. Finally, spring arrives with optimism as buyers begin to sense opportunities.
As an investor, it is important to understand asset cycles so that you are not wrong-footed. While time in the market is the key, timing the market is also important. One does not have to be 100% right, but being 80-85% right can save you a lot of stress.
As per a study conducted by CBRE, multifamily real estate experienced the least rental decline among various real estate subsegments during the recessions of 2001 and 2008. Multifamily is considered to be a resilient sub-segment within commercial real estate.
Mistake 5: Failing to Diversify
You may have heard of stories about cryptocurrency investors becoming millionaires and then losing all the newfound wealth when some news led to a crash in the price of the cryptocurrency. A similar example would be about an investor who piled all his money into Blockbuster’s stock when the streaming of movies began. These folks failed to diversify.
No matter how good an investment opportunity looks, you simply never know when the party will end. It could end after a few decades or it might end tomorrow. Never put all your eggs in one basket is what everyone says, and they do so for a reason.
One way to achieve diversification is to invest in a variety of asset classes rather than just stocks or bonds or property. Within real estate, you can achieve diversification by investing across a portfolio of properties located in different markets and locations. You can also diversify by investing in multifamily, industrial, retail, and commercial properties. That way, you get exposure to various sub-segments of real estate.
Benefits of Avoiding These Mistakes
While most people associate investing with returns, sophisticated investors will focus more on risk. For them, risk means a permanent loss of capital. They try to first minimize the possibility of losing capital. Only after that, the thought process shifts to growing capital. After all, you can enjoy the benefit of compounding only if your capital lasts for a long time.
Enhancing portfolio performance can happen by improving returns per unit of risk. One can enhance investment portfolio performance through asset allocation (choosing what asset classes to invest in and how much) and risk management (making sure you don’t lose capital). Returns can be juiced up, but at what risk? The name of the game is risk-adjusted returns.
If you ask any experienced investor what their most satisfying returns were, chances are that they may share instances when their money grew with the least volatility and stress.
Getting Started with Multifamily Real Estate Investment
If you are curious to know more about multifamily real estate, then we encourage you to check out Skyline Point Capital. The company specializes in multifamily real estate across multiple states and markets. But, before you do that, assess your personal risk tolerance and investment goals. Multifamily investing can help achieve financial goals and your portfolio’s objectives.
Skyline Point Capital’s team has more than 50 years of combined experience in real estate, business, and finance. We also believe in taking advantage of tax savings that are on offer for multifamily investors. Having executed a host of deals across multiple real estate sub-segments, we have honed our processes and best practices that position us to provide a professional investment service to clients from a variety of backgrounds. Feel free to get in touch with us to learn more.
Conclusion
Investing in multifamily real estate is a great decision. However, remember to minimize and eliminate common mistakes such as not performing due diligence, overestimating cash flows, not understanding the real estate cycle, and being too concentrated with your investments.
Always seek professional advice in financial matters and work with experienced professionals when investing in real estate. Skyline Point Capital is one option that you could explore.
