An Exploration of Multi-units as an Investment Tool in Chicago
Written by Lawrence Dunning; Broker at Main Street Real Estate Group
Every investment instrument needs to be examined by the old trading adage that I first learned in the Chicago Trading Pits – “Risk versus Reward”. On this metric, owning multi-unit buildings as an investment tool, stacks up against anything. This article will explore the pros (reward) versus the cons (risk) of multi-units on a larger macro level; before delving further into the micro, where I’ll explain some of the reasons for my excitement towards a specific area of Chicago.
The financial rewards of owning multi-unit investments are well established and have been written, in depth, by many more eloquent authors than I. What is less well known is that America’s first millionaire was the German Immigrant, John Astor, who become known as “Manhattan’s Landlord”. Astor was a real estate investor, widely acknowledged as the wealthiest man of his time, and later becoming America’s first multi-millionaire. We should never forget Italian economist Pareto’s 80/20 Rule. 80% of the world’s wealth is owned by 20% of people. It’s time to strive to be in that 20%.
So why is this business model so great? What are the rewards? Investors price buildings by ”Cap Rates”. These are calculated by the Net Operating Income (NOI) [Total rental income minus the costs associated with holding the building – property tax, insurance, common area maintenance/repairs, common utilities, and a small vacancy rate] divided by the purchase price. However, Cap Rates don’t apply to most savvy investors who typically put 25% down to purchase their buildings and finance the remaining amount. Therefore, a more accurate metric for these investors to use is their cash on cash return. This is the NOI on their 25% down-payment, minus their mortgage payment. With market rates being in the mid-4%s, their cash on cash return for a 7-Cap is usually in the double digits 10-12% range. One of the secrets of the wealthy is making their money work for them. “Dead” money is making a few percent in bonds or bank deposits, getting eroded by inflation. Wealthy money is money that grows, because it generates more than inflation, in this 10-12% range.
But this is only cash on cash return. It doesn’t include the other two benefits that investors indirectly gain from: The monthly principle debt paydown is the equivalent of an automated monthly saving plan. Lastly, there is the likely price appreciation, which has run roughly 6% in the recent era. In the last four decades we have seen less than a quarter of volatility in the U.S. real estate market compared to the broader U.S. Stock Markets. On a macro level, with interest rates still at historic lows and the stock market up 400% since its 2009 low, and looking due for a consolidation or pullback, the risk/reward pendulum certainly seems more attractive in real estate. Even professional stock pickers are having difficulty valuing Amazon’s stock, currently trading at $1,000 a share; however, I know if I’m buying a rehabbed $700,000 building, in an upcoming neighborhood, generating $6,000 rental income/month, that my downside is extremely limited. There’s a reason they call bricks and mortar investing, “as safe as houses”!
As for the negatives (the risks) of the multi-unit model. The initial acquisition costs, brings forth the immediate and significant risk of a market downtown. This is largely mitigated in Chicago, where prices are a fraction of comparable metropolitan areas on both the East and West Coasts. Indeed, sophisticated investors have already realized this and Chicago’s new construction development rate is among the highest in the country.
Many people go into building ownership expecting to close on a building and immediately collecting an ongoing passive income stream. Obtaining a completely turnkey building is the first hurdle; often a great building will be vacant, and depending on the season, and how aggressive you want to be with your rental prices, it can take several months to get these buildings fully occupied. Usually, fully rented buildings will sell at a slight premium for this reason.
By being the building’s owner and landlord, the responsibility of managing tenants can at times be cumbersome. I recall being on my second day of vacation in Hawaii, with hopes of finding some peace and solitude, only to receive a frantic phone call from a tenant with a leaking roof. The common occurrences of receiving distressed phone calls from tenants at the most inopportune times, is sadly a realistic portrayal of a landlord’s ongoing duties! If you want to avoid these with the employment of a management company, your first step is choosing a competent one, as well as monitoring their work. (I’ve had to fire one of Chicago’s largest management companies for costing me a great amount of money through their poor decision making).
Even when outsourcing management, landlords are often required to make ongoing decisions, such as which venders to keep using, how much pre-emptive maintenance to do, how to deal with tenants’ complaints with each other, and so forth. To mitigate additional minor hurdles, you need to be vigilant in choosing both the location and quality of the buildings – newly rehabbed and new construction will most likely cause fewer problems than older buildings. Owners must also find responsive and trustworthy tenants with acceptable credit scores or co-signers, to protect from missed rental payments or worse, conducting costly and vexing evictions. Deliberating in initial tenant selection will usually save both time and money in the long run.
On the micro level, what currently looks promising for the immediate future, is the segment of Chicago broadly defined as the heart of Pilsen, East Little Village, Little Italy and Rush Medical District. The last several years have seen a pronounced demographic shift, as well as an influx of new restaurants and bars to match this change. Between local hospitals and several colleges, it has a built-in local rental market for future tenants. Today, there are also several large multi-unit condo developments being planning; several smaller, but still significant, commercial developments; and a myriad of multi-unit rehabs from smaller construction groups. The introduction of the “El Paseo” recreational trail is just one example of Alderman Danny Solice’s desire to reinvent his ward, and the upward trend of property values reflects this rise.
From an existential perspective, money alone certainly won’t bring us happiness. However, it can certainly provide opportunities to gain our most precious commodity: time. Multi-units are a lucrative vehicle for a quasi-passive income stream, with a small and easily mitigated risk profile. Life is too big to think small. Start building towards your financial future today.