Investors are just coming out of their state of shock over the recent jump in rates, so lets take a look at how the new reality affects multi family investments.
Just a couple months ago (before rates jumped up) I did a video about your lender’s perspective on risk in multi family investments and another where I go into detail on your lender’s view of LTC & LTV.
The way for investors to control risk is through using less leverage which means a lower LTC/LTV.
Now that rates have gone up considerably, we see this playing out in the market in 2 ways.
First, the good news (for landlords, not for tenants):
Rents are at all time highs and all indications are that they will continue to rise.
So with rents at highs and going higher, it’s still a great time to invest in multi-family, but here’s where we run into trouble.
With higher rates, debt service (mortgage payments) will be higher and this will reduce (or even wipe out) cash flow.
Given a fixed amount of rent income and expenses, the only variable that can reduce mortgage payments is a lower loan amount.
There are only two ways to achieve a lower loan amount. One would be a lower purchase price and the other is a lower LTC/LTV which means the investor needs to put more equity into the deal.
Demand for multifamily properties has been very strong which has kept prices high and pushed cap rates to historically low levels.
We are starting to see some pressure in certain markets, but overall, sale prices have remained strong.
In order to make cash flow and risk profile numbers work, lenders are beginning to offer smaller loans (Lower LTC/LTV). Some lenders who were lending 75% LTC or 70% LTC may now be willing to lend only 65% or 60%.
This means that Investors need to put up more equity and use a bit less leverage in their investments.
Because many smaller investors are a bit less flush with cash now that their stock market positions have dropped, they will naturally be less willing and able to do that, which we’d expect would mean less buyers in the market and eventually lower prices for multifamily properties. But with rents at all time highs and pushing higher demand is still very strong, so a drop in prices may never materialize.
The bottom line is that if you are in a position to invest, it’s a great time to do it.
Using a little less leverage may lower your returns slightly, but returns are still very attractive and you have less risk!
Commercial mortgages are always adjustable anyway, so it makes less difference in the long term than with a 30 year fixed residential mortgage.
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With today’s higher rates and prices not really dropping (yet), lenders are improving the risk profile and viability of their deals by reducing loan amounts.
For example, if a lender was willing to lend 75% of value on a multi family acquisition loan before, they may now only be willing to lend say 65%.
This makes sense since rates have gone up substantially, the smaller loan amount may have a payment similar to the payment for larger loan amount at lower rates.
Assuming the same rental income numbers, if the mortgage payments and expenses are still the same, the cash flow from the deal would be the same.
The only other way to keep cash flow in an ecceptable range would be to lower the loan amount by lowering the sale price of the property.
In most markets, there has been so much demand that we just haven’t seen prices dropping.
So higher rates may mean that multifamily investors will need to put more equity into their deals to make the numbers work. This means less leverage and a bit lower returns. But It also means less risk for you in your deal, which is why I was recommending this in my prior video several months ago even though rates were much lower at that time.
With a lower loan amount and a bit more equity in your deal, returns are reduced a bit, but still attractive (especially compared to the stock market right now), so with rents at all time highs and with all indications still pushing higher, these deals still are in big demand!
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There are a lot of great neighborhoods in Chicago where people want to live in new construction and builders are putting up small condo and rental projects to meet the demand.
So why build in Lincoln Park?
Most of these other areas have lower land prices which allows building more affordably priced units.
When you look at building a standard 3 or 6 unit building on a standard single or double lot, regardless of neighborhood, the buildings are very similar.
The size limit is determined by the zoning district, so allowances are the same accross neighborhoods. Generally builders want to build as much as is allowed in order to maximize returns. But if you look at total returns for condo sales, they vary substantially.
For example, a condo project for 3 unit building on a standard lot in NorthLincoln Square/Bowmanville might have total sales of about $1.7M.
A very similar 3 unit building In the East Village area might fetch $2M to $2.1M in total sales.
In Lincoln Park, for a similar building, the units might achieve total sales of close to $3M.
Now of course land prices are higher in the more expensive areas and construction costs will also be higher for the more expensive units because they need to have upgraded finishes, but still, the higher sales numbers far out weigh the extra costs, so margins are considerably higher for the more expensive neighborhoods.
Another consideration is that buyers in these Class A locations like Lincoln Park are more affluent and are less affected by economic factors like inflation, etc.
When they want to live somewhere they have the capital to buy or rent there regardless of market conditions.
If the real estate market experiences a glitch and values begin to drop, we see that Class A locations/ projects generally tend to hold their value best and are first to recover.
From my years serving as a Bank director and on the loan committee looking at many construction loans, I’ve seen first hand that higher end projects in the best locations always tend to weather market turbulence much better.
So what is the multi-family syndicator’s secret to great returns?
Well, any multi family property you buy is going to need some work. If it’s in great condition, the price will be so high that you can’t make any money on it.
If you can buy it at a good price, it’s because it needs work to bring the rents up. So you’ll need to do some big renovations before you see any returns.
This strategy is what multi-family Investors call: ‘Value Add” and this is how most of the successful syndicators make money on their multi-family investments.
The trick is that when you do a substantial renovation, you’re making a profit on the improvements that you’ve made to your new property, in other words on the construction that you’ll be doing to fix it up.
That construction is how you bring the rental income of your new property up.
But your profit shows up not only as higher income, but also as a bump up in your equity as soon as construction is complete and the income stream is stabilized.
In other words, if you’ve done it right, the property is now worth much more than the total of your acquisition cost and improvements and that’s because of the value of the work that you put into it, right?
What most people don’t realize is that building new construction income property is the Ultimate “Value Add” strategy.
Because the entire property is new, you’re maxing out the amount of improvements and you are also maxing out the income because new construction units always command top rents.
So by building a new construction building, you’re maximizing this bump up in equity that you get as soon as your property is completed and the rental income is stabilized.
On top of that, Brand new units attract the best tenants and rent quickly for top rents. Right now, there’s huge demand for new construction units and rents are at all time highs.
This is why you see big developers putting up high rises and big multi-family buildings just as fast as they can right now and that’s why you should follow their lead!
My new book:
Don’t Buy Multi-Family! BUILD IT
is on Amazon now, but if you’re watching this, there is a link in the text below to get a Free eBook Download.
It’s a short read, but it will show you how you can get started building and owning brand new income properties.
A lot of investors are searching now for good multi-family investment properties to purchase, but not having much success finding them.
In my new book, Don’t Buy Multi-Family! BUILD IT I talk about the advantages that multi family investors can get by building new construction properties rather than buying older properties and fixing them up.
But I think a lot of people might think that they need to be an architect or contractor to build a new multi-family property.
If you’re already investing in multi-family buildings (big or small), you’re probably working harder than you have to for smaller returns.
And It’s just not as big a jump as you think to start building your own new construction properties.
In fact the majority of big developers hire outside architects to design their buildings and they hire general contractors to build them. That’s what you should do too.
So let’s take a quick look at how it works. When a new building is developed, the expenses include Soft Costs: Like financing costs, permits and architectural design, things like that.
And Hard Costs: Which include all the labor and materials to build the property. hard costs also includes the General Contractors fee.
The owner who puts up the money and hires the people necessary to build it, is actually the developer who gets the benefit of the investment. (they get the profits).
Now they may choose to hire everyone and manage the whole development process themselves, or they might partner with an experienced developer so they have someone else to manage the whole process for them, or they could even hire a developer on a fee basis manage their project for them.
The point is that the owner/developer makes money because the property she/he is building is worth more when completed, leased up and stabilized than their cost to build it.
It’s no different than when you buy a car or clothing or anything else; The finished value (what you pay for it) is going to be substantially more than the cost to build it. This is how the company makes money.
I talked in my prior videos about this “Equity Bump”. that a new property enjoys when it’s completed and stabilized (leased and operating). This is the real game changer when you compare numbers for purchasing an existing building to building a new building.
What’s really surprising is when you see how quickly this “Equity Bump” combined with cash flow and appreciation will multiply your initial equity investment in just the first few years of operation.
So whether you’re investing in a few units or hundreds, You should definitely learn more about developing new properties,