Multifamily properties and Economy of Scale

On March 18, 2017 by Chad Laird

Discussion of economies of scale usually focuses on large scale manufacturing, such as that pioneered by Henry Ford for the automobile in the first part of the twentieth century:

ford

Ford Model T’s Moving Down The Assembly Line

However, economies of scale also come to bear in a very profound way with real estate investing once that investing ventures into larger scale properties. One way pertains to the physical structure itself where you have one component (like the roof) that serves a large number of units. For example on a single building housing 40 units you have a single roof serving 40 units and 40 families. This yields a much lower cost per unit when the need arises to replace the roof. Other examples include:

  • Siding
  • Boiler system
  • Chiller System (for A/C)
  • Elevator
  • Sidewalks & Parking Areas
  • Grounds & Related Upkeep

Let’s look at the various ways that economies of scale come to bear in multifamily investing:

MAINTENANCE

We’ve already noted some ways that economies of scale have a positive impact in the maintenance arena, but let’s look at some of the less obvious.

Materials Specification: This is an area which is very often overlooked by the less sophisticated investor.  How much time does it take, as an example, to investigate what type of fire rated door needs to be used as an entry door for apartment units in a given apartment complex in order to meet code requirements?  The most conservative estimate would be a few hours.  It is self-evident that these few hours would be more intelligently spent answering this question once to apply to 150 units in a given complex vs. answering it once to apply to four units in a fourplex.  The same principle holds true for areas which do not involve building codes but still require the specification of the materials to be used.  These are too numerous to mention, but here are an example of just a few:

  • Interior Door Brand & Style
  • Interior Paint Brand, Sheen, & Colors
  • Appliance Specification, Style, & Color
  • Boiler Recirculation Pump Brand, Model, & Supplier
  • Furnace Exhaust Fan Brand, Model, & Supplier
  • Window Size, Brand, Type, & Supplier
  • Coin-Op Washing Machine Brand, Model, & Servicing Dealer

MANAGEMENT

The management of the property is another side of it where you have significant economies of scale. In the case of a larger property, using a 150 unit apartment complex as an example, the owner would be putting together a team of perhaps 4 people to handle all management and most routine maintenance issues. While as a counter example, if the owner had 150 single family homes spread out across a geographical region, he would have to build and maintain many relationships with different maintenance technicians and managers to serve each of those properties. On multifamily properties large enough to afford on-site staff, typically those 50 units or larger, you have additional benefits such as developing deeper tenant relationships as well as having the ability to better maintain everything and handle issues more promptly than would be the case for off-site management.

There is a clear gain as well on the marketing side. Assuming a 95% occupancy rate in a given market, you are likely to have a few units available on a 100 unit apartment complex while you are more likely to have only a single one available on a triplex or a single family home.  All of the following marketing tools:

  • Newspaper Advertisement
  • Internet Advertisement
  • Website
  • Wall Banner
  • Monument Sign
  • Phone Book Advertisement
  • Placards Posted Around Town
  • Word Of Mouth
  • Etc

will serve all available units on the large complex but will only serve the one available triplex unit or of course the  one single family home.

Now we come to an interesting question one might ask; ‘is the economy of scale captured in the price of the properties?’  The price of a commercial property is based on the net operating income which of course grows when the expenses decrease.  Now, since the economies of scale will help decrease the expenses, this means, all other things being equal, large properties can have a higher net operating income on a per unit basis. Wouldn’t that mean they are sold at a higher price hence we pay for these economies of scale and consequently not gaining any more in income, again on a per unit basis? It is a valid question, however, a few factors needs to be considered. One of them is that the amount of competition amongst buyers is much less on large properties, on smaller properties there is a greater number of investors and more competition among buyers which typically has the effect of pushing up the sales price. As an example, with single family homes, the investor is competing with homeowners who are looking at the house as a home rather than purely as an investment. The same can be said of duplex where the owner will live in one of the unit. Another aspect is that many inexperienced investors may not properly account for all costs that will ultimately be involved in running a property so they end up expecting a higher net operating income than they will actually achieve.  In fact, some inexperienced investors take the gross rental income and only subtract the property taxes and insurance as the total of their projected expenses. Given such assumptions, these investors may think they will achieve a nice operating income on a property after paying all of their expenses and they will therefore pay a high price for a property only to end up shocked that they are just breaking even or perhaps losing money each month once they actually begin to operate the property.

Expenses needing to be taken into account when determining the value of a property include:

  • Vacancies, Concessions, & Non-Payment
  • Taxes
  • Insurance
  • Repairs & Maintenance
  • Management Fees
  • Marketing
  • Utilities
  • Contract Services
  • Payroll
  • Capital Expenses
  • Debt Service

An additional factor driving up the sales price per unit on one to four unit properties is that they can be financed with residential mortgages that are much more broadly available and often carry more favorable terms.  Larger properties, comprised of five units or greater, require commercial financing where it is more difficult for a buyer to qualify and the terms may include restrictions that are rarely found in residential mortgages.

However, economies of scale also bring benefits that are not always fully accounted for directly in the net operating income or sales price, such as in the area of ownership overhead.  A single 150 unit property requires a single management company, a single property tax statement, a single mortgage, a single insurance policy, and a single set of services to arrange & pay (water, sewer, lawn care, etc).  150 single family homes typically require 150 mortgages, 150 insurance policies, 150 property tax statements, and a 150 sets of services to arrange & pay (water, sewer, lawn care, etc).  Ownership of 150 unit apartment complex therefore requires a lot less time & energy than does ownership of 150 single family homes.

Expanding on the roof example, we had a 97 unit apartment that required the roof to be redone. For such large scale project, we send a request for proposal (RFP) to multiple vendors who came back with detailed proposals on the job according to the RFP.  This included what they would do, how much it would cost and how long it would take along with references for their work.  Given the size of the job, the many vendors put a fair amount of care into their proposal so we had a much better idea of what to expect in the end than we would likely have with vendor proposals for small jobs.  Also we’ve found that vendors tend to get a bit more aggressive to secure large jobs rather than small jobs, so we tend to have a very competitive bidding environment.  In the case of this particular roofing project, we got pricing from $50,000 to $150,000 and ultimately selected a vendor who did it for $70,000. If we divide this by the number of units, we have about $700/unit that it cost us to redo the roof. Comparing that for a single family home where it could cost anywhere from $3000 to $6000, we see the advantages of the economies of scale in terms of the cost. Additionally of course the amount of work put into vendor selection was much less, perhaps 1/97th as much as the work that would have gone into arranging re-roofing jobs on 97 single family homes.

Another place where economies of scale show up is when it comes to acquiring assets.  Most of the tasks involved in the finding, evaluating, & purchase of the 30 unit apartment complex take about the same time as they would for a 130 unit or a 330 unit apartment complex.  When this is taken into account, it becomes quickly apparent that an investor is spending his time more wisely when he spends it evaluating larger properties.

Although many of the advantages that come with economies of scale in multifamily investing may be common sense, they are not always readily apparent to the beginning investor.  Thanks to a little reading, you’ve given yourself a leg up on your competition.

 

 

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