It is no news that multifamily property is the investment rave right now. The odds associated with this line of investment seem to be slim as prices are rising and the demands are increasing by the day. Buyers and sellers often break protocols and lay aside their financial cultures just to make sure they beat other bidders at the next deal. Real estate investments usually have a great appreciation value but the multifamily properties are even growing at a more unnatural rate. This unprecedented growth is majorly an outcome of two human factors: Deferred single-family home purchases due to high market prices and limited home availability with significant student loan debt. The second factor is the recent trend of individuals selling their homes and then opting for home rental without buying another property due to the skyward market prices and the product unavailability in the market. For others it is neither of the above factors as the retired ones just want to cut on cost and use their home sale funds for vacations are more recreational activities.
THREE MAIN RISKS ASSOCIATED WITH MULTIFAMILY INVESTMENTS
The amount of indices and parameters that tip multifamily property investments as a good form of investment are countless and clear cut. From the cash flows to the impressive and fast rate of property appreciation, nonetheless it is important to identify the risks that investors take in investing in multifamily properties.This is especially relevant because most investors partake in the multifamily property investment without caution or giving regards to precautionary investment protocols. Here are some of the risks associated with real estate investment.
- THE RISK OF HEARSAY MARKET VETTING: Usually when a business opportunity is realized or gotten, due diligence requires that the potential investor makes deep research on the investment opportunity. This research should cover all the dimensions of the investment before actually committing to it. This is typically the opposite of what we have now as most investors are drawn into the business just because they are hearing about how profitable it is right now. Their vetting of the market is based on stories heard which is actually a bad start to any form of investment.
- ECONOMIC RISK: The economy is currently in a very delicate spot and at extreme levels. These record levels usually don’t last for too long. So when the economy settles back to normal, the resulting effects usually lead to higher rate of unemployment. This singular effect ripples into other things like unpaid rents, higher vacancy rates, decreased cash flow and operating income. This worrying scenario is why flooding of the primary market with Class A properties should be restricted or regulated as it represents great risk to investors and the economy.
- REAL ESTATE MARKET RISK: As earlier mentioned, some investors often buy multifamily properties above market or asking price just to be the best bidder. In the case of the real estate market slowing down unexpectedly, the profitability and the projected cash flows might be compromised and investors might not be able to achieve their projected returns, profits or income.
- RISK OF COMPETITION: In business generally, competition represents a very strong type of risk. Even more so in real estate business as homeowner wants new tenants to maintain a good vacancy rate. Loss of tenants to close competitors represents huge risks as this grossly affects returns, cash flow and net operating income.
- LENDER’S RISK: A worrying fact in the real estate business is the fact that most multifamily properties are bought in debt. When borrowers use lender’s loan to fund properties with high loan to value ratio, there is a high leverage on the property. This represents risk as the cash flow from the property might not be sufficient to pay back the debt, in which case the property goes into foreclosure. On the other hand if the market depreciates and the property loses value, the investor’s equity is slashed or even lost completely. So the lender is faced with this risk in lending money to borrowers involved in real estate investments.
- PROPERTY RISK: This is another type of risk emanating from the high level of negligence on the part of buyers who just want to get a particular property. A lot of these buyers go for the property of their choice without due inspection or thorough research. It is after they have purchased the property that they realize the poor building conditions, code violations or utility problems. These problems might require a lot of money from the investor to solve and this might end up slowing down the investment’s rate of return.
WAYS OF REDUCING RISKS
- REDUCTION OF RISK WITH MARKET ANALYTICS: Market analytics is a very important way of reducing or cushioning the effect of diverse risks in the real estate market. Investing in a strong market automatically relieves the investor of certain risks. The question becomes how to determine a strong market. The strength of markets to some extent can be determined from the market’s overall growth. This growth includes the population growth and the job growth. A high population growth indicates that there are a high number of people moving there which suggests high demand. The high demand for rental units in a real estate market is connected to the population growth. This population growth can easily be checked on the internet. For economic relevance, the population growth of the previous is considered for any investment decision. Job growth is also an important metric to determine the strength of a market. When there is job growth in a market, the population will naturally increase to occupy the new job openings. With over 2 million jobs added throughout last year, the employment rate reduced by 3.7%. Because of the presence of more people, multifamily vacancy rates drops as there is increased demand for rental units. This translates into more rent for the investor.
- CONSERVATIVE UNDERWRITING: It is important for investors to underwrite conservatively especially in terms of rent growth. This tactic or strategy starts by checking past and future or projected rent growths. For example if a market shows a past rent growth of 6% and a projected rent growth of 5% (according to expert reports), the investor underwrites 3.5% – 4% rent increases just to be safe. Another index that relates to growth is the capitalization rate. Cap rate is real estate valuation index that measures the yearly yield of a property. It helps in the comparison of the cash flow of one property to another. The cap rate can also help the investor evaluate the risk potential in a transaction. High cap rate translates into lower purchase price of a property. Older multifamily properties with a lot of credit-defiant tenants have more risk than a new property with credit-worthy tenants. With full comprehension of the risks and the cap rate of properties, investors could bargain for lower prices for higher cap rate in order reduces the risk.
- INVESTMENT DIVERSIFICATION: The unpredictability of the business climate especially real estate investments necessitates investors to diversify their investments. No matter how promising a market is, investors should not make the mistake of investing all their money in one outfit. This diversification reduces the risk of the investor and it is just a good and basic practice for passive investors
Risks are an inevitable aspect of investments especially real estate investments. Investors are naturally faced with the responsibility of using variant means to minimize investment risks. There are several forms of risks prevalent to real estate investments; the identification of these risks is the first step which might require consulting economic experts. It is also important for investors to be conservative in their underwriting and to reduce the risk by diversifying the investments.