5 Ways to Reduce Risk When Investing in Multifamily Real Estate
There has been talks of a potential recession for the past several years, and this possibility now seems more likely given the recent inverted yield curve, trade war with China, upcoming Brexit, and more. Does this mean you should stop buying real estate altogether?
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The answer is NO!
It’s true that it’s 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. Just BE PATIENT!
I know 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, which I’ll discuss further in depth below.
How to Minimize Your Financial Risk in Real Estate
A bad market will ruin even a great investment property. A great market will make a bad investment look not so bad.
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.
You should also look for cities with great employment diversity, because this type of city is much more resilient economically than a city that is heavily reliant on just one industry or one company.
If you want to learn more about market studies, check out my previous blog post “8 Ways to Identify the Best Places to Buy Rental Property.”
2) Cash Flow
Having healthy cash flow is important in keeping your investors happy. A property with a healthy cash flow typically generates 6 percent cap, which is net operating income (NOI) divided by the initial purchase price.
You may not have this 6 percent minimum cash flow in the beginning, depending on where you buy, but you should get very close to this number after some renovation.
However, cash flow potential is heavily reliant on the specific market’s cap rate. A hot market's cap rate is about 3 to 4 percent, so it's very hard to get a property in this type of market to 6 percent cap—even after renovation.
Therefore, you need to make sure that your investors are aware of this. Let them know that the majority of return will not be realized until the property is sold. This way, they will be more understanding when they don’t see a high return during the holding period—especially if you hit a recession and need to extend the holding period by a few more years.
Be conservative with your underwriting! Don’t rely on appreciation or rent growth too much. Even if the market grew at 5 percent last year, don’t expect it to grow 5 percent annually for the next few years. Use a number that’s closer to the historical average for the past decade.
If the current market cap rate is 5 percent, then assume that you’ll be selling the property at 5.25 percent or higher in five years! The rule of thumb is to increase the cap rate at sale by five basis point annually.
4) Capital Raise and Capital Reserve
Never rely on cash flow to finance your renovation cost. This is a recipe for disaster! Relying on cash flow to finance renovation 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.
Never budget only just enough money for renovation! Raise an additional 10 to 15 percent of the predetermined budget, because construction is full of surprises!
5) Loan Term
Try to procure permanent financing as soon as possible. Either procure a 20- to 30-year loan right away, or get a loan with an option for permanent financing.
Permanent financing is important because you won’t have to worry about refinancing for many years. If a recession hits and affects your property negatively, you don’t have to worry about refinancing at a lower value or selling your property.
Do you have any questions about the above? Or any other risk-reducing tips to offer investors?
Leave them in the comment section below?