Ways to Invest in Multifamily Real Estate
First, let’s explain what a multifamily property is. At the smallest level, it’s a duplex or a building that has two living separate living areas, each with its own entrance. These can get bigger, like four-unit buildings, and can go up to buildings with hundreds of units. With more units, there is an economy of scale which means that the costs are more efficiently distributed.
Many investors start with investing in a duplex or a four-unit building. Since these have four or less units, most real estate sales agents or brokers can facilitate these transactions as they are not commercial transactions. They’re also easier to find on real estate websites. These smaller properties are popular with people who like to manage things themselves. To save money, owners often self-manage these properties. The next step is usually to sell the first property and buy a property with 8-10 units. These are still manageable by an individual owner and a maintenance contractor. At this point, investors often come to a crossroads and decide whether to maintain a small portfolio of 10–12-units, which can provide an average to higher income, or to join a group to invest in a larger property.
For this discussion, we’ll assume the investor isn’t interested in being a landlord but wants to scale their real estate investments with some specific goals in mind. Here are some ways they may invest in multifamily real estate:
1. Real Estate Syndications
A real estate syndication is when a group of investors pool their money to purchase one property. The syndication will usually have a general partner who manages the day-to-day operations, while the other investors are the limited partners. Depending on how this is legally structured, the limited partners may still be taking on liabilities equal to that of the general partners. It is important to understand the partnership agreement and equity splits to avoid or minimize disagreements. Syndications are generally open only to accredited investors (those who meet income or net worth criteria); however, some will allow a restricted number of non-accredited investors to join. These investments are often considered illiquid, meaning you can’t easily sell your share. This is because there can be a holding period before finding someone to replace the current investor should they request to sell their interest in the syndication. With performance of the syndicate usually based on one property, it is less diversified and can be more volatile. However, investors can benefit from tax advantages like passive income and losses, depreciation, and capital gains rates for gains upon the sale of the property. This method is popular among accredited investors who want to own larger properties while having a general partner manage the day-to-day operations.
2. Public REITs
Public Real Estate Investment Trusts (REITs) are companies that own, operate, or finance income generating real estate. They are often listed on stock exchanges, making them easier to buy and sell. There are some that are public non-listed REITs which register with the United States Securities and Exchange Commission (SEC) but have more limited secondary trading options. According to the Internal Revenue code (Section 856), REITs must invest at least 75% of their total assets in real estate and derive at least 75% of their gross income from the rents from real property, the financing of real property, or from sales of real estate. The attraction for investors is that REITs can be traded on the open market, allowing the value to increase through share price or dividends. REITs are run by one or more trustees or directors and are taxable as a corporation. They must pay out a dividend to investors of at least 90% of the taxable income. Publicly traded companies must disclose their earnings quarterly and annually and host annual meetings. Shareholders pay taxes on the income they receive from dividends as ordinary income. Some dividends may be classified as qualified and are taxed at a lower rate. Also, some REIT dividends can include capital gains and return of capital. The tax benefits of owning real estate such as depreciation or losses do not transfer to the shareholder. However, the shareholder may pay fewer taxes on their gains from a sale since they are paying at the capital gains rate (short or long term) based on their holding period. Financial advisors often recommend REITs to clients who want real estate in their portfolio and would prefer the cash flow provided by the dividend. REITs are a good way to develop an interest in real estate and provide cash flow for retired investors who are no longer earning their previously high salaries.
3. Private REITs
Some investors look for private real estate investment trusts (REITs), which often offer different types of real estate investments compared to public REITs. Some private REITs can be traded in secondary markets, though they are less liquid compared to public REITs. They are required to meet the rules to qualify as a REIT with the Internal Revenue Service (IRS), but they are not registered with the Securities and Exchange Commission (SEC). These types of investments are usually restricted to institutional or accredited investors only. These investments are more illiquid as they cannot be traded on an exchange and, after meeting varying requirements, would only be able to be traded on the secondary market. Investors should talk to a tax advisor to understand the tax implications since private REITs don’t directly pass through depreciation or losses to the investors.
4. Private Real Estate Investment Funds
Private real estate investment funds that aren’t treated as REITs by the IRS are another option. These funds pool money from investors to buy multiple properties, seeking to spread the risk. They’re generally closed-ended meaning you can’t withdraw your money until a certain period has passed, making them illiquid. The benefit of a real estate fund is that investments can be spread over multiple assets. Investors are only liable for the amount they invest. These funds pass on tax benefits like passive income, passive losses, depreciation, and capital gains tax rates on profits from sales. Unlike investing in REITs, the tax benefits of owning real estate are passed through to the investor in a passive state. The longer hold period and nature of the fund are factors that investors should consider before making an investment. Sponsors may have funds that are focused on appreciation of the asset over a shorter period, or they may offer a longer hold period with more of a focus on cash flow. It’s important that the investment strategy of the fund sponsor align with the investor’s personal financial goals and risk tolerance.
All investments carry risk. While good managers, real estate investment trust managers, and sponsors will try to mitigate the risks. It’s important to understand the risks of the investment prior to investing. In a future blog, we’ll discuss how to do due diligence on real estate investments and fund managers. Educating yourself and having a great team of professionals like Certified Financial Professionals (CFPs), Certified Professional Accountants (CPAs), Registered Investment Advisory firms, and lawyers can help in assessing the risks and rewards of potential investments, especially considering your investment goals and timeline. All financial advisors, accounting professionals, and lawyers should have their credentials verified with state regulators and/or the SEC.
Blogs are intended to be educational and rely on information from sources deemed to be reliable. Nothing in this blog contains legal, tax, financial, or any other type of advice. All investors should consult their own financial, tax, legal, and other professional advisors to determine if an investment is suitable for their unique situation. If you enjoyed this blog, please contact us to join our mailing list and be updated when new blogs or updates are released.