Worried about investing your dollars in a small apartment building? Don’t be

Image courtesy of Freddie Mac

Image courtesy of Freddie Mac

by Dan Rafter

When you think of the booming multifamily market, what comes to mind? New apartment towers stretching 20 stories in the sky? How about sprawling suburban communities with swimming pools, fitness centers and hundreds of units?

These larger apartment communities are an important part of the multifamily market, no doubt. And they provide great opportunity for investors today. But what about those smaller multifamily buildings, the apartment complexes that boast just 20, 10 or five units?

These smaller properties are a surprisingly important part of the apartment market, too. According to Freddie Mac, they also present big opportunities for investors.

Freddie Mac’s July report on small balance loans says that 31 percent of U.S. renter households live in apartment properties made up of just five to 50 units. Freddie Mac found that these smaller apartment buildings — despite some persistent myths about them — represent a sound place for investors to park their dollars.

The numbers bear this out. In 2013, 26 percent of the total dollar volume of loans originated in the multifamily market was made up of loans smaller than $3 million. These smaller loans made up 70 percent of all multifamily loans originated that year. Freddie Mac found, too, that 92 percent of all multifamily lenders originated these smaller loans in 2013.

Investors have long considered smaller multifamily properties as being riskier than larger ones. But Freddie Mac’s research shows that this isn’t necessarily true. Freddie studied CMBS multifamily loan performance data collected by analytics company Trepp, finding that the overall default rate for loans on small multifamily properties stood at 6 percent, while the rate for loans on large properties was 6.2 percent.

This isn’t to say that there aren’t some higher risks with smaller apartment properties. Freddie Mac says that when a credit event does occur, smaller properties tend to have higher expected losses partly because their fixed operating costs are proportionally higher. Freddie Mac found that the total loss severity — a measure of a loan’s lifetime losses as a percentage of its principal balance — is 33 percent for smaller properties and 26 percent for larger ones.

As Freddie points out, many of the costs of operating an apartment building are constant whether that property has 10 units or 250. Because of this, the loss severity tends to be higher for smaller properties.

Freddie Mac’s advice? Investors shouldn’t overlook smaller apartment properties. But they do need to take just as long a look at these properties as they would when investing in a downtown apartment high-rise or a massive suburban apartment community. Location, quality of the buildings, credit of the tenants and historic performance are still some of the key indicators of whether an apartment property is a good investment, whether it’s a large or small one.

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