Multifamily investments have a proven long-term track record of providing current income, the potential for equity growth, and significant tax advantages. Going back to the 1930s, multifamily has the best risk-adjusted return of almost any asset class.

However, there are still risks.

So when you evaluate a new multifamily investment or multifamily investment sponsor, it’s important to understand their approach to risk management.

In this article, we’ll discuss six essential risk management strategies to consider when evaluating or comparing multifamily investments or sponsors.

1. Only Work with the Best Lenders

One of the most important things to keep in mind is that the lender will be the single largest investor in the deal. Therefore, partnering with lenders who maintain low failure rates is a massive advantage. Their stringent due diligence and rigorous underwriting standards are an explicit and well-regarded safety benchmark for any project.

GSE/Insurance Company Lenders Have the Lowest Historical Losses

The multifamily debt market is sizable, with mortgage debt outstanding of approximately $2.2 trillion, comprising nearly half of the $4.7 trillion total commercial real estate debt market. The chart below shows the breakdown of the major multifamily lenders:

Investing in a project with Government-Sponsored Entities (GSEs, like Freddie Mac and Fannie Mae) and Life Insurance Companies (LifeCo) debt is statistically less likely to fail compared to almost every other debt type (e.g., CMBS, bridge/debt fund, etc.).

Consider these facts: GSEs and LifeCos currently have delinquency rates of less than 0.5%. This means that less than 1 in 200 current loans is even delinquent. Since 2000, GSE/LifeCo delinquencies have barely skimmed 1.1% for Fannie, 0.4% for Freddie, and 0.5% for LifeCo. Compare this to CMBS debt delinquency, which is currently at 4.8% and previously peaked at 9.6% – ten times more risky. The current delinquency rates for multifamily loans by lender type are found below:

GSEs and insurance companies typically avoid providing “bridge” loans that rely heavily on significant capital expenditures, higher loan-to-value (LTV) ratios, and aggressive rent projections. Instead, they focus on providing stable, long-term financing options that align better with conservative strategies. 

Knowing that you’re co-investing with the debt investor, who would you rather partner with?

2. Buy with Conservative Leverage at Fixed Rates

Leverage can amplify returns, but it’s a double-edged sword. Conservative leverage will almost always improve a deal’s returns, with only a minor increase in risk. But there are a few key points you need to consider. 

Avoid high-LTV bridge debt, regardless of projections

Many properties with problems today took on high leverage at their initial purchase. These projects often obtained floating-rate bridge debt from debt funds with 80% leverage and requirements to deploy additional lender funds toward interior improvement plans. When times are good, and you nail this business plan, you can achieve high IRRs due to aggressive leverage.

But, these types of deals are very sensitive to market and interest rate fluctuations.   

For example, if there are unexpected market changes that postpone value improvement plans or a 10% market downturn, the entire equity investment is at risk. 

There is no buffer. 

Most high-leverage bridge loans are for 3 years, and then need to be refinanced or sold. If the deal has to wait out a market downturn or is not able to implement its business plan, it will materially underperform projections, if not outright lose money. 

Avoid uncapped floating-rate debt

The vast majority of problem loans today were acquired with floating-rate debt instead of fixed-rate debt.  Floating-rate debt can be great, as it allows for more prepayment flexibility. The cost of doing so is typically only 1% of the principal balance. This penalty is significantly lower than the prepayment costs required for prepaying loans with fixed-rate debt, referred to as either defeasance or yield maintenance.  However, when interest rates increase significantly, as they did in 2022 and 2023, the cost to service floating-rate debt can quickly become unaffordable. 

While there are hedging products available to cap your exposure to rate increases (rate caps with corresponding rate cap escrows), these products become increasingly expensive to buy as rates rise and cap renewals are needed. In the current market cycle, some of the more distressed assets were purchased with floating-rate debt with the cheapest possible rate caps, which means they were materially more impacted by rising rates than projects with more conservative rate caps and durations. 

Maintain a healthy debt service coverage ratio (DSCR)

A DSCR greater than 1.3x ensures that the property’s net operating income comfortably covers its operations and debt obligations. Mathematically, it shows that the property can generate 30% more income than is required to cover the operating expenses and debt. This provides a cushion in case of unexpected expenses or temporary dip in rental income, reducing the risk of default.

Break-even Occupancy (BEO) that can handle vacancy rates at double the market average

BEO is a measure of the lowest possible occupancy the property needs to maintain to break-even financially (covering all operating expenses, debt, fees, and lender reserves). 

When evaluating potential investments, ensure that BEO levels can handle double historical market vacancy. 

For example, if historic market vacancy is 7%, then double market vacancy is 14%. In this example, you would want to see a BEO of 86% or lower. This would mean the property could handle double market vacancy for an entire year, which is unlikely to happen in the vast majority of markets.

3. Buy Assets with Goldilocks Age: Not Too Old; Not Too Young

Age or vintage is an important factor that should not be overlooked when selecting multifamily properties. Properties that are too old often come with hidden costs and risks, while those that are too new may face stiff competition from even newer developments.

Not Too Old to Have Environmental or Major System Replacement Issues

Properties constructed before 1980 often have environmental challenges, such as asbestos, lead-based paint, or other hazardous materials. These issues can lead to costly remediation expenses and complicate transactions. Furthermore, some critical building items – like plumbing and heating/cooling systems will reach the end of their useful life at 40 to 50 years old and need to be replaced.

By focusing on buildings constructed after 1980, investors can minimize the risk of facing these complications.

Not Too New to Compete with Brand-New Construction

On the other end of the spectrum, investing in brand-new properties often means competing with newer developments that offer cutting-edge amenities, modern designs, and trendy features. Such competition can limit rent growth and occupancy rates. Instead, focus on properties that are 10 to 30 years old, ideally built between 1990 and 2015. These assets are often located in well-established neighborhoods with a history of stable rents and strong occupancy rates. Investors can capture value by modernizing units or improving management efficiencies without the higher price tags associated with new construction. 

4. Buy in Great Neighborhoods

Location is always a key determinant of a property’s success. Focusing on multifamily investments in neighborhoods with specific characteristics can help ensure long-term appreciation and stable occupancy rates.

Low Crime

Safety is a top concern for most renters. Properties located in areas with low crime rates tend to attract high-quality tenants willing to pay a premium for peace of mind. Investing in a safe neighborhood also reduces the likelihood of property damage or theft, which can reduce operational costs and improve returns.

High Household Income

High-income neighborhoods often correspond to greater rent growth potential. Residents in these areas are more likely to have stable employment, translating into more reliable rent payments and less turnover. Neighborhoods with higher household incomes are also more likely to support retail and entertainment options, enhancing the area’s overall desirability.

Great Schools

Proximity to high-performing schools can drive demand for multifamily properties, particularly from families. Quality school districts can increase a property’s long-term value and provide a built-in tenant base. Many families prioritize access to good schools and are willing to pay higher rents to secure homes in top-rated districts.

5. Buy in the Right City/State

In addition to selecting great neighborhoods, investing in cities and states that offer favorable conditions for landlords and businesses is essential.

Good Landlord-Tenant Laws

States with landlord-friendly laws provide greater protection for property owners. These laws can make it easier to evict non-paying tenants, adjust rents, and minimize legal disputes. When evaluating potential markets, focus on states that strike a balance between protecting tenant rights and allowing landlords the flexibility they need to manage their properties effectively.

Good State/Local Policies to Attract and Retain Business

Investing in markets with a robust business environment helps ensure that demand for rental housing remains high. States with policies encouraging business growth—such as tax incentives, low regulations, and infrastructure development—tend to experience strong population and job growth, driving up demand for multifamily housing.

Low Environmental Concerns

Avoid cities and states with frequent environmental issues, such as flooding, hurricanes, or earthquakes, as these factors can increase property insurance costs and maintenance expenses. Locations with stable climates and minimal environmental risks offer a more predictable investment landscape.

6. Partner with Great Property Management

Effective property management is critical to the success of any multifamily investment. The right property management team can help maintain high occupancy rates, reduce operational costs, drive sustainable rent growth, and promote resident satisfaction.

Substantial Scale and Back-Office Support

Investors should work with property management firms with significant scale, which can provide more resources, such as accounting, legal, and marketing support. They can provide better property efficiencies and compliance with local laws and regulations.

Significant Market Presence for Local Knowledge and Bench Strength

A strong local presence with “boots on the ground” is equally important. Property managers with extensive knowledge of the local market can help investors make informed decisions about pricing, marketing, and tenant selection. They also provide critical support in maintaining relationships with local vendors, contractors, and community leaders.

Conclusion

For high-net-worth individuals and family offices, conservative multifamily investing is a key component of your long-term wealth strategy. Proven blended returns from tax-advantaged income and equity growth uncorrelated to the public markets is the high level goal. 

While multifamily has historically lower loss rates compared to almost every other asset class, you still have to consider and manage potential risks.

By focusing on projects with the right lenders, conservative leverage, and ideal age and location, you can significantly minimize risks while maximizing returns. Furthermore, the importance of neighborhood dynamics and choosing great property management partners cannot be overstated—they are the pillars that support stable, profitable investments.

At 37th Parallel, we have been acquiring and managing multifamily investments for our investor family since 2008, with a 100% profitable track record across over $1.1 billion in multifamily transactions. If you’re ready to explore investment opportunities that align with the conservative strategies above, click here to see our current offerings. Or, speak with our investor relations team at your convenience.