Multifamily Myths: Why Economy of Scale Doesn’t Mean What You Think it Does

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Economy of Scale. This is the big advantage of investing in multifamily — or at least it’s the one most talked about. You typically hear it expressed like this: “You only have one roof to fix, one lawn to mow and when one tenant moves out, you aren’t 100% vacant.” Since none of us likes risk in our investments, redundancy of income makes multifamily investing completely risk-free. Or is it?

If you are comparing investing in single family homes to small multifamily, the comparison isn’t as straightforward as it may first appear. If it were, every duplex would be more profitable than two SFRs. But it isn’t always so in the real world. I own over 100 rental houses and several hundred apartment units, so I have seen economy of scale at work in both asset classes. Here’s my observation, for what it’s worth.

Related: Multifamily Myths: 5 Reasons Investors Think Multifamily is Easy to Value

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Single Family Homes

Single family homes have two distinct advantages: simplicity and disposability. From an income and expense standpoint, you collect rent, pay a management fee (unless you enjoy tenant management, for which you deserve a medal), pay the taxes and insurance, and pay to fix stuff that breaks. That’s about it. What is left over is your net income, and with that, you can pay your debt service, if any, and pocket the rest. When you want to sell, there are millions of homebuyers in the U.S. every year who can take it off your hands.

Duplexes

Compare that to a duplex. You collect rent, pay all of the same expenses as with the SFR, and in many cases also pay for water, sewer and garbage because each parcel gets only one bill and has one water meter. You might not want to hear the tenants fight over who is supposed to mow the lawn, so you hire a landscaping service.

Duplex units oftentimes experience more turnover than SFR, which adds to the repair expenses, and in many cases, this tenant class doesn’t take as good of care of the property, which adds to capital improvements. These added expenses offset some of the advantage you gain from the economy of scale. Sure, at the end of the day, the duplex investment may throw off more cash flow relative to acquisition price, but this is a discussion about economy of scale, and my point here is that economy of scale is not linear. You lose part of it as you gain it.

20 and 60-Unit Buildings

Now move up to a 20-unit. In some states, a property of this size is required to have an on-site “responsible person” or resident manager. This necessitates either a rent credit or compensation and worker’s compensation insurance. You’ll definitely need someone to take care of the grounds, and you might even need a phone line and a copy machine, office supplies and ongoing advertising costs.

What about 60 units? This is the toughest space in my opinion because you get all of the added layers of cost without as much of the true economy of scale that you achieve when you are the top of the logarithmic curve of economy of scale. In this zone you get all of the added costs of the duplex and 20-unit, plus you will definitely need a full-time manager and maintenance person. You’ll likely have an office, computer and software costs, credit reporting, accounting and legal, and permitting/licensing costs.

100-Units and Up

Moving to 100 units and up, here is where you start to see economy of scale. It’s not without a headwind, however, as when your unit count goes up, your employee count will go up as well. At this size non-recourse loans are common and those require a sole-purpose entity so you’ll most likely have entity-related expenses such as franchise taxes and tax return preparation costs.

Related: Things to Consider Before You Buy That First Multifamily Building: Managing Property Management

I see the most advantage to economy of scale in the 150-unit and up space. Once you get here, your costs, expressed in dollars per unit, will improve slightly as you scale.

In larger properties, vacancy is always a consideration, and it takes shape in many forms. The simplest to understand is physical vacancy. This is the loss encountered because a unit is vacant. But there are other important economic vacancy losses that become important to account for as you scale up. These include loss to lease (units rented for less than the current asking price), concessions (free rent and move-in incentives), credit losses (the tenants who fail to pay and skip) and non-revenue units (model units and apartment units used as a leasing office or for storage). These economic losses can easily add ten percentage points to your vacancy losses in some property classes and areas.

So what about the “one roof, one lawn” argument? Don’t fall for it. It’s just a bigger roof, bigger lawn and more fences to fix. Now that I think about it, I never owned a 100-unit apartment complex with only one roof! Maybe it’s time to move up to high-rises.

Investors: Do you agree with my assessment?

Let me know your opinions in the comments section below!

About Author

Brian Burke

Brian Burke has raised tens of millions of dollars from accredited investors and family offices during his 25+ year real estate investing career. His focus is on residential real estate but has also done development, self storage, and commercial deals. Brian has completed more than 500 single family flips and has acquired nearly 1,000 residential rental units comprised of large apartment complexes all the way down to single-family homes.

24 Comments

  1. Anthony Gayden

    Great article Brian.

    From what I have been reading there is a point where you have too few units to hire staff, but too many to self manage and work a full time job.

    Buying a property in the 20-60 unit size range is actually what I wanted to do next, but I worry a lot about the management.

    • Brian Burke

      Great question, Anthony. You’re catching on but I should clarify. You are right that there is a point where self-managing while working a full-time job becomes impossible, but the unit count that exceeds your limit varies depending on how many hours you want to work, etc. Instead, what I’m saying is that if you buy an apartment complex of a certain size there needs to be an on-site manager whether you are self-managing or even if you have a 3rd party property management company, and that size might be set by law or it might be set by practicality. And that additional staff creates additional expenses.

      20 units can likely be managed by yourself and a par-time on-site person that maybe receives little or no compensation other than a discounted or free apartment (depends on the value of the unit and how much the person is expected to work). It could also be done with an on-site person as just mentioned plus a management company to oversee the rest.

      60 units, on the other hand, would likely require a full time manager and a full time maintenance person (depending on the age of the property and how much maintenance needs to be done), You should also have a third party manager that is experienced at managing properties of that size and class in that area. Inexperienced owners that attempt to self-manage properties of that size before they are ready is a recipe for disaster.

      So economy of scale, yes, but you have to build the added costs into your financial model and make sure you are buying at a price where the numbers make sense with the added layers of cost.

  2. Jerry W.

    Brian,
    Excellent post. I have not exchanged information directly with you, but you are my favorite poster on BP. I have been a volunteer fireman for 26 years now, and am thrilled when one of our own make it huge. I assume your prior job was a combination of law enforcement/fireman/EMS in some way. I can only dream of the success you have had. I currently have about 30 doors, but 12 of them are in an old apartment complex that is mostly managed by a local realtor. They still call me if they are unsure of renting to someone, or to get big items fixed. Recently I have been looking at a few fourplexes and a 16 unit consisting of 4 fourplexes all on the same lot. They will just barely cash flow on a 15 year loan, and I am concerned about the local economy. We have had several job losses from the drop in oil prices. While we do have tourism and agriculture, oil is our biggest cash crop by far. So far I am sticking with SFRs that are run down and can be bought and fixed up to cash flow as decent rental houses. The closest we have to big apartment buildings are 2 eight plexes built next to each other and 6 four plexes on one lot. Both have changed hands in the last 10 years and had the value increases added to them leaving no meat on the bone. Not that I have 20% to put down on either one. Anyway, great post and thanks for taking the time to share your knowledge and experience. I know your time is very valuable.

    • Brian Burke

      Jerry, thank you for the kind comments! Going from police/fire/EMS to Multifamily investor to syndication sponsor is a pretty unlikely path in life and it was no small task, believe me! It took many years to pull it off but now that I’ve been here a while the weather is nice. I love what I do and couldn’t imagine doing anything else. I do miss going into burning buildings though! Sounds like you’ve found a way to do both RE and fire, and it’s guys and gals like you that stitch together the fabric of communities that don’t have the ability to support a full time fire department.

      There is no rush to the finish line, Jerry. If you are concerned about the impacts of oil, sit tight and wait it out. It could mean better deals on those same properties in the not too distant future. I have seen this in one of my markets already. I just closed on 276 units that would cost me at least $1MM more last year because oil fears drove a few buyers out of the market. Well, actually I wouldn’t have bought the deal at all, because my underwriting wouldn’t have allowed for the higher price!

      • Anthony Gayden

        Brian, I forgot that you are former law enforcement from your first podcast, but that is quite a change to where you are now. I am law enforcement right now, and it presents unique challenges to investing. A lot of people don’t understand when I say I work nights, weekends, and holidays, or that my work days are 10-12 hours long.

        • Brian Burke

          Yeah, many people don’t understand that, Anthony. It’s great, though, because working nights and weekends is a great way to grow a real estate business while still working full time. It served me well for years.

  3. Ben Leybovich

    The weak link in all of income-producing property is the systems. And the week link in the systems are inevitably the people on the ground. It matters little whether we’re talking about pay roll personnel or a part-time handy man – good people are hard to find, period. Yet – they will make or break your deal…

    I believe you know something about that, Brian!

    • Brian Burke

      I do, Ben, and you are right. Great people can make a real difference in performance, both on a physical asset level and a financial level. It’s one of the reasons why it’s harder to go to a new market than grow in the market you are in if you already have built a team of great people.

  4. Kevin Yeats

    Brian, Economies of Scale can be “casually observed” like you have done here noting that you observed some savings once the apartment complex size reaches 150 units. I say observe in that you probably experience using some of your resources more completely such as copiers and handymen (handypeople?). Each resource has less downtime. Perhaps with copies, there is a level of need that make it more economical to outsource that chore.

    EoS, to really prove the existence thereof in an economics perspective, would require statistical testing — well beyond the discussion here.

    Keep in mind that not all industries have economies of scale. I seriously doubt if heart or brain surgery would exhibit any EoS but industries with commodity-like products like most agriculture probably have very meaningful EoS. Thus we see very large corporate farms (while many family farms struggle) but very few hospitals with assembly line-like setups for brain surgery.

    • Brian Burke

      Spot-on, Kevin. Certainly my article on EoS is anecdotal not statistical, as I think it would be very challenging to scientifically analyze it on real estate given that there is such variation from one property to another. That said, I couldn’t resist the opportunity to counter the frequent stipulation that there is a linear benefit from scale when in actual practice it isn’t the case. Benefit, yes, but with headwinds.

  5. Cordell Martin

    Very helpful and practical – you mention some states require an onsite manager/responsible person for units of 20 or more. In your experience (legislation aside, practical and functional considerations), what is the typical number of units someone would be foolish to not have an onsite manager vs self manage? If units are located 20-30 minutes from owner.

    Thank-you for your time

    • Brian Burke

      As an example, California requires an on-site “responsible person” for 16 units or more. Other states may vary. Be careful not to confuse a “responsible person” with a management strategy. You can self-manage, hire a resident manager and manage that manager, or hire a third-party management company that you oversee and they manage the manager. There are many differing opinions on which strategy is best and valid arguments for each position. Personally, I like to hire best-in-class third party management companies and watch them like a hawk and treat them like a partner. It’s hard to scale if you are deep in the muck of tenant management.

  6. David S.

    Brian,

    Thanks for the informative article. I think you were spot on concerning turnover and asset class. When I review my P & L’s for each property, time and time again, the most profitable are the ones with a lower turnover and higher tenant quality. The numbers are higher on the income side and lower on the expense side. Going larger from SFH to multi-unit complexes, as you alluded to, also increases the headache factor. This is very much like the small business man trying to move to the next level. Many times this leads to twice the amount of work for just a little more profit. I am not saying this is necessarily a bad thing, it is just that this must be taken into consideration. This entrepreneurial drive to get better and start new things is quite impressive.

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