Risk Management in Multifamily Investments

In any investment the elements of leverage and risk management are at work to accomplish the investment objectives. These concepts can be understood as different sides of the same coin. Leverage, in its various forms, is what make’s it possible to magnify potential gains by using information, technology or capital that is not one’s own advantageously. Financial leverage, in particular, can also magnify losses. Risk management, on the other hand, is the discipline that seeks to reduce the probability and magnitude of potential loss by identifying and controlling as many variables as possible through careful investment analysis and selection. Let’s focus on the risk management side of the coin and take a look at a few of the most important elements in a commercial apartment investment.

MARKET SELECTION

Choosing a market is one of the most important decisions a real estate investor makes. There are different levels on which this analysis takes place. The top-level analysis occurs when considering the Metropolitan Statistical Area (MSA) or candidate city. For example, should we invest in Denver, Houston or Phoenix? When evaluating MSAs we look at several metrics. The first is population of the MSA. We prefer cities with at least 500K – 1M residents and the population should be growing at a rate equal to or greater than the national average over the last 10 years. This implies that there is likely to be an adequate base demand for apartments homes now and into the foreseeable future.

The second metric is job growth. People generally move from one place to another in order to improve their situation in life, and that most often means following job opportunities. Cities with strong job growth will attract new residents more readily than cities with fewer job opportunities. This frequently means that individuals are relocating from other cities and states. Positive net domestic migration – the net movement of people in and out of an MSA – is another positive indicator of the prospects for investment in a given city.

Another high-level indicator of a healthy apartment market is economic and industry diversity. Greater diversity in an economy means that cyclical changes within a specific sector, headquarter relocations, or plant closures are less likely to have a significant negative impact on the metro as a whole. In particular, it is good to see a strong presence of government related employers, institutions of higher education and healthcare job centers. Over the long run, these employers tend to have a more stable presence in a market since they are less able and less likely to relocate.

Finally, two important legal factors are, first, a business-friendly tax and legal environment and, second, favorable landlord-tenant laws. Continuing job growth into the future depends on the growth of business opportunity within a state and MSA. Tax and other legal issues significantly influence this trend over the long term. Similarly, a landlord’s ability to collect rent, deal with delinquencies and pursue eviction when appropriate can seriously impact the performance of an investment property. We avoid states where, we think, the legal environment curtails landlord rights too much.

These are a few of the metrics one should use to confirm the suitability of a market for multifamily investments. At the high-level perspective of investment analysis, this illustrates some practical aspects of risk management. By adhering to these specific investment criteria one can increase the probability that there will be stable and growing demand for apartment assets as well as rising wages to support rent growth, and decrease the risks that could lead to unwanted vacancy and its negative impact on investment returns.