Know Your Risks Before You Grow: Here’s What to Expect in Multifamily

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For the past several years, there has been talk of a potential recession for all kinds of reasons. But there’s always a risk or a reason not to invest in real estate. Should that stop us from doing so? Simply put, no.

It’s indeed better to have no deal at all than to tie yourself up with a bad deal. But that doesn’t mean there are no deals to be had. You just have to be patient and wait for the right ones.

Yes, the competition is fierce, and the prices are expensive. This is why you need to be even more selective and pay more attention to the fundamentals when investing in multifamily real estate. Unlike single-family properties, there are unique multifamily risks if you aren’t paying attention to its specialized needs.

There’s no way to avoid risk completely. Due to all the variables that aren’t in your control when it comes to investing in real estate, anything could go wrong at any time. But when it comes to multifamily investing, it’s even more important to be aware of those risks and how to manage them effectively. To help prepare yourself, check out the most common types of risk below and ways to mitigate them.

1. Asset risk

This kind of risk is about the value of an asset and its general risk in the market. All assets basically have this, and it’s important to understand how high it is in terms of the property you’re interested in before investing in real estate.

Honestly, there’s no way to get rid of this kind of risk completely. It’s pretty much built into the world of investing. But to deal with as little of it as possible, it’s best to learn everything you can about the asset. Make the most informed investment by being educated and making sure the risk is worth it. Ask yourself these questions to get started.

• How much is the investment?
• Will I have to do renovations, and if so, how many?
• How much will those renovations cost?
• What kind of neighborhood am I planning to invest in, and where do I see it going in the future?

That last bullet is very important. A bad market will ruin even a great investment property. But investing in real estate within the same asset class can help you manage the expectations of multiple places at once.

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2. Manager risk

A property will be less likely to perform well if it isn’t managed well. Whether you manage the property directly or hire someone to do it for you, if the job isn’t done properly, you’ll most likely see a decline in the investment’s revenue.

To help mitigate this risk, save some money. A healthy cash flow is important in keeping your investors happy. A multifamily property typically generates a 6% cap, which is the net operating income divided by the initial purchase price.

You may not have this 6% minimum cash flow in the beginning, depending on where you buy, but you should get very close to this number after some renovation. By the way, renovations also cost money.

In terms of upkeep, you also have to be on top of repairs needed for the home. These can become very expensive very fast if you aren’t quick to act on them. Having about $10,000 on the side just in case anything happens while you have tenants is a great idea. But getting everything fixed up before you put your place on the market is also a smart move.

Letting your property develop all kinds of issues will make it less valuable to people looking to move in, and if they do, they may not be likely to stay.

Never rely on cash flow to finance your renovation cost. Doing this will restrain your capital and slow down the value-add progress. It’s also risky if the cost turns out to be higher than budgeted.

In addition, you should never budget only just enough money for renovation. Raise an additional 10% to 15% of the predetermined budget because construction is full of surprises. Things like multifamily loans can be an option, but those kinds of lenders can be pretty serious about paying back the money on time. If you won’t be able to make a payment for any reason, it’s likely that you won’t get assistance from the lender.

But this doesn’t mean you should avoid renovations altogether. In fact, that’s what will give you the edge when it comes to competition in the marketplace. The right kinds of changes will attract tons of potential residents to you. This, on top of expected rent growth, means that you can charge even more per tenant over time.

3. Overleverage risk

This kind of risk is all about being in too much debt compared to your property’s value and cash flow. Basically, if a piece of real estate is in such bad shape that it isn’t worth fixing up, your overleverage risk is really high.

Sometimes, having this risk isn’t a bad thing because people can see the potential in projects. And if you’re planning on flipping the property, you can save a lot of money by living in one unit while fixing it and renting out the vacancies as they become ready for tenants.

To avoid this one, be sure to go into your investments with a plan. Have a set budget for how much you’re willing to spend on a property and then how much you’re open to spending on renovations. So many landlords love a good project and fixer-upper, but if your money is not managed effectively, the multifamily risk here would be too high and turn the home into a money pit.

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4. Economic and local market changes

As investors, we all know that market conditions never stay the same for long. That’s why it’s so important to research the area you’re investing in beforehand.

Think about which industries are most likely to get hit the hardest during the next downturn, and avoid cities that rely heavily on those types of industries. Part of that multifamily risk is that you’ll have multiple families living on your property. If every one of them works in the same field and that industry goes down tomorrow, you’re out of luck.

Cities with great employment diversity are much more resilient economically than a city that is heavily reliant on just one industry or one company. You’ll be able to draw many different kinds of people to your multifamily property, which could lessen the need to continuously be on the lookout for tenants.

5. Difficulties with financing

Getting started in real estate can be difficult, but it can be even more so with multifamily housing. For example, many states, like New York, require investors to put down three to four times as much money in a down payment on a multifamily compared to a single-family property. Getting a loan or investors can be more difficult too.

To combat this, you have to save up even more money to cover the cost of the down payment, renovations, marketing, and more. At least $100,000 for a property with three or more units should be enough to get you started, but also remember that with multifamily housing, a lot can go wrong at once. The responsibility to take care of all of that is on you. If you don’t have the money to manage all of this upfront, it will be easy to fall into debt you can’t get out of.

No reward without risk

Even though we are discussing avoiding risk as much as possible, that doesn’t mean the risk isn’t worth it. Making the right kinds of choices with the right kind of risk could ultimately mean a great outcome for you.

At the end of the day, any real estate investment is a gamble because we never know what the future holds. Adding the extra concerns with multifamily risk only makes things that much more stressful. But being educated about all of these topics can make it as easy as possible to get involved and help you make the best possible choices, so it’s more and more likely you’ll be able to cash out.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.