Understanding Different Multifamily Investment Types
Core, core plus, value-add, and opportunistic investment opportunities have different levels of risk and rates of return.
The real estate industry has many different investment opportunities. These exist for every investor's needs and risk tolerance. Deals range from conservative to aggressive, and several factors determine the level of risk. These factors include the property type, a building's physical qualities, location, and the capital structure.
To choose a deal aligned with investment objectives, risk appetite, and expected return, investors must understand the differences between deals. There are four broad categories to describe various investment opportunities: core, core plus, value-add, and opportunistic. Below, we look at what investors need to know about each type of investment.
Core Real Estate Investment
Core is the safest investment play. These investments focuses on stabilized, fully leased assets in primary markets. Core buildings are typically Class A assets in desirable locations with high credit score tenants on long-term leases. These properties are usually well maintained and require few, if any, upgrades. Investors targeting core assets usually aim for stability, predictable cash flow, and low risk.
Expected annualized returns range from approximately 6% to 10%, and investors use around 40% to 45% (or even less) debt to capitalize a transaction. Most of the return is generated through cash flow rather than property appreciation.
Core Plus Real Estate Investments
Similar to core investments, core plus real estate investments target more stabilized properties with reliable tenants and low to moderate risk profiles. These investments usually involve Class B properties in good locations; however, they require some improvements. Core plus properties might also have tenants with expiring lease terms in the near term, adding some risk to the investment.
Due to a slightly increased risk profile, core plus investors expect a higher return. Investors generally expect annual returns to be in the 8% to 12% range, generated through income and some growth. Leverage to acquire these assets ranges between 45% and 60%. Core plus assets are an optimal investment strategy for investors with a somewhat higher risk tolerance and an eye toward some capital growth.
Value-Add Real Estate Investments
Value-add properties are higher-risk investments but provide more growth opportunities. Value-add investments might have little to no cash flow at the time of an acquisition. Their investment upside stems from appreciation by upgrading Class B and C assets. Some of these buildings might also have significant management and occupancy issues. Properties with value-add opportunities are typically located in growing or supply-constrained markets.
A successful value-add investment can generate returns between 11% and 15%, while investors are likely to use leverage between 60% and 75%. Value-add investments are a good strategy for investors with higher risk tolerance and a desire for growth.
Opportunistic Real Estate Investments
Opportunistic investors have a similar approach to investing as value-add investors, but with greater risks and potential returns. Opportunistic assets usually have almost no predictable cash flow. These types of assets are often fully vacant or involve ground-up redevelopment. If a business plan is successfully implemented, this types of investment offer the highest level of return. It may take around three years for investors to see a return on investment.
Opportunistic investors are likely to use 70% or more leverage, depending on the project type. Annual returns can reach 20% or more. These investments are suitable for real estate players with a high risk tolerance and a good, proven long-term strategy.
Calculating the Cap Rate of Your Investment
When making a decision on what type of investment is best, it's worthwhile to look at each option through the lens of its cap rate, or capitalization rate. You can use cap rates to figure out the annual net gain or loss on an investment, using only net operating income and the asset's market value.
Use our cap rate calculator below to quickly determine your investment's cap rate.
Related Questions
What are the different types of multifamily investments?
The different types of multifamily investments are Core, Core Plus, Value-Add, and Opportunistic. Core investments are stabilized properties with low risk and low returns. Core Plus investments are properties that have some upside potential, but still have low risk. Value-Add investments are properties that require some improvements to increase their value. Opportunistic investments are properties that require significant improvements and have higher risk and higher returns.
For more information, please see this article from Multifamily.Loans.
What are the advantages and disadvantages of each type of multifamily investment?
The main advantage of multifamily investing is that it provides investors with the opportunity for a steady stream of income. With this type of investment, investors are able to rent out the units to tenants and receive a consistent, ongoing return on their investment. Multifamily investments also offer the potential for a higher return on investment than other types of investments, including single family homes, with less risk. Multifamily properties also perform better in a recession.
The primary disadvantage of multifamily investing is that it requires more capital upfront than other types of investments, apart from other, large commercial assets. Multifamily investments often require a larger down payment than other types of investments, as well as larger monthly mortgage payments. Additionally, multifamily investments can require a significant amount of time and effort to maintain, as tenants must be screened and managed, and repairs and upgrades must often be made to keep the units in good condition. While a property management company can help with all of these operational aspects, this comes at an additional significant cost.
Finally, multifamily investments can be subject to a number of legal and regulatory issues, such as zoning and landlord-tenant laws. Investors must be aware of applicable laws in their area, and may need to consult with an attorney or other legal expert before investing in a multifamily property. Additionally, investors may need to obtain the appropriate licenses in order to rent out the units, which can add to the complexity and cost of multifamily investing.
For single family investments, the main advantage is that they are generally less expensive to purchase than multifamily investments. Additionally, single family homes can be easier to manage than multifamily investments, as there is only one tenant to manage and maintain. However, single family investments can also be more volatile than multifamily investments, as they are more susceptible to market fluctuations. Additionally, single family investments can require more time and effort to manage, as repairs and upgrades must be made to keep the property in good condition.
What are the tax implications of investing in multifamily properties?
Investing in multifamily properties comes with several tax incentives. It’s possible to deduct operating expenses and maintenance costs, including management fees, insurance, and marketing costs, or any legal and professional services, such as property management companies. Additionally, investors should be aware of potential capital gains taxes when investing in commercial or multifamily property. Strategies such as 1031 exchanges, investing in an Opportunity Fund, and tax-loss harvesting can help investors save money on taxes.
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What are the risks associated with investing in multifamily properties?
The risks associated with investing in multifamily properties include expensive purchase costs, rising construction costs, and construction delays. Banks usually require a 20% downpayment, depending on the real estate market or the size of the property. Construction costs have risen dramatically over the past few years, and construction delays are an unfortunate fact of life. Additionally, the investment outcome may not be what you're looking for if potential renters are looking for a newer building.
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What are the best strategies for financing a multifamily investment?
The best strategies for financing a multifamily investment depend on the investor's individual needs and goals. Generally, the most common ways to finance a multifamily property include traditional bank loans, FHA loans, and private money loans. Each of these financing options has its own advantages and disadvantages, so it's important to do your research and understand the terms of each loan before making a decision.
Traditional bank loans are typically the most popular option for financing a multifamily property. These loans are usually offered at a fixed rate and have a longer repayment period than other types of loans. However, they may require a larger down payment and have stricter eligibility requirements.
FHA loans are government-backed loans that are designed to help first-time homebuyers purchase a multifamily property. These loans typically have lower down payment requirements and more flexible eligibility criteria than traditional bank loans. However, they may have higher interest rates and shorter repayment periods.
Private money loans are another option for financing a multifamily property. These loans are typically provided by private lenders and have higher interest rates than traditional bank loans. However, they may have more flexible eligibility criteria and shorter repayment periods.
It's important to consider all of your options when financing a multifamily property. You should also research the terms of each loan and make sure you understand the risks and benefits associated with each option. For more information, you can read The Pros of Investing in Apartments Early and The Most Common Ways to Finance a Multifamily Property.
What are the most important factors to consider when evaluating a multifamily investment?
The most important factors to consider when evaluating a multifamily investment are the desired return on investment (ROI), metrics such as cap rate, cash-on-cash return, internal rate of return (IRR), and equity multiple, and the multifamily market in which the investment is located.
ROI is a personal goal that depends on the investor's expectations. Metrics such as cap rate, cash-on-cash return, IRR, and equity multiple are important to understand in order to form ROI goals. It is also important to consider the multifamily market in which the investment is located, as properties in some areas may be overpriced or have a low supply. Shopping around in different markets can help an investor find the ideal environment to chase their investment goals.