Multifamily real estate is an IDEAL investment. IDEAL is a simple acronym for these five important investment components:
We’ll examine each and see how real estate satisfies all. We’ll then explore how multifamily investments satisfy an additional, often overlooked criteria – Scale. Lastly, we’ll go through examples of several investment vehicles to see how they stack up to the IDEAL formula. Let’s get started.
Components of IDEAL Investments
Income – money produced by the investment that can be spent, saved, or reinvested. Income is often referred to as cash-flow, which represents cash remaining after all the expenses are paid. Real estate produces income when the tenants pay rent. Great real estate investments cover all the expenses and have a healthy amount of money left over after. A great part of real estate investments is that it can be largely passive, requiring little effort on your part.
Depreciation – a tax benefit that lets you discount the value of the property over time against your earned income. The IRS lets you use the value of your property to offset your income over a period of time. You may hear this referred to as phantom cash flow or a paper loss. It acts like cash flow from a tax perspective allowing you to reduce the amount of taxed income.The IRS tax code allows for depreciating an apartment building over 27.5 years, and associated assets over shorter periods using component depreciation concepts. The Code allows only real estate investments to be exchanged to defer taxation under Section 1031.
Equity – the ownership amount of an investment. Over time, as the mortgage is paid off, the amount of equity you have in a property increases. Equity affects your net worth and, as you build equity, you build your wealth. Having more equity also helps you when you apply for loans. The equity comes back to you when you either sell or refinance the property.
Appreciation – the growth of the value of an investment. There are two types of appreciation. The first is the natural increase of the property value over time. This is influenced by the surrounding market as well as inflation. The second type of appreciation is forced-appreciation. This happens when you purchase a property and increase its value through improvements – such as raising rents, decreasing expenses, or fixing up a property.
Leverage – using someone else’s time or money to do more with less. Often you purchase real estate using other people’s money (OPM) in the form of a loan. By leveraging, you can grow your investment at a faster pace. You also leverage your tenant’s time as they work hard to earn the money needed to pay rent.You leverage the expertise of others, such as a qualified property manager, legal resources, lenders and the syndicator. They help you find the right properties to buy, manage them effectively and arrange for financing. You do not have to use up your own credit rating and valuable time.
Scale – the improvement gains you get as you grow to larger-sized investments. This is the additional criteria found in multifamily real estate. With multifamily, you can more easily purchase many units in one transaction. This separates apartment buildings from single family houses. Compare the effort it would take to buy 100 houses to one apartment building with 100 units. You also gain economic advantages having all of your units on one property.
Now that we have gone over the components of an IDEAL investment, let’s compare several types of investments to see how they stand up. We’ll compare multifamily apartments, businesses, stocks, and bonds.
Comparison of Common Investment Vehicles
Do apartments have passive income? Yes, in the form of rent and with the use of a management company.
Can apartments be depreciated over time? Yes, the IRS tax code allows for depreciating an apartment over a 27.5-year period.
What about equity? The equity of apartments is the difference between the value and any loans on the property. It grows when the mortgage is paid down or the value of the property increases.
How does appreciation apply to apartments? Apartment buildings typically appreciate at a rate of 2-3%, depending on many factors. They can also appreciate much faster in high growth markets or through forced appreciation.What is forced appreciation? Apartments with 5+ units are valued by the amount of money they produce. Because of this, you can force appreciation by increasing rents or decreasing expenses. Any positive increase in the bottom line will directly increase the value of the multifamily real estate.
In what ways are apartment investments leveraged? Multifamily properties leverage other people’s money when purchased using loans. They also leverage the time of the tenants who work hard to come up with the needed money to pay for rent.
In what ways are multifamily apartments scaled? Apartments come in all kinds of sizes. It is possible to purchase a small duplex or even thousands of units at once. As the number of units grows, you gain more efficiencies, further allowing you to scale.
In summary, apartments satisfy all the conditions of an IDEAL investment. Additionally, multifamily investments have historically experienced higher returns like stocks and lower risks like bonds, giving you the best of both worlds. Thus, they present some of the highest risk-adjusted returns available in the investing universe.
Multifamily investments have performed relatively well under high risk environments – such as housing crisis of 2008-2009 and the corona virus threat. These are just some of the reasons why we have chosen to focus on multifamily real estate.
Can businesses generate passive income? Yes, if the management and operations are handled by employees and not the owner. Often, however, small businesses end up being another form of a job for the owner.
How does depreciation apply to businesses? Businesses can depreciate equipment and property. However, this doesn’t usually account for much unless the business has a large amount of equipment or property.
In what ways do businesses have equity? The equity of a business is the value minus the debts. Determining the value can be tricky unless the business is sold or appraised by a competent appraiser.
Do businesses appreciate? Yes, businesses appreciate over time if their value increases through increased profits. Profits grow through higher sales or increased operational efficiencies.
How do businesses use leverage? Businesses are sometimes purchased using loans and can also use loans to expand. Additionally, they leverage the time of employees to accomplish more.
Can investments in businesses scale well? While it is true that businesses come in all sorts of sizes, usually smaller businesses require more hands-on work from the owner. This makes it difficult to scale.
Overall, businesses can make a lot of money for their owners. However, it can be harder to set them up as an IDEAL investment without delegating the management and operations. This can be a tricky balance, which often results in lack-luster performance of the business or an over involvement of the owner.The over involvement of the owner can present severe life style-degrading characteristics. Typically, an effective business investment requires special expertise from the owner.
Do stocks generate passive income? Yes, stocks can generate passive income in the form of dividends. Not all stocks pay a dividend and the rate and timing varies widely.
Can you claim depreciation from stocks? No, as a shareholder you don’t get any of the benefits of depreciation.
How about equity? Yes, the value of the stock is the amount of equity you have in the investment.
Do stocks appreciate? Yes, stocks can appreciate if the value goes up. However, the value can be up one day and down the next without much rhyme or reason.
How can you use leverage with stocks? Stocks can be leveraged when traded as options. Options give you the right to buy or sell a number of shares at a given price. What you initially invest in is the option and not the stock. Usually the option allows you to purchase or sell a larger number of shares than you could otherwise if purchased directly. However, options carry extra risk and require specialized skills. Another way to leverage stocks is to borrow against their value. This is called margin loans and can be used to purchase more stock, futures, or options.
Can you scale well using stocks? There aren’t many additional benefits to purchasing a larger number of shares. You still earn the same return per share regardless of the number of shares you own. That is unless you purchase a controlling number of shares in a company.
While stocks do have a lot of the components of an IDEAL investment, they don’t have all the benefits. Also, with stocks, you have little control over the performance of the investment and the returns can vary widely for no apparent reason.
Is it possible for bonds to generate passive income? Yes, bonds are essentially loans to businesses or governments that generate income as they are paid back over time.
Can bonds be depreciated over time? No, bonds can’t be depreciated.
Do bonds have equity? Yes, the equity amount for a bond is typically the amount you initially invested.
Do bonds appreciate? Yes, the value of a bond can appreciate if the interest rate drops. When you hold a bond with a higher interest rate, the value increases once you can no longer buy bonds at that higher rate.
Can you use leverage with bonds? No, you normally can’t leverage bonds.
Can you scale your bond investments? Like stocks, purchasing a larger or smaller number of bonds doesn’t have any added benefit. The return per bond will be the same regardless.
Bonds do have some aspects of an IDEAL investment but don’t satisfy all. Like stocks, there is little you can do to improve the performance of your investment and you are at the mercy of the market.
Here is a summary of the different types of investments and at what level they can be considered IDEAL.