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

Brian Burke
3 min read
Multifamily Myths: Why Economy of Scale Doesn’t Mean What You Think it Does

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

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!

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