Your Economics 101 Class in Multifamily Investing

Economics has many real-world applications, and one of the fundamental concepts of this science is the relationship between supply and demand. The basic premise is that as supply for a good is reduced, the demand, and ultimately the price a customer is willing to pay, increases for that good. The objective of this post is to provide you with a basic understanding of this principle’s relevance to multifamily investing, particularly in respect to the inventory of available units in the market and the demand for those units from prospective tenants.

The relationship between supply and demand is intuitive, but let’s use two examples to drive the subject matter home:

 

Example 1

 

In an isolated market, if you have 10 people that each desire 1 widget, and the total supply of widgets in the market is 20, then there are more than enough widgets for each person to get the 1 widget they desire.

There is no excess demand to drive price.

 

Example 2 

 

Now, say you have the same 10 people that each desire 1 widget, but there is only 1 widget in the market (instead of 20). The demand (10 people wanting 1 widget) greatly exceeds the supply (1 widget), and competition is created. This widget is the same as the 20 in the first example but commands a higher price in this market because there are not enough widgets for everyone.

Demand exceeds supply which drives price.

In a market of supply and demand there is an optimal price to maximize the seller’s profitability, which is referred to as the equilibrium price. This is the inflection point where the supply and demand curves intersect.

If the price of a good is set below the equilibrium price, all the seller’s products may be sold, but at the sacrifice of a lower profit margin. Conversely, if the price of the good is set too high, the seller may be left with excess inventory, and resultantly lower revenue.

 

Application to Multifamily Investing

 

It’s difficult to think of multifamily units as a product because tenants aren’t paying for the physical unit, but the right to live in it, but it is a tangible good. Tenants exchange money for housing, and while a portion of the rent is allocated to other aspects and features such as security, amenities, repairs, and utilities, these make up a small portion of the overall rent relative to the primary use of the unit.

Demand is the price prospective tenants are willing to pay in exchange for a housing unit.

Supply includes all available multifamily units of a similar asset class in that market.

There are distinguishing factors which categorize multifamily properties into each of the asset classes (A, B, and C). This is important to ensure that we are making a fair comparison between units of competing properties. While class C properties occasionally compete with B properties, and B properties occasionally compete with A properties, very rarely do C properties compete with A properties for prospective tenants.

In a previous article I discussed the features of each of the multifamily asset classes in greater depth.

Stabilization

 

The process of increasing occupancy, maximizing revenues, streamlining expenses, and creating operational efficiencies is referred to as stabilization. One of the primary objectives in achieving stabilization is to attain and maintain the equilibrium rental rates for each of the unit types on the property.

If we set prices too low, the property will be full, but our margin spread will be thin, and if we set the prices too high, we’ll have too many vacant units on the property, lowering revenue overall. Getting the formula right requires market research. We need to be informed of the current occupancy for all competing properties in the market, and then use this information to make a strong assessment of the equilibrium price points for each of our units.

The reason we price unit types separately is to account for differentiating factors, because unlike our widget example, these units aren’t all the same. Number of bedrooms, unit sizes, and interior finishes are just some of the factors that will require price adjustments when comparing our product to the market supply.  

Aside: Learning the price adjustments for each differentiating factor in a market guides us in making strategic investment decisions, allowing us to make improvements that generate the highest ROI for our investors. We discuss this in greater detail in this article.

While we strive to achieve stabilization, the work is never really completed because the market is constantly changing. It’s by monitoring these changes and consistently making improvements that we maximize profits over the life of the investment.

If you’d like to learn more about how you can make your first multifamily investment, you may schedule a call with one of our team members here.