Real Estate Investing Basics

5 Ways to Reduce Risk When Investing in Multifamily Real Estate

Expertise: Real Estate Investing Basics
16 Articles Written
New modern apartment building exterior concept. Residential house and home.

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.

Man sit on the Bench looking out a sunset over grassy field

How to Minimize Your Financial Risk in Real Estate

1) Market

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.

Related: 3 Ways to Reduce Risk in Your Real Estate Portfolio

3) Appreciation

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.

Austin Skyline in the evening and bluehour

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!

Related: Why Risk is the Most Inaccurately Assessed Factor When Investing

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?

Jay Chang, a civil engineering graduate from UCLA, is an active investor, developer, writer, and Founder of Hestia Capital. He moved to Phnom Penh, Cam...
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    Francisco Escobar Real Estate Agent from Alexandria, Virginia
    Replied over 1 year ago
    "The rule of thumb is to increase the cap rate at sale by five basis point annually." Can you please further explain this? Does that mean multiply by 1.05?
    Ben Wuollet Rental Property Investor from Phoenix, AZ
    Replied over 1 year ago
    If deals sell at a 6 cap today, next year budget 6.05, the year after, 6.1, then 6.15, etc.
    Kavitha Baratakke
    Replied about 1 year ago
    We are generally increasing it by 25 basis points instead of 5! We underwrite 100-125 bps over entry cap on most deals. Guess we are super conservative :)
    Jay Chang Developer from Los Angeles, CA
    Replied about 1 year ago
    WOW! 25 basis points a year is a lot. Have you sold a property recently? What was your actual exit cap compared to your projected cap?!
    Dave Rav from Summerville, SC
    Replied about 1 year ago
    Wow, your opening paragraph reads like something the fake media would print. What does Brexit have to do with my investments here in the states (well, i guess if I'm buying in Europe, OR purchasing a super large MF property - then the macro level economic state of things may play a role). Otherwise, these things are drama points and just mere background noise and distraction.