What is Riskier? Multifamily Apartments or Mutual Funds?

As investors, we are concerned with building wealth while taking on the least possible risk. The reason I invest in real estate is because I’ve determined that it’s the best and safest way to grow my personal wealth. But is this really true? I’m biased because of my personal experience. I’ve seen my fair share of capital destruction through stock and mutual fund investing. I’ve lost less through my real estate investing efforts. But what does the data say? I shouldn’t rule out mutual funds due to missteps of my own or a financial advisor or institution should I? Those same missteps can happen in real estate as well. And I’ve certainly had a few of those too. So rather than base my conviction on personal anecdotal experience, I wanted to know what the data is saying about the risk between mutual fund investing and multifamily investing. In specific, I’m concerned mostly with a comparison to the most passive form of real estate investing in my current portfolio: multifamily syndications.

Comparing Risk Through the Great Recession

Currently we’re experiencing one of the longest real estate cycles we’ve ever seen as well as a very long and historical bull market in stocks. My investing intuition tells me that it’s safer right now to put my money in a multifamily syndication rather than a mutual fund. Here is my reasoning. The long run up in the stock market has primarily been the result of Quantitative Easing. The Federal Reserve is now running out of tools to keep the markets going higher, therefore the risk of a fall has increased. Also, trade policy is unclear. The markets are moving based on what figureheads are doing and saying in Washington. We just don’t know what they’re going to do. This creates more risk in my mind. Multifamily on the other hand is expensive, but at least I know that with a large 25% down payment, low-fixed rate financing, and a culture shift in renting as a lifestyle, my downside is covered. In fact, it’s very reasonable that in a recession, those who over bought in housing, may downsize and move into the types of projects I’m investing in, which are typically value-add multifamily assets in growing metros.

But in order to test this out, we need to look at historical data. These conclusions may be generally true and enough to assemble a basis of investing doctrine, but we need to look at data to see if it corroborates or not.

It seems to me that if I want to understand the performance of multifamily assets during the Great Recession, then I should look at default rates. I did some research on multifamily default rates during the period from 2007-2009 and here is what I found:

It’s clear there was quite a bit of default risk in the single-family residential sector, but not much risk in multifamily. A default in a multifamily investment would mean near or total destruction of the invested capital. I think what this tells us is that this type of loss was extremely rare, but it was also rare to lose everything on a mutual fund during the crisis. Multifamily assets may not have defaulted at a high rate, but there could be any number of things that could seriously dent returns. Prepayment penalties, high vacancies, and generally poorly managed assets could cause any multifamily asset to perform terribly. Also, if rent rates were underwritten to increase over the hold period, but stagnated, this means that investors didn’t get much profit on the sale. Certainly there are risks in multifamily investing. But it seems to me that the greater risk isn’t capital destruction, but capital underperformance. In the case of the stock market, we see the potential for awesome capital destruction.

The stock market seems priced to perfection and ready to fall. Historically, however, one can make a strong argument that the long-term risk is quite low. If you invested beginning in the 80’s your average return still looks pretty good. But on a 5-year or 7-year basis, which is the time horizon I’m most interested in right now, the risk picture isn’t attractive.

Multifamily Assets can be quite risky in this climate also. Apartments that are purchased at compressed cap rates (net operating income divided by price) with very little value add component or none at all are the riskiest. I wouldn’t be buying an expensive deal right now that doesn’t have a clear-cut and obvious value add component. Many projects are being advertised as value-add, but have very little value left to add. This is a dangerous time to be playing with a thin delta there.

In conclusion, I’m sticking with multifamily apartments. Ha! Yes, I am biased and I know you saw that coming. But based on the data and my personal experience (yes, that does factor in at some point and is valid), I’m convinced real estate is less risky. I won’t say it’s without risk, but done a certain way, I believe the risk can be significantly minimized.