By Tom K. Wilson
One of the most common questions I get is: Which are better investments, multifamily properties (apartments) or single-family homes? My answer is, both, but not multifamily without experienced or qualified and experienced partners.
A multifamily property is defined as 5 units or greater, and single-family homes, duplexes, triplexes, and four-plexes are referred to as “1-4s”. For someone with a goal of building a medium to large real estate portfolio, I generally recommend considering the inclusion of a commercial or multifamily property with one caveat: Don’t start by yourself and don’t put all of your real estate working capital into one large investment.
After purchasing and selling over 2,000 units and 12 multifamily properties over 37 years, my experience is that the best investment property I ever owned was a multifamily property and the worst investment property I ever owned was a multifamily property. These properties have ranged from 10 units for $400K to 176 units for $10M.
Multifamily properties offer higher potential reward along with higher risks. On the surface, an apartment building seems to be nothing more than many units, like single-family detached homes, but in one address, however, their proper management is a specialty. There are many more variables and expenses than in 1-4s including utilities, landscaping, contract maintenance, on-site maintenance, office management, tenant profile, advertising, lender and government inspections, requirements, and more.
So why are the largest investors attracted to them? For one factor, the rent ratios are usually higher and, therefore, the potential Net Operating Income (NOI) and the cash-on-cash return can be higher. In the multifamily world, rent ratios are represented as the GRM (gross rent multiplier): The property price divided by the annual gross income, the lower the better.
There is also generally an efficiency of scale for maintenance and other expenses, and with good management, expenses are easier and more efficient to control. The advantage of scale best manifests itself when the monthly income is great enough to afford full-time, on-site management and maintenance. For non-high end metro areas this is usually about a $2.5M property or higher. With a typical 60-70% loan this is a stiff barrier to entry that may best be solved by partnering with other experienced investors.
And then there is the issue of the loan. In these post crash years, getting a government- backed loan such as from Fannie Mae is virtually impossible in today’s tight money market without current or significant past multifamily ownership experience. Regional banks and private lenders may sometimes provide loans at the cost of higher rates, shorter terms and amortization, and lower LTVs. For investors who are “tapped out” at 10 loans for 1-4 residential properties and can’t get more loans because of Fannie Mae loan quantity restrictions, a multifamily purchase has the advantage of not being forbidden just because you have 10 or more loans on 1-4s.
For an investor who would like to own a multifamily product, but who does not have the experience or local residency that the lender wants, one can work with a syndicator who can connect you with an investor or investors who can qualify for the loan, reduce your risk and exposure, provide the expertise needed to evaluate a deal, and to manage the property for maximum return on investment.
Many investors are drawn to small multifamily “Tweeners” (5-50 units) because it is a lower entry price. However, the problems include:
- Loans are generally more difficult to obtain
- Loan terms are not as good
- Price per unit is higher
- Banks prefer local borrowers
- Properties are generally older
- The economics cannot justify full-time, on site management and maintenance
And, it is usually difficult to manage effectively. Stories of offsite management showing up after a week or two at small multifams only to discover that drug dealers have run off decent tenants are common stories. Also, a single vacancy in a small mulitfam has a greater percentage impact on cash flow than in a larger investment. Again, one valuable way to mitigate these factors is to purchase a larger product with partners through syndication.
Due diligence is much more critical than with single-family rentals but there are also more resources available to get a lot of the general information because there are a lot of marketing firms that support the REIT and institutional investors who mostly purchase large multifamily and commercial properties.
A multifamily seller’s proforma (projections of the potential income and expenses in a perfect world) should for the most part be disregarded. True expenses are seldom less than 50-60% of gross income, otherwise be suspect. And study local demographics carefully. Visit the prospective property unannounced, walk it, and then sit in your vehicle to observe who is living on and visiting the property. Take note of the time of day and night. Yes, evening observations are the most enlightening. Go to the local schools, parks, and retail stores and see whom your prospective tenants and demographics are.
Do you feel at risk parked so near your potential property, or would you feel comfortable joining the tenants for a barbeque? Please do not rely on website data about the neighborhood. There are a lot of variances in a one-mile radius. Lastly, my post data analysis is always punctuated with the satellite view question: Would I be comfortable with my daughter living here?
In addition to syndications an alternate way to have many of the benefits of a multifam with less money down, an achievable loan, and much less risk is with a portfolio of single-family properties. Throughout my investment career, I have always also owned many 1-4s.
This approach spreads your risks by building a “mutual fund” of properties in various locations. In addition to having a variation of rent, price appreciations, and occupancies that tend to converge on the averages for a region, single-family homes are more liquid, have less expenses, are less complex to manage, and tend to appreciate more because they are based on owner occupant demand rather than on income. In the next decade, most economists project a higher upward trend in occupancies and rent for single-family homes and for multifams.
The most important ingredient is to select that right team of professional resources. How much experience and knowledge do they have in the region and product of interest? Are they invested in the products themselves? If you are considering partnering to own multifamily properties, do they have experience with syndications and access to experienced and qualified investors, lenders and property management?
When you invest in real estate, don’t start with the “deal.” An honest assessment of the amount you have available to invest, your risk tolerance, your experience, and your long-term goals, along with the right professional team, will lead you to the right deal or deals: A multifamily investment or a portfolio of cash-flowing single-family properties? I choose both.
Tom Wilson is a 37-year real estate veteran who has executed over $100M and 2000 units of real estate investments. Wilson is also a weekly host of the Real Estate 360 Radio program on KDOW 1220 am every Wednesday at 2 pm. Listen to his podcasts on iTunes or his website: www.tomwilsonproperties.com