In my opinion, comparing the investment benefits derived from buying scattered single family homes and condominium units, versus multifamily rental properties is a no brainier. Purchasing single rental units is not the better option.
Sure, learning how to become a rental house investor is easier to grasp than owning multifamily income producing properties. And, in most instances, buying multifamily real estate requires deeper pockets.
But if you’ve been a homeowner, or even rented a house or condominium unit to live in, it’s no sweat learning how to buy and rent out few. But perfecting your real estate management skills, controlling operating expenses and constantly squeezing out profits is much more difficult for the neophyte.
For the purpose of our discussion, let’s compare buying single-family rental houses to purchasing a small apartment property with four units.
I’ve chosen four units because the same single-family financing programs are available to purchase two to four-unit residential properties. What’s more, if you live in one of the units, the down payment is lower. And notably, conforming conventional and government programs are available from traditional mortgage banks. Equally as important for novice real estate investors, owning a small multifamily investment is an excellent way to get the experience needed to own larger properties in the future.
You will pay less per unit for a multifamily property than for a comparable house commanding similar rent. In part it’s because you’re competing with purchasers who buy homes to live in and their emotions drive prices higher. Paying more for an investment property puts you at an immediate disadvantage. It reduces your cash flow and adversely impacts your profit when you sell.
Emotional homeowners are likely to quickly sell at lower prices for non-economic reasons such as divorce, job transfers or a growing family needing more space. By comparison, investors want to sell for economic reasons and try to time their exit during market highs for the most profit. But competing by with emotional homeowners, you are more likely to pay too much when you buy and sell too low.
When you invest in scattered houses, the operating expenses are higher and management is more intense than it would be for a multifamily rental property with all the units on one site. That’s why management companies charge more for scattered houses. It is difficult to monitor for unruly parties, pet damage and illegal activities such as making and selling methamphetamines.
You’ve likely heard about rules of thumb to buy investment properties. But rules of thumb have no relevance for professional real estate investors to set the purchase price. Instead, they run the numbers on each property.
Their due diligence is performed before considering the effect of making mortgage payments. The reason is that comparing properties free and clear of debt is more accurate than adjusting for different mortgage amounts and payments on each property.
Even if the target property is currently rented, it is important to check out market rents for similar properties in the neighborhood. Also determine market vacancy rates and learn how much it typically costs to paint and make repairs after an existing tenant vacates. Subtract the market vacancy and tenant turnover cost from scheduled rents to get the gross effective income.
Next you need to estimate the fixed and variable operating expenses. For fixed expenses, get a copy of the seller’s hazard insurance policy to learn the premium, a property tax bill and the last 12-months utilities from the utility companies. Check with management companies to learn how much third-party management will cost.
Variable expenses are more difficult to estimate. Start with the property’s financial statements. Match the largest expense items to actual invoices. You can also compare the expenses to data collected by trade associations such as the National Apartment Association and the Institute for Real Estate Management. Consider your cost to eventually replace items such as roofs, heating and air conditioning units and worn out paving.
Subtract the operating expenses and annual replacement cost allocations from gross effective income to arrive at net operating income. Use it, not rules of thumb, to compare your target to other properties.
The net operating income minus your mortgage payments is what you have left over to spend. If it’s negative, your target property may be a bad investment. Keep on looking for a better one using the due diligence process that we discussed.
