Most real estate investors begin their journeys with single-family homes. But, as you become more experienced – and build bigger portfolios – you may want to expand into multifamily homes to benefit from economies of scale.
In other words, investors find the increased income from multiple units attractive, but they also want to ensure that they receive the same long-term home value appreciation inherent to single-family properties.
The biggest question here is, do multifamily homes appreciate? Yes, multifamily homes most certainly appreciate! Specifically, I’ll dive into each of the following topics to help you understand the reasons multifamily homes appreciate, as well as get started with investing in multifamily homes:
- What is a Multifamily Home?
- Appreciation, Defined
- Valuation Option 1: Comparable Approach
- Valuation Option 2: Rebuild Approach
- Valuation Option 3: Income Approach (a.k.a. Cap Rates)
- Multifamily Property Valuation
- Why Multifamily Properties Appreciate
- Using Investor’s Edge to Track Appreciation
- Importance of Intent
- Final Thoughts
What is a Multifamily Home?
Prior to discussing multifamily homes appreciation, I need to first define what I mean by multifamily.
While large-scale apartment buildings technically qualify as multifamily, these types of properties fall under the umbrella of commercial real estate. For our purposes, when I talk about multifamily homes, I’m talking about the following “plexes:”
- Duplex: two-unit property
- Triplex: three-unit property
- Quadplex: four-unit property
When investors jump from four- to five-unit (and greater) properties, they transition from personal lending to commercial lending, which opens the door to the complexity and challenges inherent to commercial real estate.
Here at Do Hard Money, we’ve made a career (and helped others make their own careers!) investing in single-family homes and “plexes,” and I absolutely support this model for new and experienced investors alike.
What Does Appreciation Mean in Real Estate
Put simply, when a home appreciates, the property value increases. Real estate investors make profits in a variety of ways, and appreciation represents one of those profit paths.
For example, say you bought a house for $100,000. If, ten years later, that same house appraised at $150,000, you would say that it appreciated in value by $50,000 over that ten-year period. For an investor, if that $50,000 appreciation outpaced the inflation of $100,000 over the same ten-year period, his or her wealth would increase solely based upon holding a property (assuming rents covered debt service and operating expenses).
When investor buy properties, they typically see appreciation in two different forms:
- Value-add appreciation: In a well-analyzed deal, investors will gain more in the value added to a property based on improvements than those improvements actually cost. For example, if an investor spends $15,000 renovating a kitchen, and that renovation adds $30,000 in value to the house, they would have created $15,000 in appreciation.
- Buy-and-hold appreciation: Even if investors do nothing to improve a house, they’ll typically reap the benefits of appreciation simply by holding the property. In other words, home values typically increase over time, and they have historically increased in the United States at a rate higher than the associated inflation, creating wealth for investors.
How Do You Value a Home
If appreciation represents an increase in value, the next logical question becomes, how do you actually value a house?
Broadly speaking, three different valuation options exist for real estate investors.
Home Valuation Strategy 1: Comparable Approach
The first being the comparable approach. If you’ve ever heard real estate agents talking about “comps,” they’re abbreviating “market sale comparables.”
With residential real estate, most neighborhoods don’t include an enormous amount of property diversity. In other words, if a residential block has one 3-bedroom, 2-bathroom ranch, it probably has several other 3-bedroom, 2-bathroom ranches. Neighborhoods generally fall into the same zoning, socioeconomic, and development patterns, meaning that the homes in these areas tend to be similar in layout (albeit not necessarily in upkeep and improvements).
This similarity provides appraisers the ability to look at both recent sales and current listings to assess the market rate for similar properties, that is, market comps.
Let’s use the above example of the 3-bedroom, 2-bathroom ranch. Assume the owner of the house wants to sell the property but doesn’t know its value. Using either a home value estimator tool like Zillow or paying for an actual appraisal, that homeowner can compare the layout, neighborhood, and quality of his or her home against similar properties that have sold or been listed in the area.
If, in this market comparison, three comparable properties sold within a week for $210,000, sold within a month for $205,000, and listed currently for $220,000, respectively, an appraiser would likely conclude that the property fell within that $205,000 to $220,000 range, generally leaning more towards the sales comps than the listing comps (listings represent what sellers want, whereas sales represent what the market values).
Home Valuation Strategy 2: Rebuild Approach
The next two valuation approaches pertain more to commercial properties than residential, but I want to discuss them anyway, as you’ll likely encounter this verbiage on your real estate journeys.
The rebuild approach ties property valuation to construction cost, and lenders typically use this method during the construction phase of a commercial project, that is, before it stabilizes and becomes income-producing. Specifically, commercial construction loans distribute money based on inspection-approved draws. If you have a $1,000,000 construction loan, the bank won’t just give you $1,000,000 (because the property securing the loan doesn’t exist yet!).
Instead, to minimize lender risk, developers submit periodic draw requests stating the percentage completion and current costs associated with a project, and the bank will distribute that amount. In this way, lenders ensure that, if a project goes belly-up, they’ll likely recover their funds via a cost-to-construct valuation model.
Home Valuation Strategy 3: Income Approach (a.k.a. Cap Rates)
The final valuation model pertains to a stabilized commercial property, that is, a completed, income-producing project. Due to the fact that commercial properties don’t share the same uniformity inherent to a neighborhood of houses, real estate professionals need a method besides sales comps to determine a property’s valuation.
To understand how the income approach works, investors first need to understand net operating income, or NOI. Commercial real estate professionals use NOI as their key performance indicator, or “bottom line.” Simply put, NOI equals rental income minus operating expenses.
NOTE: NOI does not include mortgage interest (financing expense) or depreciation (non-cash, non-operating expense).
Next, investors need to understand capitalization, or cap, rates. This is the theoretical return investors would receive on an all-cash (that is, no debt financing) deal. For example, if you purchased a property for $1,000,000 and it had an NOI of $100,000, the property would have a cap rate of 10% ($100,000 NOI divided by $1,000,000 value). And, the market largely dictates cap rates for a particular asset class and region.
So, modifying the above example, here’s how investors value commercial properties with the income approach:
- Property NOI: $50,000
- Market cap rate: 5%
- Property valuation: $1,000,000 ($50,000 divided by 5%)
How to Valuate Multifamily Property
Okay, now that I’ve described the above valuation techniques, I need to bring it back to multifamily property appreciation.
As discussed, residential properties, to include multifamily “plexes,” generally use a market comp valuation approach. As such, investors looking to analyze potential deals – or decide whether it makes sense to sell a multifamily home – need to identify comparable properties that have recently sold or listed.
However, investors should note that, unlike single-family homes, duplexes, triplexes, and quadplexes may not have as many readily apparent comps. In other words, not a ton of neighborhoods full of these sorts of multifamily homes may exist in a given market, as they more frequently fall as one-off projects in a given neighborhood.
This doesn’t mean that the market comp approach doesn’t work, it just means that a broader range of comps may exist, as appraisers typically need to look further back in time and in larger geographic areas to find reasonable comps. For sellers, this means you may need to accept a lower offer on a multifamily than initially expected.
But, on the flip side, this wider range provides investors more flexibility – and justification – in underbidding the asking price on a multifamily home.
For example, say you want to purchase a quadplex in a given neighborhood, with each unit having two bedrooms and one bathroom. With a single-family home, you’d likely be able to find a nearly identical layout in the same neighborhood that either recently sold or listed.
But, with this quadplex layout, you may need to weigh design comps against location comps. For instance, say that an identical layout sold four $450,000, but it happened to be a mile away on the other side of a main road. Conversely, a triplex with similar unit types sold two weeks ago on the same block. Can you accurately extrapolate the triplex selling price to a fourplex, or are you better off weighing the layout accuracy of the recent sale further away?
No absolutely correct answer exists to this question (though professional appraisers have industry-specific practices they follow to determine a best estimate). However, broader ranges inherently exist, providing investors this increased bidding flexibility.
Why Multifamily Properties Appreciate
As I stated in the introduction, yes, multifamily homes most certainly appreciate, making these assets outstanding investments! And, three primary causes drive this appreciation.
- You can’t build more dirt: In other words, supply and demand drives appreciation. The demand for properties continues to grow with the population, but the supply of available land remains the same. As such, equilibrium prices continue to increase, that is, properties continue to appreciate.
- Desirability of a location: While real estate, in general, tends to appreciate, multifamily homes in more desirable locations will appreciate at a greater rate. When looking at a local market, investors need to have the judgment, experience, and market familiarity to determine the long-term trends, that is, where do – and will – people want to live? By investing in more desirable neighborhoods, investors will reap the benefits of greater appreciation for their multifamily properties.
- Increased construction costs: As stated, multifamily properties use market comp appraisals. But, that doesn’t mean that construction costs don’t still have some effect. As the economy as a whole improves, prices typically rise. When prices for building materials increase, developer costs increase, and they’ll inevitably pass some of these increases on to buyers, thus driving up market comps and indirectly causing multifamily appreciation.
Easier Way to Evaluate Homes
Using Investor’s Edge to Track Appreciation
Now that investors understand A) how to value multifamily properties, and B) that these same properties will appreciate in the long term, the next step entails actually tracking this appreciation.
Specifically, accurately appraising multifamily properties plays two important roles for investors:
- Finding deals: As real estate investors look for deals, they need to understand what properties represent good buy opportunities. Without an independent means to value a property, investors need to rely on a seller’s asking price, an inherently inflated metric. On the other hand, if investors can look at a market and quickly determine market comps for a given property, they can determine with confidence whether a particular multifamily property constitutes a good deal.
- Refinancing opportunities: With long-term buy-and-hold investors, a cash-out refinance represents an outstanding means to roll a property’s equity into further investments. For example, say you own a multifamily property currently worth $400,000 with a $100,000 outstanding mortgage. This means that, with a 75% LTV requirement on a cash-out refinance, you could take up to $200,000 in cash out with a re-fi ($400,000 x 75% = $300,000 – $100,000 = $200,000 available equity). However, to run these numbers, investors first need to know the actual value of their multifamily properties.
So, it’s clearly important for investors to track the appreciation of their multifamily properties, but what’s the best way to do that?
Use Do Hard Money’s Investor’s Edge software!
As discussed, our team has personally done or mentored hundreds of deals, so we’ve learned through all that experience the best ways to analyze deals. For multifamily deals, we can’t emphasize enough the importance of understanding A) current valuations, and B) long-term appreciation trends.
As such, we’ve integrated an outstanding appreciation tool into our software. With Investor’s Edge, you can look at heat maps of a given market that clearly tell you both the current valuations and the long-term appreciation trends for that market. Put simply, we arm investors with the knowledge they need to confidently pursue multifamily deals.
And, to provide further insight and value to investors, our software incorporates the following capabilities:
- Find deals: Investor’s Edge lets you filter through over 160 million properties – instantly – to find the perfect deal for you. As multifamily properties can be difficult to find, this provides investors a critical advantage in identifying high-quality deals.
- Save preferences: Once you create the perfect list of potential deals, Investor’s Edge will save those preferences and automatically update your cache with new listings. This means that investors can literally set-it-and-forget-it when it comes to identifying potential multifamily deals.
- Market instantly: Investors can print postcards with pre-filled addresses or automatically send voicemails to their saved list of potential deals, further increasing the likelihood of finding – and closing – multifamily deals.
Long Term vs Short Term Multifamily Investment
Next, when it comes to appreciation, investors need to honestly assess their intent and strategies with a given multifamily property. Are they looking to hold it for the long-term, or take a fix-and-flip approach with it?
If you’re planning on holding a multifamily for the long-term, it will appreciate in value. The challenge for most investors comes down to having the discipline and staying power to actually stick to this strategy.
While becoming rich overnight requires a ton of luck, building wealth long-term just comes down to having the discipline to stick with a plan.
Consequently, multifamily real estate investors need to ask, am I planning on holding this property long-term. If so, they’ll certainly reap the benefits of appreciation. However, in analyzing a deal they need to ask two equally important questions:
Will this property’s rents cover its expenses?
If rents decrease, will they still cover expenses in the long-term?
If you answer yes to both of these questions, you will most certainly reap the benefits of your multifamily property’s long-term appreciation.
At the end of the day, when it comes to property appreciation, all real estate will increase in value if you hold it long enough, a reality aptly reflected in long-term multifamily homes trends.
As such, investors would do well to remember this real estate anecdote:
When’s the best time to buy real estate? Yesterday.
When’s the second-best time to buy real estate? Today.
While meant to be somewhat humorous, the most important takeaway for any real estate investor is just getting started.
Multifamily homes will absolutely continue to appreciate. So what does this mean for investors? If you don’t buy today, you’re just going to need to pay more tomorrow, as multifamily property valuations will continue to increase.