When people first think of investing returns, they often think of metrics such as return on investment (ROI) or equity multiple. While these metrics are useful for simply quantifying total returns on a given investment, they leave out details as to how the investment is paying you. Some investors prefer high cash flowing opportunities while others might chose properties that will appreciate more quickly or perhaps include a high tax write off. Today's article will look at the four ways multifamily investments provide returns and what you need to consider as an investor when looking for your next investment.
Investors who come into real estate from the world of the stock market are familiar with distributions. A stock whose company is performing well might distribute cash proceeds to investors on a quarterly basis. In a similar way, real estate investments also provide proceeds to investors typically on a quarterly basis. This means that investors who are looking for their investment to pay for their expenses will want to look for a high cash on cash (CoC) return. Often, investments in stronger markets will favor appreciation while those in secondary or tertiary markets will provide higher cash returns.
When you buy a property in a strong primary market, you will purchase it at a lower cap rate due to the perceived risk of it's value decreasing being much lower. While this often results in the cash returns being lower it also means that the likelihood of the cap rate fluctuating drastically is lower too. Additionally, when purchasing for appreciation at a lower cap rate more value is achieved when increasing the NOI. For example, increasing the NOI by $100 in a 7% CAP market would result in a $1,429 increase in value while in a 5% CAP market the increase in value would be $2,000. Many investors looking to build long term wealth will choose this type of investment over one that is high cash flow in a weaker market.
When you make a loan payment to a bank, it typically consists of two components. The interest and the principal. While the interest is the bank's charge for lending the money and will never be seen again by the investor, the principal is the portion of the payment which reduces the overall debt. The bank employs an amortization schedule for the debt paydown as a way of mitigating the risk of their money being returned should the property or the market take a turn for the worst. While a higher amortization schedule will reduce the cash returns, it still provides a return to the investors which is realized at the time of sell or refinance along with the appreciation return mentioned above.
Tax Write Offs
One of the most overlooked returns in multifamily investing is the return one receives from the accelerated depreciation. The IRS believes that once you place a property into service that it begins to dilapidate or depreciate over the course of 27.5 years. The truth though is that the property is likely appreciating if it is being taken care of and well managed. This results in a paper loss which can be used to offset the income from this and other investments.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please set up a meeting with us through our Calendly link and subscribe to our weekly blog here.