New investors often think the safe way to move into apartment investing is with smaller apartment projects.
These projects, which typically range in size from 10-50 units, have their appeal. Their size makes them seem less intimidating, and their price points are attractive because they seem relatively attainable. By going small, you think you are reducing risk.
But in the case of commercial multifamily investing, reducing size to reduce risk is simply untrue. Larger apartment projects (80-100 units and up) are much safer and easier to manage (and ultimately drive better returns) than their smaller counterparts.
Larger apartment projects have lower transactional costs (on a percentage basis), are more stable, easier to finance, and easier to sell.
Let’s compare small multifamily projects to larger projects and review the key differences you need to consider:
1. Cost Management
You might think that the costs (fixed or variable) of operating a smaller apartment project are proportionate to larger projects.
This just is not the case.
With smaller projects you do not get the economies of scale. Your fixed costs are higher per door and your variable costs do not enjoy the discount that a larger project can afford. As a result, a smaller apartment project has a higher operational expense ratio (operating expenses compared to gross income), which erodes your overall returns.
Let’s look at why:
If you are really looking to scale in multifamily (multiple assets in multiple markets), you need professional property management. The size of the asset will affect what property managers will charge you, and it’s the smaller assets that bear the higher cost. In fact, it is not uncommon to see property management fees decline by as much as 50% as the size of the project goes up.
Marketing and Advertising
The cost to create a website or place an ad in the local paper is the same for any size apartment complex. A larger apartment project can spread that cost out over a much larger budget. Smaller apartment complexes, in turn, see a higher cost per door for marketing and advertising.
Landscaping and Other Contract Services
These costs will certainly go up when you have a larger apartment project. But, the rise in cost is not in proportion to the size of the project. You can expect to see savings from 20-30% on landscaping and other contract services as you move from smaller projects into 100+ unit projects.
Smaller properties typically cannot afford the cost of a dedicated maintenance staff. This leads to three typical and problematic maintenance solutions:
- costly non-dedicated maintenance
- ineffective tenant maintenance, or
- unsustainable owner maintenance.
Each of these options have glaring weaknesses and will often lead to increases in costs or vacancies (the #1 reason tenants leave your apartment complex is poor maintenance.) With a larger apartment project, you can afford a dedicated maintenance staff. This is the most efficient and cost-effective way to keep your project well-maintained and gives you a significant competitive advantage.
Leasing Software – in todays multifamily industry, you need to leverage software to run your apartment complex efficiently. This software is almost always scaled not by door count, but by number of users. Again, you will bear a larger relative cost because of this.
While it may seem counter-intuitive, it is easier to qualify for a larger multifamily loan than a smaller one. Fannie Mae and Freddie Mac are no longer offering loans of less than 1 million – they consider the risk too high.
This should tell you something.
Further, mortgage brokers are paid by the size of the transaction, and many of the best commercial brokers may decide that you are not worth their time or their full attention because the deal size is too small.
Even when you find lenders that will work on smaller projects, be prepared to bring a larger down payment to the closing, as the lender looks to reduce risk. You will also see higher interest rates for these smaller loans and most will be full recourse loans, meaning you will be liable if the loan defaults. Your personal balance sheet will be impacted (via the incremental contingent liability) and your ability to purchase other properties will be hindered as a result.
3. Acquisition Costs
When it comes to transaction costs related to the purchase of a property, you will likely pay more per door in a smaller complex for items like inspections, title insurance, surveys etc…this means the up-front cost of the investment is higher for a smaller project, driving down your returns for the life of the investment.
4. Exit Strategy
Too many apartment investors do not consider the importance of an exit strategy with their investment. While that dream deal might have been too good to pass up when you bought a smaller property, what hurdles will your potential buyers need to clear when you are looking to sell? Could the lending environment in a few years be such that the high risk loans needed for smaller projects are simply not available (or offered at much higher interest rates?) This question needs to be asked even if you plan to hold the investment through 1 or 2 refinance events.
5. Profitable Operations
By owning a smaller asset, you will face a unique competitive environment. Your apartment complex likely does not have the amenities of a larger competitor, making it difficult for you to charge the same rent.
Without amenities like pools and clubhouses, you will find yourself competing for renters with single family homes that are available to rent. Single family homes don’t have amenities either, but offer a tenant no neighbors above or adjacent to them, which is a big plus for some renters.
All of this means you will feel competitive pressure from both sides of the market, forcing you to keep rents below market average in order to keep your apartments occupied.
Finally, it is important to remember any blip in vacancy will be more painful in a smaller project. 3 vacancies in a 30 unit complex will impact your returns more than three vacancies in a 100 unit project.
6. Time Management
Before purchasing a smaller multifamily complex, you must take into account the most valuable resource of all – your time.
It does not take triple the time to manage a 200 unit complex as it does a 70 unit complex. And of course, that 200 unit building will provide you much better returns for the reasons we just discussed above.
So what’s your strategy?
Ultimately, it comes down to your plan. If your goal is to own and operate 1-2 smaller unit projects in your market and you are willing to mitigate the increased risk and potentially lower returns with extensive (more hands-on) management, then smaller projects could very well work for you.
If however, you are looking to own or syndicate 1-2 projects a year in different markets, then larger apartment complexes offer you better risk management, lower operational costs and more financing options.
Learn how commercial apartment investing works.
Learn from professional investors with over $415,000,000 in commercial multifamily transactions and a 100% profitable track record. Download your Essential Guide now.