Different people calculate investment risk differently. Some people equate risk to the amount of money invested. Others utilize more complex concepts, like the Sharpe Ratio to calculate their risk level. Ultimately the risk of any investment is equal to the impact of any adverse situation times the probability of that adverse situation occurring divided by the capital placed into the investment. Risk = (Impact x Probability) / Cost.
It’s no different in real estate. Risk in real estate is equal to the impact that market forces, vacancy, repairs, etc. can have on your investment times the probability of those issues arising divided by the capital you have in the deal. So if the impact of the adverse situation is large (such as becoming 100% vacant at a property) and/or the probability of the adverse situation occurring is high (such as repairs arising on older properties with deferred maintenance) then you have a high level of risk. That’s pretty intuitive, right? Your comparative risk can also be minimized if you have little capital in the deal to lose, but the risk of loss is still high. When you couple that with a large amount of capital at play, you really increase your odds of being ‘Sorry Charlie’. For those smarter than the average bear, the key is to reduce potential impact that a loss will have; keep the odds of losing low and limit the amount of capital in any one deal.
With real estate you actually reduce your risk by going bigger and adding more doors in one investment. I can hear the thought forming in your head right now: “Bigger means more expensive. And you just said more money in the deal is more risky”. Very keen thinking.
In comes multifamily syndication. Syndication is where funds from several, or many, investors are raised together to purchase an asset. With the funds coming from different investors, it limits the capital of each individual investor, thus keeping their overall risk lower (all things equal). Let’s look at a million dollar purchase for a syndication example. With a 75% LTV loan (the amount the bank will lend), that leaves $250k to raise for the down payment. By combining the funds of five investors, each individual investor limits their capital at risk in the deal to $50k instead of the full $250k needed to close the deal. The most they can lose is their individual investment, yet they have a greater chance of participating in above average terms in this advantaged asset class because they combined forces in a syndication. Another way to limit risk is to refinance the initial capital out so that losses are limited only to future incomes.
Continuing with the $1M example syndication deal. Let’s say we are purchasing a smoking hot deal and the as-is value of the property is really $1.3M. Let’s say that once we close on the property, we have an instant $300k in equity that we can reinvest by refinancing or cash out by selling (these are the kind of deals that I like to buy). The impact from any adverse situation is now significantly decreased because we are now only leveraged at less than 60% of the value of the property (remember, because we have a loan at 75% of the purchase price for $750k and the property is worth $1.3M). This means the market could drop by 40% with another housing bubble crash and we would still be above water in this deal. To wrap up this point, a single investor would put in $50k to have ownership in $1.3M of real estate with $550k in equity, and downside protection of up to 40%. That’s greatly reduced risk due to going bigger, and of course by finding a great deal.
Any property owner will tell you that maintenance is the one thing that can make your real estate investment sink or swim, and going big right off the bat with property size is like jumping in the water with a floaty. With large multifamily properties (generally over 70 units) revenue reaches a point where it can sustain a full-time, on-site maintenance staff. That means whenever something breaks, a tenant calls the office to reach a staff member and that staff member fixes the issue. Then they document the scope and cost, and you read about it in your weekly or monthly owners report. You are not involved in the maintenance – it becomes a justified business expense. What’s even better is that because you have many units that are all the same or similar, they all are all made of the same parts. You can buy in bulk and make savings on a per unit basis, and save the cost of running to the store for each item saving time and transportation expense. Multifamily reduces the impact and probability of an adverse effect because maintenance issues are known and expected. This is economies of scale at work and in action, and why owning a large commercial multifamily lowers your risk AND lowers your stress.
Investing in multifamily oftentimes gives returns better than the stock market with a risk profile lower than bonds. It’s no wonder why insurance companies and pension plans invest in commercial multifamily. Following the big money alone into this asset class could make you very wealthy. Knowing the why behind why bigger is better in real estate is so important for taking charge of your returns.